REITs, short for real estate investment trusts, offer some of the richest dividends on the market today. These unique stocks make their money by investing in real estate. Many own land or buildings directly and make their money by renting out this available space. Meanwhile, others hold real estate related assets such as mortgage-backed securities.

Fat Yields
Some REITs may yield 10% or better, but most average 6% to 7%. That’s three times more than the average 2% yield sported by the 374 dividend-paying stocks in the S&P 500.

What’s behind the big payouts? Simply, REITs are legally required to pay out 90% of their taxable income as dividends. In return, REITs can deduct these payouts from their reported income for tax purposes. As such, most REITs pay little to no taxes.

One hitch is that since REITs don’t pay income tax, their dividends are mostly taxed as ordinary income, up to 38.6%. Unlike other stocks, REITs don’t qualify for the new 15% dividend tax rate. Even after the higher tax rate, though, REIT dividends will put more cash in your pocket than most other stocks. In addition, you can defer taxes by stashing your REITs in a tax-advantaged IRA or avoid taxes altogether by placing them in a Roth IRA.

Another potential downside to REITs is that because of their hefty dividend payouts, these firms are only able to reinvest a maximum of 10% of annual profits back into their businesses. As a result, REITs typically grow earnings at a slower-than-average pace. In many cases, this translates into slower dividend growth. Compared to the 7% five-year dividend growth rate shown by S&P 500 stocks, REIT dividends have grown less than 2% over the same time. The good news is that there are exceptions to this general rule, as you’ll see in the REITs we profile below!

And looking at the broader picture, slow dividend growth certainly hasn’t kept REITs from running up stunning returns. In the bear market of the last three years, the benchmark Morgan Stanley REIT Index gained +103% compared to the S&P 500, which lost -24%. As the market recovered in 2003, the S&P 500 gained +26%, but REITs still outpaced the market with nearly +37% returns.

Interest Rate Jitters
REITs continued their run-up in the first quarter of 2004, rallying +12% and easily topping the market’s paltry +1% gains. However, fears of rising interest rates have weighed heavily on this sector ever since. In fact, the average REIT has lost over -10% of its value since April. That compares unfavorably to the market’s +1% recovery.

The problem is that when interest rates rise, real estate investors often head for the hills. Since most REITs borrow heavily in order to fund new real estate purchases, the fear is that the industry's bottom line may be hard hit by higher debt-servicing costs. Another fear is that rising rates will make low-risk bonds more attractive than dividend-paying stocks such as REITs. Expecting REITs to decline as rates rise, investors have dumped these stocks ahead of the anticipated round of continued Fed rate hikes in the coming months.

Our belief is that savvy investors should view the recent pullback as a selective buying opportunity. Yet with nearly 200 publicly traded REITs on the U.S. market, it's often hard to separate the wheat from the chaff. With that in mind, in this month's issue my staff and I set out to help you identify a number of REITs that now look attractive.

Yields To Trounce Interest Rates
After carefully sifting through hundreds of companies, we recently uncovered a handful of REIT investment ideas that we believe are well positioned to thrive in a rising interest rate environment. All are relatively insulated from higher interest rates and all should benefit from an improving economy going forward. Thanks to their solid performance and stellar long-term prospects, each of the companies we identify below offers a safe dividend and a good deal of capital appreciation potential.

One of our picks sports above-average dividend growth that should easily outpace a measured rise in interest rates. Neighborhood shopping center owner Kimco (KIM, $46.25) has grown its dividend a dramatic 10% a year for the past five years. The stock has increased its dividends three times faster than its peers and over six times faster than the overall market. 

Also attractive is hotel owner Hospitality Properties Trust (HPT, $42.50). The firm's five-year average dividend yield of 7% to 10% gives it a leg up on lower-risk fixed-income investments. 

As shown below, both REITs have delivered market-beating returns throughout the past 12 months. The chart below shows the one-year performance of Hospitality Properties Trust (HPT) and Kimco Realty (KIM) against the S&P 500 (GSPC).

Property Type
Both REITs hold property portfolios that are well suited for an expanding economy. Hospitality’s hotels should benefit from an expected rebound in business spending and travel. Meanwhile, a portfolio of neighborhood shopping centers such as Kimco’s should deliver steady earnings growth throughout nearly every economic cycle.

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REIT ETFs
In addition to owning individual stocks, a quick way to profit from the industry’s high returns is to buy an entire index of REITs. With REIT ETFs, you can hold a cross-section of property types in one simple security.

ETFs, aka exchange-traded funds, pay dividends and capital gains that mirror the returns of the index or group of securities they track. Think of ETFs as a cross between stocks and mutual funds. Like stocks, ETFs trade on major exchanges such as the American Stock Exchange (AMEX). Like index funds, they represent an interest in a basket of underlying securities. As managed funds, ETFs do charge a management fee. However, since they are not actively managed, these fees tend to be fairly minimal. Since they trade in the open market just like stocks, you'll need to pay a transaction fee to purchase an ETF. But again, these small fees tend to be fairly insignificant for the long-term investor. 

Together with the capital gains potential, REIT ETFs pay attractive quarterly dividends just like the REITs they track. These payments are derived from dividends received from the REITs they hold, as well as capital gains earned from these holdings. The capital gains portion is taxed at the reduced long-term capital gains rate of 15% (if held for more than a year).

Although only a handful of REIT ETFs are available, two particular funds provide superior long-term growth and income potential...

Important Note: To view the remainder of this article, which includes an analysis of our favorite REITs and REIT ETFs, you'll need to read the July 2004 issue of our premium High-Yield Investing newsletter.  If you haven't already subscribed to this newsletter, please visit this link to gain immediate access to this premium content.

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