Cash In on Offbeat REITs

What do publicly traded prison companies, cloud-computing firms and billboard operators have in common? All suffer from real estate envy.

Such companies, as well as others that you wouldn't call traditional property businesses, are seeking to become real estate investment trusts. And with REITs recently yielding 4.3%, on average, income-hungry investors are eager to snap them up. (For an explanation of how REITs differ from regular companies, including their special tax advantage, see Why You Need REITs.)

Sizzling results. With the REIT market red-hot, the bosses of regular companies may find such a switch appealing. Investors poured about $15 billion of new money (net of withdrawals) into real estate mutual funds over the past three years, according to Morningstar. Property-owning REITs returned 15% in the first 11 months of 2012 and a whopping 20% annualized over the past three years, according to the National Association of Real Estate Investment Trusts (all returns and share prices are as of November 30). That compares with a 15% return for Standard & Poor's 500-stock index in 2012 and 11% annualized over the past three years.

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Investors often win out in the short run when a conversion is announced. Since May 2011, when American Tower (symbol AMT, $75), an owner of wireless-phone towers, announced that its board of directors had approved the company's conversion, the stock has returned a cumulative 46%, compared with a gain of just 9% for the S&P 500. Document-storage company Iron Mountain (IRM, $32) -- which is on track to switch over to REIT status at the beginning of 2014 -- returned 27% since it announced last June 5 that its directors had approved a conversion. The S&P 500 returned 11% over the same period.

Just as with any other investment, how these new REITs fare over the long term will depend on the strength of each company's underlying business. "The tax treatment is just the topping on the cake," says Kevin Finkel, an official at Resource Real Estate, which manages REITs. "You'd better like the cake."

In addition to American Tower, another cell-phone-tower operator, Crown Castle International (CCI, $68), is in the process of converting, and some analysts speculate that rival SBA Communications (SBAC, $69) is considering the move. The cell-tower industry is an oligopoly dominated by the three major players; they make money by leasing their towers to service providers, often on long-term contracts that include automatic 3% to 5% price hikes each year. With more people buying sophisticated phones that soak up oceans of data, the future looks bright for tower operators. "The growing use of smart phones will drive demand for space on cellular towers," says Brian Jones, co-manager of Neuberger Berman Real Estate Fund.

All three firms are attractive. But shares of industry leader American Tower aren't cheap. The stock yields just 1.2% and trades for 21 times analysts' estimates of the company's 2013 adjusted funds from operations (FFO), a measure of cash flow that pros use to determine value for REITs. Jones says that the average property-owning REIT trades for about 18 times his team's projections of 2013 adjusted FFO. Neither Crown Castle nor SBA Communications pays a dividend yet. But both stocks could pop as they move closer to REIT status.

REIT wannabes are also cropping up in the information-storage business. Iron Mountain, which handles records management and document storage for businesses with large paper archives, such as law firms and health care concerns, is due to make the switch starting in 2014. Equinix (EQIX, $186), which houses data centers for companies, is also in the process of converting and hopes to make the switch at the start of 2015, assuming it wins approval from the Internal Revenue Service. (Because conversion is essentially a tax matter, a company that switches begins life as a REIT at the start of a new tax year. Businesses that aren't plain-vanilla property companies also generally need to seek the blessing of the IRS first.)

Consider picking up Iron Mountain but passing on Equinix. The latter is already heavily indebted and may need to borrow more while getting REIT-ready. And because REITs must distribute at least 90% of their profits, little is left for reinvesting in the business, which means the structure isn't ideally suited for companies, such as Equinix, with strong growth prospects. But a world that's moving away from paper storage and toward digital storage means fewer growth opportunities for Iron Mountain, which needs to focus more on cutting costs and improving efficiency. Its stock will likely jump if or when it receives the go-ahead from the IRS for its conversion. A 3.4% dividend yield enhances the appeal of its shares, which trade at just 9 times estimated 2013 adjusted FFO.

Weyerhaeuser (WY, $28), a timber and paper-products company, has served shareholders well since it became a REIT in 2010, returning 23% annualized. The company owns, leases and licenses about 20 million acres of forests. It sells lumber for building homes, pulp used as filler in disposable diapers, wood fiber to be built into milk cartons, and more. And Weyerhaeuser's homebuilder unit stands to gain from a continued recovery in home prices. "Both through its ownership of timberlands and through its homebuilder unit, the company is well positioned to benefit from improvement in the single-family home market," says Jones. The shares yield 2.5% and trade for 23 times analysts' estimates of 2013 adjusted FFO.

Some REITs deal in office space; Lamar Advertising (LAMR, $39) deals in eyeball space. The billboard company announced in August that it was laying the groundwork for a conversion, assuming IRS approval, at the start of 2014. The stock has returned 25% since the announcement.

We suggest you take a pass on Lamar for now. Advertising tends to depend heavily on overall economic growth, which can lead to volatility; Lamar shares plunged 74% in 2008, then leapt 148% in 2009. The firm carries a lot of debt, and it leases, rather than owns, much of the land on which its billboards stand. That means Lamar may have limited residual value if it ever fails to sell ad space, because billboard frames have few alternative uses, says James Kammert, co-manager of Aston/Harrison Street Real Estate Fund.

Steer clear. Skip entirely Corrections Corp. of America (CXW, $34) and Geo Group (GEO, $28), the two prison operators that are considering conversions. Running prisons is risky business. The companies lease their facilities to federal, state and local agencies, including the Federal Bureau of Prisons. But they have no guarantees that their contracts will be renewed, and they'll have little other use for their facilities if a contract is scrapped. "It's a very capricious business model," Kammert says. "If I have an office building, anyone can become a tenant. It's not like you can go out to the market and say, ‘We have a prison to rent.' " The companies are also at the mercy of municipal finances: Corrections Corp. has in the past received IOUs from the state of California instead of cash.

If picking stocks isn't your favorite pastime, consider a fund. T. Rowe Price Real Estate (TRREX) and Fidelity Real Estate (FRIFX) are fine options among actively managed real estate funds. The Price fund returned 19% annualized over the past three years, and the Fidelity fund gained 14% over the same period. Among index funds, we like Vanguard REIT Index, which is offered both as an exchange-traded fund (VNQ) and as a mutual fund (VGSIX). The traditional fund charges 0.24% in annual expenses, and the ETF costs just 0.10%.

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