As a financial writer and real estate investor for over three decades, I can attest to the temptation for yield chasing. Over the years, I have learned some tough lessons of investing, and as a writer I’m constantly encouraging readers to avoid the fool’s game with regard to “sucker yield” REITs.
You’ll simply be far better off avoiding these “pie in the sky” yields that eventually end up sacrificing capital in the process. Just because high dividends appear superior, it doesn’t necessarily mean the highest yield is the best. There’s a point in which being a high yield dividend landlord can be hazardous.
As readers know, I write frequently on the “sucker yield” stocks that have a dividend payout ratio greater than 100%, that means they’re paying out more than their earnings as dividends. If their earnings don’t recover promptly, dividends can become unsustainable because the company will be unable to reinvest, reducing its capacity to grow in the future.
Also, if the company is highly leveraged, and is having trouble meeting its liabilities, it’s going to be a big red flag for the dividend.
Simply put, we constantly warn readers about avoiding dividend traps as we seek to identify the highest quality companies with a sustainable competitive advantage and a robust operating model. A high-yielding stock with poor fundamentals is often forced to cut its dividend and investors get hit with a double whammy.
Not only do they lose the income they desired, they also get handed a sizeable capital loss - since a stock’s price often plunges following a dividend cut.Our first and foremost objective for investing is to always seek to protect principal at ALL costs.
3 Dividend Traps
This “reaching for yield” is just asking for trouble. These high yielding REITs are often referred to as yield traps, meaning they have terrible fundamentals, including deteriorating business models and cash flows, weak balance sheets, and the risk of having their dividends cut or eliminated.
Just because "dividends are good," it doesn't follow that the highest dividend yield must be the best. There’s a point at which high yielding dividend-paying stocks become riskier than the average stock, broadly speaking. Business Insider explains three types of dividend traps:
“A Cow Feeding Itself Its Own Milk” - A company has deteriorating fundamentals but attempts to maintain its dividend policy, usually financing the payout with debt.
One textbook example of this trap is CBL & Associates Properties (CBL), the owner of many low-quality malls that are being decimated by the rise of e-commerce and the collapse of retailers such as Sears and J.C. Penney. CBL reduced its quarterly dividend from $0.2650 to $0.2000 in the fourth quarter of 2017. The payout was cut again in the fourth quarter of 2018 to $0.0750, an overall reduction of 72% from the prior year.
Before CBL finally gave in to the realities of its disastrous fundamentals, the stock’s yield was around 18%... and by the end of 2018, had reached 31%. The stock price since that first dividend cut in fourth-quarter 2017 has collapsed 73%, because stock prices generally track dividends, both to the upside but especially to the downside. Even adjusting for those “too good to be true” dividends, CBL investors have faced a -67% total return over the past five quarters.
Let’s not forget that during recessions credit markets tighten for all but the strongest REITs. CBL’s BB junk bond credit rating and sky-high leverage ratio means it’s likely going to have to cut the dividend even more in the future (or possibly suspend it entirely), especially during a recession.
“A Falling Knife” - This is where an apparently compelling yield is actually the result of a substantial drop/freefall in the price of a dividend paying stock, (i.e., the market anticipates substantially lower future earnings of the company in question).
One textbook example of this trap is Washington Prime (WPG) which has a current yield of 17%. Although WPG’s quarterly dividend has been the same since mid-2015, the REIT - which was formed by Simon Property Group (SPG) spinning off its lowest quality malls - has seen its AFFO (adjusted funds from operations) per share steadily falling since 2014. The AFFO payout ratio is now closing in on 100%, and analysts expect the REIT’s cash flow to shrink further in 2019, pushing the payout ratio to an unsustainable 111%.
That falling cash flow means that the dangerous 7.1 net leverage ratio is expected to rise to 7.2 - and combined with WPG’s need to invest heavily into redeveloping stores to try to replace bankrupt anchor tenants - its dividend is almost certainly doomed to be cut in 2019. Like CBL, WPG’s weak balance sheet (so bad it doesn’t even pay S&P to rate its debt) means that during a recession the dividend might have to be suspended entirely.
“Fool’s Gold” - This is where a company decides to pay a large dividend without any intention for this large dividend payment to persist.
Another factor in determining whether or not a REIT is a yield trap is the quality of the management team. For example, most equity REITs are “internally managed” - meaning executives work for the shareholders. In contrast, “externally managed” REITs, like Global Net Lease (GNL), sign management contracts with asset managers, which mean management works for itself first, and shareholders second.
While some externally managed REITs are worth buying (mostly in the commercial mREIT sector), for the most part externally managed REITs have conflicts of interest. That’s because they are essentially hedge funds, where management is usually paid a fee based on assets, plus an incentive fee for growth.
This means that an externally managed REIT has an incentive to grow its asset base, and therefore may take on too much debt and issue more shares at low prices (and a high cost of equity). For GNL, its cost of equity is about 10%, and its overall cost of capital is about 8%, but the kinds of triple net lease properties it’s trying to buy usually only have cash yields of 7.7%.
In other words, the high cost of capital (a direct result of those high management fees) means that even if GNL were able to double its property base, AFFO per share would actually decline. Thus, it’s not surprising that GNL’s dividend has been frozen since 2016, because the AFFO payout ratio is 100% and is expected to remain at this dangerous level in 2019.
Basically, the most important thing for REIT investors to do is focus on the fundamentals, first. Only after determining whether you want to own a part of that company, should you consider yield, and valuation.
Play it Safe
Keep in mind, all good dividend yields must be sustainable and one of the reasons we decided to create our Rhino Rating model is so that investors can evaluate the sustainability of the dividend based on a number of factors such as earnings, capitalization, and the dividend payout ratio.
