U.S. Markets closed

3 Misunderstood High-Yield REITs

Reuben Gregg Brewer, The Motley Fool

There's been broad strength across much of the real estate investment trust (REIT) space in 2019 — the Vanguard Real Estate Index ETF is up an impressive 18% so far. But income investors looking to add some high-yield REIT names to their portfolios still have opportunities — it just requires looking past the biggest and most loved names and getting to know some REITs that investors haven't quite figured out just yet. Here are three of them and why they might have a place in your portfolio.

1. The legal overhang

VEREIT (NYSE: VER) , with a portfolio of just under 4,000 properties, is one of the largest and most diversified net lease REITs in the United States. It flies under the radar of most investors because of a somewhat sordid history. The company was once known as American Realty Capital Properties, a fast-growing REIT built with large and rapid-fire acquisitions. The growth-at-any-price mentality came to a screeching halt in 2014, however, when the emergence of a small accounting error cast doubt on the company's internal practices . Although the dollars involved were trivial, the revelation and the fallout soured the market on ARCP and led to massive change at the company.

The acronym REIT spelled out with dice sitting atop piles of coins

Image source: Getty Images

Under new CEO Glenn Rufrano, VEREIT worked to streamline its portfolio, jettison complicated assets (an asset management arm that created and managed non-traded REITs), and strengthen the balance sheet. There's been excellent progress on all fronts. VEREIT today is really just a boring net lease REIT offering a roughly 6.5% yield -- well more than the 3.7% you'd get from industry bellwether Realty Income .

But there's a reason for the relatively high yield: VEREIT is still dealing with the lawsuits that resulted from the accounting issue. That said, there's been material progress here, as well. The company has settled with owners of a bit more than a third of the shares for a total cost of around $245 million. Assuming it can reach similar agreements with the other shareholders, the cost of dealing with this issue will be in the $1 billion range.

That's a lot of money. However, VEREIT's revolving credit facility had well more than a $1 billion of room on it at the start of 2019. In other words, it should be able to handle the hit and maintain its distributions. The projected 2019 adjusted funds from operations coverage ratio, by the way, is expected to be around 80%, or better -- a robust figure that builds in some room for adversity. Income investors looking to add a net lease REIT to their portfolios, but that think names like Realty Income are too dear, should dig into VEREIT's story.

2. Retail hell

Tanger Factory Outlet Centers (NYSE: SKT) has been swallowed up by the fears surrounding the retail industry's struggles. There's no question that this owner of 40 factory outlet centers is dealing with tough market conditions. For example, management expects occupancy to fall from roughly 98% in 2016 to a low of around 94.5% in 2019 (the recent sale of four underperforming properties may lead to an upward revision here as the year progresses). Rental rates have also been coming down, as the company provides concessions to struggling retailers to keep its malls full.

Clearly there's a reason why Tanger's yield is 7% -- the highest it's been in over 15 years. But there are other things to consider here. For starters, the company's balance sheet is very strong. Total debt to adjusted total assets started 2019 at around 50%, with robust interest coverage of roughly 5 times. And the funds-from-operation ( FFO ) payout ratio was just 56% in 2018, meaning that after the dividend Tanger still had 44% of FFO left to cover other needs (like maintaining its malls and reducing debt). That leaves plenty of room for working through the current headwinds without the need to end an impressive 26-year streak of annual dividend increases.

But what about the retail apocalypse? First off, the hype surrounding this issue is likely overblown . Yes, lower-tier indoor malls are badly struggling and many are likely to close. Only Tanger doesn't own lower-quality indoor malls -- it owns outlet centers. Outlet centers have lower costs and don't have the struggling anchor tenants that are causing the biggest problems for enclosed malls. As for the rent concessions, that's a playbook Tanger has used before to keep its properties desirable for lessees and customers as the company adjusts to the retail industry's new normal. Basically, it just takes time to work through transition periods like the one now facing the retail sector.

SKT Dividend Yield (TTM) Chart

SKT Dividend Yield (TTM) data by YCharts

Management has made it clear that 2019 will be a transition year for Tanger. But if you look at the REIT's financial strength and unique niche, it starts to look a lot more interesting than many of its mall peers, with largely enclosed mall portfolios.

3. An old-school business model

Iron Mountain 's (NYSE: IRM) core business is pretty simple to understand: It collects physical documents and puts them into its secure long-term storage facilities. The problem is that the world is quickly moving away from physical documents. This is, of course, true, but there are some stats that investors should consider before moving on from this unique, 6.8%-yielding REIT.

Although the developed world is certainly going digital, paper records aren't going away. For example, Iron Mountain works with 95% of the Fortune 1000 and has an incredible 98% retention rate. Moreover, half of the boxes that were put into the company's facilities were still there after 15 years. The storage business accounts for roughly 80% of the REIT's total gross profit, and while that may decline over time, this business isn't going away overnight. Meanwhile, with adjusted EBITDA margins consistently in the high 60% range, this is a classic cash-cow business.

IRM Dividend Per Share (Quarterly) Chart

IRM Dividend Per Share (Quarterly) data by YCharts

Which brings up the other 20% of gross profit, which is made up of services like shredding and scanning physical documents so they become digital documents. These businesses are complementary and allow Iron Mountain to continue to benefit even as developed nations shift away from physical documents. But that's not the only story here, Iron Mountain is using its cash-cow businesses to build out data centers, which will increasingly replace its physical storage business. It's also working to increase its exposure to emerging markets, which are still heavily reliant on paper. It expects revenues from these businesses to increase by about 50% by the end of 2020. In other words, there's growth here if you look past the core operation.

So, if all you consider is the big picture (storing boxes full of paper), Iron Mountain doesn't look very interesting. However, if you dig in just a little , you see that this old-school business is providing the steady cash flows management needs to shift into new areas that have longer-term appeal. And with an adjusted FFO payout ratio of around 80% in 2018, there's no reason to worry about the dividend.

Misunderstood yields

The REIT sector as a whole has become increasingly mainstream. As investors have gotten more comfortable with the asset class, yields have come down. Income investors have to dig a little deeper to find attractive opportunities. VEREIT, Tanger, and Iron Mountain are examples of REITs that appear to be a little misunderstood today. Take a little time to get to know them and you might find that one or more ends up in your income portfolio.

More From The Motley Fool

Reuben Gregg Brewer owns shares of Tanger Factory Outlet Centers. The Motley Fool recommends Tanger Factory Outlet Centers. The Motley Fool has a disclosure policy .