You Can Thank My Daughter — and Maybe Your Kids, too — for the Big Yields in This Surging Sector

After this weekend, my nest will be empty.

In fact, right about the time you read this article, I’ll be loading the car in preparation for a 33-hour drive to Nashville, Tenn. That’s where my remaining homebound daughter, 25, will be striking out on her own.

There’s nothing particularly unusual about a grown child leaving home, of course. After all, it’s a scene that plays out hundreds, if not thousands of time a day across the United States.#-ad_banner-#

But that’s the point…

In recent years, an increasing number of debt-laden and job-challenged 20- and 30-somethings (including my daughter) had little choice but to move back home with mom and dad. Only 11% of 25- to 34-year-olds lived with their parents in 1980, according to Pew Research. By 2000, that number increased to 15.8%, and by 2010 the percentage was up to 21.6%.

These days, however, there’s evidence to suggest the tide is turning — a demographic shift that could provide economic relief for baby boomer parents and opportunities for investors.

Thanks to a gradually strengthening U.S. economy, many young adults (including my daughter) are finally making their move — from their parents’ basement to their first apartment rentals. To help meet the anticipated growing demand for rentals, revenue from apartment and condominium construction will grow an average 10.6% annually to more than $44.9 billion by 2017, according to research firm IBISWorld.

“As this group’s members increasingly move out of mom and dad’s or out of the dorms, their share of demand for apartments will grow, pushing up overall demand for rental properties,” IBISWorld says.

When my daughter — and her growing legion of cohorts — moves into her first apartment, she’ll have created a “household.” In real estate parlance, a new household is formed when a couple marries or a child leaves home.

Until recently, household formation hovered at historically low levels. But that’s changing in a big way.   

During 2008 to 2011, as economic circumstances caused many young adults and others to retrench, an average of 650,000 new households formed per year. In the 12-months ended last September, formation soared to nearly 1.2 million households — most of them of the multifamily variety — as the economy showed signs of improvement.

And there’s still room to run, particularly on the rental front.

In an article about the apartment boom, The New York Times last December said there were still some two million doubled-up households “waiting for the opportunity to split in two.” Jeffrey Friedman, the CEO of Associated Estates Realty (NYSE: AEC), a real estate investment trust (REIT), wrote in his company’s annual report that nearly 70% of 5.5 million new households between 2012 and 2016 will be renters.

No wonder High-Yield Investing‘s Carla Pasternak dubs this era “Renter Nation.”

In her February issue, Carla assesses investment opportunities in the multifamily sector — all with a focus on income, of course — including a look at REITs in general and the aforementioned Associated Estates Realty in particular.

Note: Several REITs made Carla’s list of “Ten Retirement Savings Stocks That Can Give You the Second Income You’re Looking For.” Some of these stocks pay quarterly. Others pay monthly. All offer you a safe, stable, and reliable source of high income even if the market goes down. To learn more, click here for an audio presentation or click here for the text version. And if you already subscribe to High-Yield Investing, you can access Carla’s report directly by following this link.

In the following interview, Carla explains REITS and names her favorite apartment play right now, a growing small-cap that’s currently yielding 4.4%.

Bob: Let’s start with the basics. Explain REITS.

Carla: REITs (pronounced “reets”), 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.

Some REITs may yield 10% or better, but most average 5% to 6%. That’s more than double the average 2.5% yield sported by the 407 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 39.6%. Unlike other stocks, REITs don’t qualify for the 15% or 20% “qualified” dividend tax rate. Even after the higher tax rate, though, REIT dividends will put more cash in your pocket than most other investments. 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.

Bob: What’s your top apartment REIT right now?

Associated Estates Realty, which you referenced above, is a relatively conservative play on the multifamily housing recovery. Currently, AEC owns 52 multifamily properties with a total of 13,950 units in 10 states. In the past several years, it expanded to higher-growth markets such as the Washington, D.C. metro area, southeast Florida, and Dallas.

Management focuses on the millennial generation, as it believes renting is a preferred and in some cases permanent lifestyle for some in the 21-34 year age group. In one new apartment complex, for instance, it added such high-end features such as granite countertops, stainless steel appliances, deluxe cabinets and nine- to 11-foot high ceilings to attract and retain these clients.

For the first nine months of 2012, AEC had adjusted funds from operations (AFFO) of 93 cents a share and distributed 53 cents, for a sustainable payout ratio of 57%. In the comparable period of 2011, an AFFO payout ratio of 66% still resulted in distribution hikes, so further increases are possible.

AEC provides a solid yield of 4.4% and is projected to have double-digit FFO growth. The payout ratio is low and allows for further distribution growth. The shares are suitable if you’re seeking a relatively conservative play on the multifamily housing recovery.

Bob: Will dividend payers continue to outperform in 2013?

Carla: If history is any guide, then dividend payers will outperform non-payers over the long-term. Numerous studies show that dividends account for more than half the returns of the S&P 500 over the decades. For example, according to a recent report by Henderson Global Investors, during the past seven decades, from the 1940s through 2010, dividend payers contributed 52.7%, or more than half, of the total returns of the S&P 500.

The study also found that high-yielding equities historically outperformed lower-yielding equities. A look at the average 12-month relative returns among the top 1,500 performing stocks during the period from 1978-2011 shows that the best performing stocks, when ranked by dividend yield, are those in the first quartile, with above-average yields.

In 2011, 100% of the stock market’s returns were from dividend-paying stocks, and last year dividends accounted for about half of total returns. But even more important than these stats to individual investors like you and me is that dividends provide you with income you can pocket today, not just the promise of capital gains tomorrow.

Bob: Aside from REITS, what types of dividend payers are piquing your interest right now?

Carla: As readers of High-Yield Investing know, I’ve been favoring plays on the housing recovery, whether these are real estate investment trusts like AEC or common shares like Home Loan Servicing Solutions (Nasdaq: HLSS), which have surged a dramatic 35% since being profiled as my “High-Yield Security of the Month” in the November 2012 issue. In addition to the housing recovery, today’s low interest rate and recovering economic environment is providing a perfect backdrop for mergers and acquisitions. The recently announced privatizations of Dell and Heinz are just two of the more prominent examples of what’s happening. And there’s one sector in particular that’s benefiting from these deals that I’ll be taking a look at in the upcoming issue of High-Yield Investing. It’s private equity firms, many of which are organized as limited partnerships or business development companies (BDCs). I’ll save the specifics for subscribers, but I have chosen two top picks with yields of up to 9% that I think are poised to benefit from Goldilocks conditions right now.

Further Reading:
  “Renter Nation: The Incredible Housing Story Nobody Is Talking About

  Special Report for Income Investors: Former Military Intelligence Analyst Uncovers Instant Income Glitch in the Financial Markets.

I promised my daughter we won’t sublet her room (“just in case”), tempting as that may be given the current surge in demand for rentals. But I’m interested to know if there’s anecdotal evidence to build on here…

Do you have a child who recently moved to an apartment for the first time, or is about to? Write us at Conversely, if you’re a 20- or 30-something who’s formed a new household of your own during the past year, tell me your story.

Action to Take –> But if all you want to do right now is learn about investments that can hand you a “second income” as much as 14 times what you can get with CDs, seven times higher than bonds, and as much as three times higher than brand-name Dow stocks, then simply follow this link.