Owning shares in real estate investment trusts (REITs) can be a remarkable source of passive income. Even more so right now, with most of these stocks trading at a significant discount with chunky dividend yields.
Just looking across the FTSE 350, there are a lot of options to explore and diversify across, including:
- Supermarket Income REIT (LSE:SUPR) – 7.8%
- Primary Health Properties – 7.4%
- Workspace Group – 7.4%
- Land Securities Group – 7%
- LondonMetric Property – 6.8%
So is now the time to add REITs to a passive income portfolio?
Why are REITs so cheap?
As a quick crash course, a real estate investment trust is a special type of corporate structure. These businesses own and manage a portfolio of rental properties. This rent’s then collected and redistributed to shareholders via dividends. And so long as 90% of net earnings are paid out, REITs are immune to corporation tax.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice.
Of course, investing in real estate comes with risk. And the most prominent right now is interest rates.
Beyond making it more expensive for REITs to expand their portfolio, it also drives up the cost of their existing debts. After all, with 90% of net rental earnings being paid out, these businesses are almost always reliant on debt financing to fund growth.
Having a highly leveraged balance sheet is fine so long as rental income remains sufficient to cover these liabilities. But if cash flows are disrupted, REITs could be forced to sell some of their properties at a discount, destroying shareholder value. And that’s one of the main things making investors nervous right now.
Which REITs to buy?
While interest rates are steadily falling, this risk factor remains prominent for many of these businesses. That’s why the yields are so high.
But in some cases, the companies have the financial strength to weather the storm. And identifying these leaders while yields remain high opens the door to fabulous potential investment returns.
So with that in mind, let’s zoom in on what’s currently the most generous landlord in the FTSE 350 – Supermarket Income REIT.
As its name suggests, the company leases a portfolio of retail stores used by some of the biggest names in the sector, including Tesco, Sainsbury’s, Morrisons, Waitrose, and Aldi.
These leases tend to span decades instead of years. And subsequently, the group has enjoyed 100% occupancy levels since 2017, with 100% rent collection as well. And with many of its lease agreements including an annual uplift linked to inflation, dividends have been hiked every year for the last seven years.
However, despite the robust nature of its cash flows, they’re actually insufficient to cover dividends right now. And this largely links back to the added pressure of higher interest rates, making its debts problematic.
Yet, with interest rates steadily falling, management appears confident that this dynamic will soon change, fixing the dividend coverage issue while continuing to grow its cash flows over time.
The bottom line
Supermarket Income REIT’s high yield comes paired with high levels of risk. With substantial leverage, its dividends could end up on the chopping block if interest rates don’t fall as expected next year. This lack of passive income security doesn’t sound particularly enticing so it may not be one to look at right now. But luckily, there are plenty of other, stronger options to explore.
