Real estate investment trusts have been just the ticket for investors looking to boost their portfolios' income. With more traditional income-producing investments having seen their rates fall to historically low levels, investors have had to get creative in order to find the cash flow they need, and REITs have been one of the big beneficiaries of that trend.
But one potential downside that many REITs have is that they take on relatively high levels of leverage. That can pay off with extra yield during periods like now, in which low short-term rates and freely available credit combine to reward companies that borrow in search of higher returns. But leverage leaves investors open to interest rate and credit risk, and so if you're looking to tone down your risk, you may want to look for REITs that aren't as aggressive about borrowing.
Below, I'll reveal some REITs that fit the bill. But first, let's look at why investors have been willing to take on risk with their REIT holdings.
Bring on the leverage
One of the classic ways to make money is to borrow short and lend long. When the yield curve has a "normal" shape, with short-term rates low and longer-term rates higher, it gives companies a big incentive to take on debt and reinvest the proceeds into higher-yielding, long-term securities.
That's the strategy that most mortgage REITs have used to produce double-digit yields. In particular, Annaly Capital (NYS: NLY) and American Capital Agency (NAS: ACAS) are able to obtain high amounts of leverage because they invest in relatively liquid agency-backed mortgage securities. In fact, earlier this year, ARMOUR Residential (NYS: ARR) achieved leverage ratios of more than 11 times assets through judicious use of borrowing. Even mortgage REITs that don't invest in liquid securities and therefore can't lever up as much still manage to borrow to some extent; Chimera Investment (NYS: CIM) , which owns substantial amounts of non-agency mortgage securities, had leverage of about three times assets earlier this year.
Mortgage REITs are clearly on the extreme end of the leverage spectrum. But even most regular REITs use leverage to some extent. That introduces risks that some REIT investors may not fully understand -- and that others simply may not want to take on.
By contrast, if you want a real estate investment to generate income without a huge amount of leverage, then you have to look in different places than the highest-yielding parts of the REIT market. In fact, as a recent Bloomberg study found, self-storage REITs offer the best risk-adjusted gains over the past 10 years.
Most of you are probably familiar with the services these storage REITs provide. With Public Storage (NYS: PSA) and its peers, you can rent storage lockers by the month or year. Management costs are minimal, and demand can be extremely strong, especially in certain areas.
For the most part, storage facilities require relatively little capital investment. Once you obtain land, putting up low-cost warehouses involves only a fraction of the cost that an office building or apartment complex would entail. That allows storage REITs to avoid the leverage that their peers require.
What you can't expect from storage REITs are high yields. Most storage REITs, including Public Storage, CubeSmart, and Sovran Self Storage, pay dividends in the 2.5%-3.5% range. But price appreciation has added a lot to their total return as investors come to appreciate the simplicity and stability that storage REITs give them.
Sexy double-digit dividend yields have become synonymous with REITs in the minds of many investors. But high-yielding mortgage REITs aren't for everyone. By opening your eyes to a lower-yielding and often-neglected area of the REIT market, you can reduce the risk in your portfolio and potentially earn better returns in the process.
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At the time thisarticle was published Fool contributor Dan Caplinger has been leery of real estate but finds REITs easier to swallow. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is well grounded.