After underperforming the S&P 500 by 30% over the last two years, 2014 could be the year when REITs finally deliver great returns to their shareholders.

With interest rates still near historical lows, income investors have been flocking to stocks that pay a healthy dividend.  This has included real estate investment trusts or REITs, which often offer yields of 3% – 6%.

I like to say that REITs are “tax advantaged,” since these companies can legally avoid paying federal income taxes.  And because REITs aren’t paying Uncle Sam, they’re able to put more money in the pockets of shareholders.

For income investors who want to own real estate – but don’t want the headache of being a landlord – REITs offer a great solution.  These companies are formed to own and operate real estate assets.  While most REITs are in the business of commercial office space, there are others focused on hospitals, shopping malls and apartment buildings.

Despite these attractive reasons to invest, 2013 proved to be a challenging year for REIT stocks.

The Vanguard REIT Index (NYSE: VNQ) is the largest REIT ETF.  With $34 billion in assets, this ETF owns shares of more than 100 different REITs.  Last year started off strong, with the ETF rising 17% from January through mid-May.  But following Fed Chairman Ben Bernanke’s announcement of the upcoming taper, REIT stocks plunged.  Between May 21 and the end of 2013, the VNQ gave up all of those gains and ended the year down 3%.

After considering the ~4% dividend yield, VNQ investors were essentially flat last year.  Most big REITs, including Simon Property Group (NYSE: SPG), Public Storage (NYSE: PSA) and ProLogis (NYSE: PLD), saw similar performance.

There are two reasons that REITs got hammered immediately after the taper talk started.

First, REITs are capital-intensive businesses.  Since they own big portfolios of properties, they borrow lots of cash.  Rising interest rates means that these companies will have higher interest payments when they borrow money to buy or build more properties.

Second, higher interest rates mean that yields on bonds will be rising.  You’ll recall that the yield on the 10-year U.S. Treasury rose by 50% between May and December of 2013.  With the 10-year now paying a 3% yield, some investors will simply choose to buy bonds rather than REITs.

As a value investor, I’m always looking for stocks that have been discarded.  Most investors hate to own poor performers, and this creates an opportunity for a contrarian investor.  And that’s what’s encouraged me to dig into REITs again right now.

I’m most interested in the basic REITs that own properties, and lease office or retail space to businesses.  The business is relatively easy to understand, and the economics are simple.

After big declines and two years of considerable underperformance, 2014 may be the year when REITs start rewarding investors once again.  My advice is to focus on REITs that own top-tier properties, have high occupancy rates and are growing their dividend payments.

Do you own REITs in your investment portfolio?  What are your favorites REITs?  Please send me an email and tell me about your top REIT holdings, and why you like these stocks.   My email is [email protected]

You can expect to hear more about this sector in the weeks ahead.

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Published by Wyatt Investment Research at