Global Income Edge is introducing a portfolio of eight real estate investment trusts (REITs) with an average dividend yield of 6%.

Now is a particularly good time to add REITs to a portfolio. True, they’ve already had a great run, tripling in value since the financial meltdown. But analysts think the revival in real estate—particularly commercial real estate—will continue through 2015. And given the continued weakness in the U.S. and global economies (along with the Federal Reserve’s reluctance to raise rates quickly for fear of impeding the recovery), REITs are still a superior investment compared with Treasuries and bonds.

Another bonus: Not only do REITs have high income and returns that rival those of stocks, they usually move independently from stocks. While your stocks are declining, your REITs may be increasing so that adding them to your portfolio decreases its volatility.

Subscribers have requested income from asset classes beyond our two portfolios of dividend-paying stocks, and this new REIT portfolio is our first addition. The portfolio contains different types of REITs that specialize in mortgages, healthcare, and commercial and U.S. government real estate.

The two main types of REITs are mortgage and equity REITs. The latter own or invest in real estate properties, collecting rents and lease payments with most of that income passed on to their investors. Equity REITs own everything from apartment buildings to warehouses, hospitals, shopping centers, hotels and even timberlands. Mortgage REITs (we have just one, but it’s a great one) finance properties through commercial loans and behave more like bonds.

REITs are strong income vehicles because they must pay out at least 90% of their taxable income as dividends to shareholders. The REIT pays few taxes on this income, though it is generally taxed as personal income to REIT holders. So, unlike dividends, REITs have only one level of taxation for the distributions investors receive.

Our REIT Portfolio

We carefully screened the REIT universe to come up with eight strong candidates. Among the criteria we used: diversification, company size, occupancy rates of the properties, the company’s growth rate, its market valuation, and dividend and earnings history.

We are also weighting our portfolio toward healthcare, with three holdings. We believe healthcare REITs are the best investment within the REIT category right now and for the foreseeable future because the graying of America represents the best bankable demographic trend in the income-investing world.

The elderly population in 2030 will be twice as large as in 2000, increasing from 35 million to 72 million and constituting nearly 20% of the total U.S. population, according to an analysis by Galliard Capital Management.

Most of the healthcare REITs we selected were mid-size, which offer the greatest balance of growth, safety and value. In fact, most of our new portfolio names are mid-cap companies in the $2 and $10 billion market capitalization range. These firms are mainly low-beta stocks that are less susceptible to wild market swings to preserve value.

Diversification

But even as healthcare is one of the safest subsectors in the REIT universe, there are always risks. So, the rest of the portfolio is composed of other REIT types with less exposure to tenants and greater diversification, such as REITs that focus on commercial, hospitality and entertainment real estate.

Our REIT portfolio includes one of the nation’s largest commercial mortgage REITs, Starwood Property Trust. Although we believe REIT investments will beat Treasuries and bonds for some time, mortgage REITs specializing in commercial loans often have variable rates that rise along with interest rates in general. Consequently, these REITs are often less vulnerable to changes in interest rates than REITs focused on residential mortgages.

Our portfolio mainly holds REITs with long performance track records, but we also included two that launched in the last five years. Both exhibit strong growth and performance. Starwood Property Trust is one, and Government Properties Income Trust, which manages properties for Uncle Sam, is the other.

Our Portfolio Companies

Realty Income Corp. (NYSE: O) is known as “the monthly dividend company” because it pays dividends monthly rather than quarterly. The company owns more than 4,300 commercial real estate properties in 49 states, and with a total market capitalization of about $11.1 billion, this firm is the second-largest in our REIT portfolio after HCP.

 This is an established REIT player (it started operations in 1969) that pays a 4.6% dividend yield. O is a Buy up to $55.

Starwood Property Trust (NYSE: STWD) is the nation’s largest commercial mortgage REIT investing in and originating commercial real estate debt. We believe this is the ideal investment to weather Treasury rate increases. Yielding 7.8%, STWD is a Buy up to $32.

