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Get A 4.8% Yield From The Best REIT You've Never Heard Of

Daniel Cross

The real estate investment trust (REIT) is one of more misunderstood asset classes.

There's an undue amount of confusion with these companies -- but they may be some of the simplest types of stocks out there.

A REIT is a company that owns a portfolio of real estate properties that generate income from rentals and capital appreciation when the property is sold. A REIT must pass on 90% or more of its profits on to investors because of its unique tax structure, making them a staple in any dividend-oriented portfolio.

Investors have shied away from anything remotely attached to mortgages since the 2008 financial crisis. This can be clearly seen by looking at the Vanguard REIT Index ETF (NYSE: VNQ).

In the past two years, this exchange-traded fund rose just 15% compared with the S&P 500's climb of about 38%. Adding to the issue is the Federal Reserve's taper of its quantitative easing program and expected rise in interest rates, which is adding more skepticism to the sector.

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REITs have been a "hated" sector for years, but the trend should start to reverse. Interest rates may be rising, but they are still at historic lows, and most companies have been able to refinance debt burdens in preparation for steadily climbing rates. REITs have also been mislabeled as huge debt-laden entities, when they're anything but. In fact, an environment of rising rates is actually a positive issue, according to the National Association of Real Estate Investment Trusts, because it translates into higher rental prices.

The tides are beginning to shift for these forgotten asset classes and residential REITs could lead the way. Catalysts like an improving job market means that young people can afford to start renting again. As housing prices and rental prices start to finally reach equilibrium, rental properties will be able to fill vacancies and drive up margins.

For Home Properties (NYSE: HME), it's the perfect storm for profits.

Like the name suggests, the company is a residential REIT that manages apartments along the East Coast.

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Home Properties has aggressive expansion plans, with the goal of investing $250 million over the next 12 months in purchases of multi-family communities. The company missed earnings last quarter by about 17%, but the shortfall did little to affect investors' confidence in the stock. Since then, the stock has actually gained just over 5%.

Like most REITs, Home Properties comes with a hefty dividend currently yielding around 4.8%.

The company has exceptionally high operating margins at 33.7% and gross margins in excess of 64%. As a testament to Home Properties growth, Moody's gives HME an investment-grade credit rating of Baa2. Management has made it a goal for 2014 to get an investment-grade credit rating from Standard & Poor's as well. The company has made strides in improving its balance sheet -- debt-to-total value dropped from 45.2% at the end of 2012 to 38.5% for the end of 2013.

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The company's largest competitor is $20 billion Equity Residential (NYSE: EQR). While likely to benefit from the rising REIT tide, the company lags behind Home Properties on core valuations like price-to-earnings (P/E) ratios, dividend yield, margin and expected earnings per share (EPS) growth. EPS growth this year was actually a loss of 187.5%.

Risks to Consider: The growth of the rental market is largely reliant on improving employment figures. Rental revenues are essential in paying for operational expenses as well as dividend distributions. Any setback could hurt Home Properties' growth opportunities and impact future earnings. In addition, real estate is a highly illiquid investment and the company's ability to quickly adapt to a changing environment could be compromised.

Actions to Take --> EPS growth for the last five years is 32.6%, with EPS growth this year of 35.5%. If management is able to take advantage of investment opportunities, the stock could trade about 16% higher.

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