REIT Report

If you listen to most pundits, you would think housing is on its way back.

But we don't listen to people. We do our own research and make up our own minds.

And what we've found is that this housing rally is a double-edged sword. But if you're smart you take advantage of its potential while eliminating much of its real risks.

The one edge: A more active market is undoubtedly good for the economy, since it leaves less money trapped in houses people no longer want. But rising prices have their adverse effects too, which we'll get to below.

The other edge: There are still some excellent opportunities in the real estate sector through real estate investment trusts (REITs), but you need to be very selective (also below).

That's because some REITs have yields in the teens and even over 20%. But those investments are pure traps. For investors wanting to find the best REIT you need to keep in mind one thing- it's all about location.

Before we show you where the best REIT is located, we'll cover which REITs to avoid.

Navigating the REIT Minefield

REITs came into existence because of President Dwight Eisenhower's "Cigar Tax Excise Tax Extension" of 1960. Under this initially obscure tax provision, REITs can avoid corporate income tax, provided they invest in real estate-related assets and pay out at least 90% of their income in dividends to investors.

Mortgage REITs, as their name suggests, invest in residential and commercial mortgages.

Up until Bernanke spooked markets last year by announcing QE could end sooner than anyone thought, residential mortgage REITs had been dividend darlings, paying yields around 15%.

However, for an entire sector that has built its business model on sand, we draw your attention to the residential mortgage REITs such as Annaly Capital (NYSE: NLY) and American Capital Agency (Nasdaq: AGNC).

There are also smaller competitors, such as Chimera Investment (NYSE: CIM) in the same business, but NLY and AGNC are the two biggies.

Annaly and American Capital offer tantalizing yields of 11.7% and 12.9%, but are particularly dangerous stocks in a rising interest rate environment.

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NLY and AGNC are very substantial companies, with market capitalizations of $11 billion and $9 billion respectively. Nevertheless, they make money by buying mortgage-backed securities and leveraging them through repurchase agreements (effectively borrowing in the short-term market).

As of their last balance sheet date, NLY had assets of 9 times capital and AGNC almost 10 times capital.

With interest rates at all-time lows the past few years, this was a very good business to be in. The gap between repo rates and mortgage rates was some 2.5%, so if you leverage that 9 times you get a return of 22.5% before expenses. That allowed NLY and AGNC to be able to pay such high dividends

The problem comes when interest rates rise and the rate structure flattens out, equalizing short-term and long-term rates. At that point, the spread between short-term and long-term rates will disappear, reducing the return on NLY and AGNC to just the mortgage rate, perhaps 5% before expenses.

And it has already started.

At the end of April 2013 the rate on 10-year bonds sat around 1.6%. Now that rate has touched 3% and will continue to rise. That caused AGNC to lose 35% last year and NLY dropped over 30%.

Further, the value of the mortgage bonds themselves will decline, and it won't take much of a rate rise to wipe out the companies' capital value when they are leveraged 9 or 10 to 1.

That leaves the risk that they won't be able to carry out the tens of billions of short-term "repos" they need to finance themselves. Regulators worry about money market funds, but the financing risk on these two REITs is many times greater.

Of course, the companies claim they hedge themselves by very sophisticated strategies in the swaps and options markets, but the reality is these risks can't be hedged away, except by dumb luck on timing. And a 2% rise in long-term interest rates from here could make them insolvent.

This makes them entirely dependent on the Fed.

But that's not the case for all REITs...

Big REIT Opportunities in Housing Recovery & Healthcare

For the Best REITs, look to still undervalued properties, as well as the booming healthcare industry.

The latest figures show New York State's average home sales price is $329,000 and California's $299,000, while Nevada's is $138,000 and Indiana's $130,000.

Of course, there are network advantages to locating your business in or near a major city such as New York or a tech hub such as Silicon Valley. Still, at some point the real estate cost differential outweighs these advantages, especially for businesses for which such network effects are not crucial.

Indiana's cheap real estate prices (and other cost savings, such as its relatively new right-to-work law and lower state income taxes) make it a very tempting alternative for businesses not subject to major network effects.

Even bankrupt Detroit, if it is able to provide adequate policing, decent government and keep property and other taxes down, may find recovery is remarkably quick because of its immense advantage of extremely cheap housing.

For investors in real estate, whether directly or through real estate investment trusts, the message is clear.

Ultra-low interest rates have given an artificial advantage to regions with very high real estate prices, while artificially depressing rents. The wise investor will thus buy property or REITS in areas of the U.S. where prices are low - Indiana is a fine example.

In those areas, rental yields will generally be better.

A rise in interest rates, which will suppress house prices in high-cost areas such as California and the New York, Boston and Washington suburbs, will increase Indiana's relative cost advantage, as the annual savings from its lower house prices will increase.

Our favorite Indiana-based REIT is Duke Realty Corporation (NYSE:DRE) which specializes in a varied mix of office, industrial and commercial properties.

The operating costs of their head office staff will be relatively low and the growth prospects for their Indiana properties relatively good.

Duke currently offers a 4.53% yield and has been publicly traded since 1993. Besides its Indiana-based properties, Duke has expanded into growing markets such as Houston and Phoenix, as well as in key port locations such as Savannah, Baltimore and Norfolk.

Duke's portfolio currently exceeds 145 million square feet with properties in 18 major markets nationwide.

To complement its office, industrial, and commercial properties, in 2007 Duke acquired an experienced medical office developer and began offering healthcare properties. Its healthcare team is focused on the planning, development, ownership and management of healthcare facilities, ranging from small medical office buildings to facilities with diagnostics, oncology centers and surgery centers.

Speaking of healthcare....

By far the best healthcare REIT to own is Sabra Health Care (Nasdaq: SBRA).

Sabra Health Care is a self-administered, self-managed REIT headquartered in Irvine, CA currently yielding 5.25%. Through its subsidiaries, Sabra owns and invests in real estate for the healthcare industry.

The business strategy is simple: "opportunistic acquisition and property diversification." That means the company has flexible acquisition goals; it only pursues properties that are attractively priced.

Sabra operates through an umbrella partnership (commonly referred to as an UPREIT). The company primarily generates its revenue by leasing, at present, 119 properties to tenants and operators (including its own subsidiaries engaged in joint venture arrangements).

Sabra has a total of 12,232 beds and counting - mostly in skilled nursing facilities - spread across 27 states.

Its properties include skilled and assisted living and independent living centers, mental health and memory care facilities, continuing care retirement communities, and a rapidly growing number of senior housing facilities.

Sabra owns 100% of the real estate in its portfolio and earns a lot of its fat revenues from triple-net leases, like the one they just inked with First Phoenix Group that throws them 8% net.

It finances its real estate purchases through secured revolving lines of credit, as well as by issuing notes and other debt instruments to mostly institutional buyers and other REITs.

As Baby Boomers enter their golden years, expect Sabra to benefit immensely. That will be especially true if Obamacare remains intact, which lessens budget pressures on medical care facilities.

What's more, Sabra expects earnings to more than double in 2014 from last year. With numbers like that investors should expect significant returns.

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