Senior Housing Properties Trust (NYSE: SNH) owns independent living and assisted living communities, nursing homes, wellness centers and medical office, clinic and biotech laboratory buildings throughout the United States. Most of SNH’s tenants are “triple net leased,” which reduces management costs and makes the trust’s cash flow steadier. With triple net leasing, each tenant pays rent and is responsible for all taxes and insurance as well as operating and maintenance costs. Its current yield: 7.13%. SNH is a Buy up to $30.

Omega Healthcare Investors (NYSE: OHI) provides financing and capital to the long-term healthcare industry with a particular focus on skilled nursing facilities in the United States. OHI is one of the most solid healthcare REITs, having delivered consistent annual growth in dividend, revenues and funds from operations for five straight years. OHI yields 3.7% and is a Buy up to $45.

Hospitality Properties Trust (NYSE: HPT) owns hotels and travel centers throughout the United States, Ontario, Canada and Puerto Rico. It has two types of real estate investments: hotels and travel centers. Yield: 6%. HPT is a Buy up to $38.

HCP (NYSE: HCP) is the number-three best buy for Global Income Edge’s Conservative Portfolio and a member of Standard & Poor’s 500 Dividend Aristocrats for steadily increasing its dividend for 29 years. The premier healthcare REIT, HCP owns or holds interests in $22 billion worth of healthcare-related properties.

Yielding 5.3%, HCP is a Buy up to $44.

Government Properties Income Trust (NYSE: GOV) is an office real estate investment trust specializing in properties leased to U.S. federal and state government agencies. As a result, it offers strong stability: Compared with private sector tenants, government tenants remain in place much longer, historically occupying the same space for more than 20 years, on average. Yield: 7.6%. GOV is a Buy up to $30.

EPR Properties (NYSE: EPR) is a specialty real estate investment trust consisting of three main segments: entertainment, recreation and education. We believe EPR is a good play for when consumers’ disposable income picks up and more dollars are spent on movies and theme parks.

Education holdings add to the trust’s stability. Yield: 6.1%. EPR is a Buy up to $68.

The Science of REIT Evaluation

We selected only those companies with exceptional performance or a track record of outperformance over at least four years based on a number of measures.  

One key measure for REITs is funds from operations (FFO). It’s a bedrock indicator because FFO measures cash flow from operations, and REITs are all about generating cash flow and passing it along as dividends to investors. FFO is calculated by adding depreciation and amortization expenses to earnings, and is sometimes quoted on a per share basis.

FFO is considered a better indicator of the results of a REIT business than net income, and likewise FFO-based ratios are better for REITs than income-based ratios.

We looked for REITs with exceptional growth in FFO over the last three to four years, as well as consistent growth in revenues and dividends. To make sure that the growth from these REITs was coming from higher profits we applied our proprietary Dupont Hybrid Model that determines if growth in return on equity resulted from profitability or leverage.

I developed the Dupont Hybrid Model, known as the Early Warning System, for our sister publication Utility Forecaster, and I’ve found it works just as well on REITs. In addition to identifying promising investments, this system will alert us to declining margins and will be used to monitor the REIT so we can sell any that start to falter.

Of course, we also looked for REITs that offered good value. Finding undervalued opportunities is a little different with REITs than with stocks. In evaluating the REIT version of the P/E ratio, price-to-FFO, Global Income Edge’s new REIT portfolio holdings typically had to be within the average price-to-FFO 2014 multiple of 16 times earnings to be included. The FFO-per-share ratio should be used in lieu of earnings per share (EPS) when evaluating REITs and other similar investment trusts. Similarly, price-to-FFO is used in lieu of price-to-earnings (P/E) ratios to evaluate different REITs.

Finally, capitalization rates are used to analyze real estate returns. Unlike other analysis methods that base a property’s value on its size or gross rent, cap rates account for the property’s net income. Typically, the lower the cap rate the higher the value of the investment and the lower the risk.

Most investors like to see cap rates of 5% to 6%. Capitalization rates for the REIT portfolio generally fell between the current average cap rate of 6.75% to 8.75%, with three of our holdings even lower.

We’ll list many of these measures in our tables and discuss them in greater detail as we profile the new REIT portfolio companies in the coming weeks.