Forget bonds, buy REITs – US Today News

Tadamichi

Co-produced by Austin Rogers,

Real Estate Investment Trusts (VNQ, “REITs”) are often viewed as “bond alternatives” due to their relatively high dividend yields. REITs are required to pay out at least 90% of their taxable income (not equal to their cash flow) as dividends, making them a preferred investment for passive income seekers.

In the 2010s and early 2020s, interest rates, and therefore bond yields, were in the low to mid-single digits, making them increasingly unattractive to income investors. Hence the growing popularity of REITs as alternative sources of income.

But there is much more to REITs than just their dividend yield. They own real, scarce assets that can increase in value over time and generate increasing rental income, providing inflation protection and upside potential. And they have professional management teams whose interests tend to be well aligned with those of shareholders.

Even though investment grade corporate bond yields reach 6-7%, we still think it’s a good idea for long-term income investors to favor REITs over corporate bonds at this time.

Let’s explain why.

Why REITs beat bonds in the long run

There are several key differences between REITs and bonds.

click to enlarge

Bonds are fixed-interest investments. These are debt securities issued by companies or governments that pay a fixed coupon for a set period of time until the maturity date. At maturity, bondholders receive the face value of the bond back in cash.

REITs, on the other hand, are investments. Like any other stock, these are ownership shares in companies. As long as REITs have positive taxable income, they are required to pay a dividend and most REITs pay out 50-90% of their cash flow. Depending on the valuation the market places on the REIT, REITs offer dividend yields ranging from approximately 2.5% at the low end to over 10% at the high end.

For bonds, the returns are very well defined. You receive a fixed coupon and the promise of receiving the face value of the bond at maturity. If you purchase the bond at a price less than its face value, you will receive a return on your investment equal to the difference between your purchase price and the face value.

These are the only two sources of return for bondholders: the fixed-interest coupon and any markup on the face value of your purchase price.

REITs, on the other hand, bring with them all the risks, opportunities and complexities that come with any other investment in a real company. That’s why we insist on investing in REITs with a landlord’s mindset rather than a trading mentality.

Certainly corporate bonds are higher in the capital stack and therefore in the worst case/restructuring scenario, bondholders would be paid out first before shareholders. But unless you invest in high-risk companies, this point usually doesn’t matter.

In the vast majority of cases, with REITs with investment grade credit ratings, both the dividends for shareholders and the coupons for bondholders are safe and reliable.

There are two fundamental reasons why we believe long-term income investors should favor select REITs over bonds:

1. REITs have more potential upside than bonds
2. REITs offer inflation protection through increasing dividends, while bonds only offer fixed coupons.

Let’s address each point.

1. REITs have greater upside potential

Bonds have lower volatility than REITs (or other stocks, for that matter), so it’s not surprising that corporate bonds, as measured below by the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), sold off less than REITs, below as measured by Vanguard Real Estate ETF (VNQ), since the peak in stock prices and the trough in bond yields in early 2022.

Data from YCharts

But REITs have far greater future upside and total return potential than bonds. There are mutliple reasons for this.

First and most obvious, REITs have already been sold off heavily, losing more than a third of their combined market cap since the start of 2022. Their valuations have been reduced as interest rates have risen. However, if interest rates eventually reverse and fall (as they may already have), REIT performance should reverse: outperforming bonds when interest rates fall, just as they outperform bonds when interest rates rise.

Second, remember that REITs are real companies that own real estate. Land is naturally scarce and more is not being made of it. And while developers have a wave of new offerings Building Delivery is scheduled for around next year, but high interest rates have caused construction starts to fall sharply this year. This should lead to a balance between supply and demand in 2025 and beyond, which will significantly benefit landlords.

Thirdly, based on the second point, REITs should benefit from an increase in the value of their assets and growth in rental income in the future, which in turn should be reflected in increasing EBITDA and cash flows.

In short, while bonds actually only have one potential source of upside (falling interest rates), REITs have several.

This is why we see REITs significantly outperform corporate bonds over long periods of time:

Data from YCharts

Keep in mind that corporate bond yields are BBB higher today than when the above chart began in late 2004, and the price of LQD is lower today than it was then. So the sole Source of the total return you see in the table above is coupon income.

When it comes to REITs, however, the price of VNQ has increased by about 50% since the end of 2004, despite trading over 30% below its all-time high. Therefore, the upward trend of REITs is clearly due to both the increase in share price and increasing dividends.

2. REITs provide inflation protection against dividend growth

A common mistake investors make is forgetting to take inflation into account. Nominal returns are a useful shortcut, however real Yields (subtracting inflation from nominal yields) are ultimately what investors, especially income investors, should be concerned about.

Due to the combination of the above factors, particularly tenant demand for space exceeding real estate supply, REITs have a very strong and long track record of increasing rental income, EBITDA and cash flows – or funds from operations (“FFO”). This has allowed them to grow their dividends faster than inflation over time.

On the other hand, bonds only pay fixed interest coupons that do not increase over time, resulting in real The (inflation-adjusted) value of bond income streams decreases over time.

When prices rise, the fixed coupon on a bond you bought many years ago has less purchasing power today than it did when you first bought the bond. This applies whether you purchased the bond with a 3% or 7% yield.

Since the end of the Great Recession in 2009, REIT dividends have outpaced inflation while bond yields have fallen in both nominal and real terms.

Data from YCharts

This applies whether you invested in a bond fund like LQD or individual bonds and rolled them over at maturity.

And by the way, investors who have chosen individual REITs wisely have seen far greater growth in dividend income over time than the VNQ. The chart above shows one reason why we don’t invest in REIT ETFs, but rather choose the best and most opportunistic names.

Take, for example, the dividend growth of three high-quality blue-chip REITs since the Great Recession, all of which significantly outperformed inflation:

Data from YCharts

These three REITs all own different types of properties.

Alexandria Real Estate Equities (ARE) owns Class A life sciences buildings in top research markets across the United States. Mid-America Apartment Communities (MAA) owns apartment communities in fast-growing Sunbelt states. And Realty Income (O) owns a diversified portfolio of high-quality triple-net lease properties in the United States and Western Europe.

Yes, it’s true that we’re picking some of the best players since the global financial crisis. But there are many other REITs with similar dividend growth records. We are merely pointing this out to demonstrate the possibility that a portfolio of intelligently selected REITs can provide generous initial returns And inflation-dampening dividend growth.

We think this is significantly better than bonds seeing this real The value of their coupon revenue declines over time in the face of rising consumer prices.

Bottom line

There is nothing wrong with looking for secure sources of income. We simply believe that selective REITs are generally a better source of passive income than bonds. They offer greater upside potential as well as inflation protection through dividend income.

We think it’s generally prudent for investors to maintain an emergency fund of cash and short-term bonds equal to living expenses between three months and two years or more, depending on age, employment status, health, etc.

But for money that investors won’t need back in the next few years, we think REITs are a far better long-term investment than bonds.

Source : seekingalpha.com