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5 REITs to Grow Your Portfolio

I have written in the past about low-volatility stocks that yield above market dividend rates. Now I want to turn to an entire asset class, real estate investment trusts (REITs).

REITs are companies that invest in real estate and receive special tax treatment.

Provided that a REIT distributes 90 percent of its taxable income to investors, the REIT can avoid taxes at the corporate level, hence removing the double tax quandary that many investors face.

The REIT business has grown tremendously over the last decade. According to the industry group National Association of Real Estate Investment Trusts, the market capitalization of REITs representing 153 companies at the end of 2010 was $389.3 billion.

Be forewarned that REITs do carry many risks that other stocks face, such as the vagaries of the economy, interest rates and financing availability.

It is necessary to introduce a unique metric for REITs: Funds From Operations (FFO), which measures cash generation by the REIT. FFO equals net income plus depreciation plus amortization and less gains on property sales. FFO can then be equalized on a per-share basis.

In order to compare REITs, one can use the ratio of price-per-share to FFO-per-share (P/FFO), sort of a proxy for price-to-earnings ratio for the industry.

REITs can be divided into many different subsectors. It is the purpose of this article to put together a portfolio of REITs across several of those sectors.

American Campus Communities

REIT Subsector: Apartments
Market Cap: $2.7 billion
Dividend Yield: 3.51 percent
P/FFO: 21.6

My wife and I have three children in college or graduate school, with more yet to enroll in the future.

One of the most challenging aspects of going to college is finding housing. Most students live in campus housing their freshman and/or sophomore year. However, the dormitory experience grows old quickly and students seek off-campus housing.

I also know several people who own off-campus residences which they rent out to students. This is a very good business which also tends to be somewhat immune to declining economic conditions.

The same cannot be said for general housing REITs, which tend to focus on apartment buildings and cater to families.

The best pick in this subsector is American Campus Communities, which owns and operates off-campus housing in and around colleges and universities.

American Campus' P/FFO is less than that of the two largest residential REITs, Equity Residential (25.0) and Avalon Bay (28.8).

Furthermore, American Campus' dividend yield is greater than that of Equity Residential (2.23 percent) and Avalon Bay (2.65 percent).

Taken together, American Campus is my top choice in this subsector.

Rayonier

REIT Subsector: Diversified
Market Cap: $5.0 billion
Dividend Yield: 3.92 percent
P/E: 20.7

The diversified subsector is kind of a catch-all for everything does not fit elsewhere in the REIT kingdom. However, a large part of this subsector is the forestry and timber companies.

Unlike most other REITs, the concept of FFO is less important (but not irrelevant) for forestry and timber companies and we can rely at least in part on the more conventional concept of P/E ratios for analytic comparisons.

There are three major forestry and timber REITs to choose from: Plum Creek Timber , Rayonier and Weyerhaeuser .

Immediately I would knock Weyerhaeuser out of contention in this category. The stock has acted poorly over many years and the dividend is less than its peers.

That leaves us with Plum Creek Timber and Rayonier.

I have followed these two companies for a while and can say that Rayonier has generated superior earnings growth to that of Plum Creek. While Rayonier's dividend of 3.92 percent is less than that of Plum Creek's 4.55 percent, I am happy to pick up superior earnings and FFO growth with Rayonier, making Rayonier my choice in the sector.

Senior Housing Property Trust

REIT Subsector: Healthcare
Market Cap: $3.6 billion
Dividend Yield: 6.37 percent
P/FFO: 13.1

I thought long and hard about opportunities in the health-care REIT subsector.

On the one hand I could have easily selected HCP, which is one of the largest companies in this sector with extensive holding in senior housing, nursing homes, medical offices, life sciences and hospitals in the nation.

With an estimated P/FFO of 14.23, HCP is rather cheap. That company's FFO is expected to grow nearly 35 percent this year. And a dividend yield of 5.28 percent is certainly welcoming.

However, as our population is ever aging and the baby boomers set to retire, I chose to get more thematic in this sector and focus in on a pure play in Senior Housing Property Trust, which concentrates its investments on retirement communities and nursing homes.

Senior Housing Properties Trust pays a more robust dividend of 6.37 percent and sells for a lower P/FFO of 13.1 than HCP. While FFO growth has been erratic the last few years, I am confident that growth rate will increase in a positive fashion as our population continues to age.

Annaly Capital Management

REIT Subsector: Mortgage
Market Cap: $16.9 billion
Dividend Yield: 14.9 percent
P/E: 6.7

Annaly Capital Management was one of my featured low volatility stocks for a volatile market.

As it also turns out, Annaly is a REIT. I would add that Annaly is the best in its class, led by a world-class mortgage specialist, Michael Farrell.

If Annaly Capital Management is good enough for my low-volatility portfolio, it should no doubt be included in my diversified REIT portfolio.

Sovran Self Storage

REIT Subsector: Storage
Market Cap: $1.1 billion
Dividend Yield: 4.53 percent
P/FFO: 15.5

If you are a fan of the reality TV show "Storage Wars," as we are in the Rothbort household, then you would know that the self-storage business is big.

People will pay to keep valuable items, as well as junk, in storage lockers.

The storage business is growing as more and more people are losing their homes due to the mortgage crisis, and the REIT storage subsector offers interesting opportunities that are worth taking advantage of.

The largest player in this subsector is Public Storage , with a $22 billion market capitalization that dominates the industry.

But the stock has a lower yield (3.13 percent), higher P/FFO (20.8) and declining FFO (-15.9 percent) relative to my pick in this sector, Sovran Self Storage.

However, I would note that Public Storage has several preferred stock issues that offer superior yield to its common stock, which income-oriented investors may want to consider.

I currently own the Public Storage 6.5 percent Series Q Preferred shares, which yield 6.07 percent.

For my REIT portfolio, I prefer to go with the higher-yielding Sovran Self Storage which also has the potential for greater future growth and as a future takeover target.

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CNBC Data Pages:

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Disclosures:

TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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