Avoiding REITs that pay out more than what they’re earning as dividends may be an obvious strategy, and we believe there should always be an adequate margin of safety with the payout ratio.
Importantly, REITs with growing dividends are signaling confidence about their future earnings as they tend to be stable businesses, well positioned to perform throughout market cycles.
"Dividend Aristocrats" are companies that have maintained a policy of increasing dividends for more than 25 years. Over the past 40 years, stocks in the S&P 500 index that increased their dividend payout annually averaged a 9.4% annualized return… whereas companies that paid a dividend, but didn’t increase that payout, had an annualized return of about 7%.
The strength of a company’s dividend lies in its ability to continually increase dividend payments to shareholders, and for that reason, these companies have historically outperformed the S&P 500 by a little more than 1% per year and have been slightly less volatile.
There are around 50 stocks that make up the S&P 500® Dividend Aristocrats®index - companies that have increased their dividend for 25 consecutive years or more. The companies that comprise the Dividend Aristocrats are balanced across eleven sectors within the S&P 500 index and encompass both large cap growth and large cap value companies.
Although buying opportunities are scarcer today in REIT-dom, we believe it’s still a good time to identify high-quality, solid REITs, and gradually build positions in order to create a diversified portfolio of REIT securities. We’ve screened our Intelligent REIT Lab, and found the following jewels…
3 Blue Chip Buys
Tanger Factory Outlet Centers (SKT) is the only “pure play” outlet center REIT. It also has the best dividend growth record of all the retail REITs. And counts 26 annual consecutive dividend increases - most recently a 1.4% increase on annual common share dividends, now at $1.42 per share.
With department store closings (none in Tanger’s portfolio), retailers are seeking the most economical channels - and outlets are an effective way to connect with entry-level, budget-wise customers. Tanger has 44 centers - in 22 states and Canada, across more than 15.3 million square feet.
Over the years, Tanger has become a highly effective partner - more than a landlord - to the best-in-class brands, with the demand for outlet space underscored by the operation’s overall profitability, which is one reason Tanger’s business model holds up well during recessions. Also, Tanger’s occupancy rate has never dropped below 95%; re-tenant turnaround costs are impressively low, compared with malls; and outlets offer an important competitive advantage, as a “low-cost provider.”
Maintaining a strong balance sheet remains a strategic priority for Tanger, which reduced its 2018 consolidated debt by approximately $50 million; and by year’s end, had repurchased nearly 1 million of its shares. In Q4-18, Tanger’s AFFO per share was $0.64, compared to $0.66 per share in Q4-17.
And while growth has been modest (only 1% FFO growth in 2018), I appreciate Tanger’s capital markets discipline; the consistent, growing, premium-level dividend, now at 6.95%; the lowest payout ratio of all retail REITs; and favorable, low valuation by “Mr. Market”… which all keep this blue-chip REIT one of my most steadfast Strong Buy recommendations.
Federal Realty (FRT) is the only REIT on the more exclusive, 25-member, blue-chip “Dividend Kings” list of companies that have increased annual dividends over 50 years in a row. This shopping center REIT is an industry leader with 105 flexible retail-based properties, primarily in eight major, transit-oriented coastal markets, including Washington D.C., Boston, San Francisco, and Los Angeles.
The company owns real estate purposefully positioned to be the real estate of choice for the widest selection of tenants –creating urban, mixed-use neighborhoods such as Santana Row (San Jose, California), Pike & Rose (North Bethesda, Maryland), and Assembly Row (Somerville, Massachusetts).
Federal Realty is “cycle tested” – maintaining a best-in-class track record of consistent earnings growth, as the only publicly-traded shopping center REIT (and 1 of two retail REITs) to grow NAREIT FFO per share every year since 2010. Of the company’s 2,933 total tenants, the top 25 account for only 27% of ABR (Annual Base Rent).
Federal Realty has an A- rating from S&P - one of 12 "Dividend Kings" with that rating or better. The company’s balance sheet continues to improve and is very well positioned from a capital perspective as they head into the next phases of new development in the coming years. Federal Realty generated a -8.1% total return in 2018, has a well-covered annual dividend yield of 3.1%, and a BUY rating.
Urstadt Biddle (UBA) is a much smaller shopping center REIT, yet has an impressive dividend growth record with 25 years in a row of annual increases. Last December, the company announced a quarterly dividend increase of 2.1% (from $.24 to $.245 per share).
Urstadt Biddle’s 83 properties total 5.1 million square feet. Most are grocery-anchored, in high-density, high-income suburbs around New York City (one of the best suburban retail markets in the country) - in regions of Fairfield County, CT; Westchester, Putnam, and Rockland counties, NY; and Bergen County, NJ.
The company's focus on necessity-based retail and strong demographics has allowed it to generate higher rent per square foot (3rd best in the peer group), and maintain very stable occupancy. Owning properties in high-barrier-to-entry markets gives the company a competitive advantage, due to high costs of land, entitlement, and construction, which make new development difficult, given a limited amount of remaining developable land in Urstadt Biddle's core markets.
The company’s balance sheet is one of the lowest-leveraged REITs, with aggregate mortgage debt equal to only 27% of total book capitalization. And while Urstadt Biddle is too small to be rated by S&P or Moody’s, the low leverage is certainly an indicator of prudent capital management.
Kudos to their management team’s strict discipline with its payout ratio - one of the primary reasons the company didn’t cut its dividend in 2008 and 2009, and in fact, raised it. In 2018, UBA’s total return was -6.6%. The dividend currently yields 5.39%. We maintain a BUY.
Closing Thoughts
In closing, we insist on owning blue-chip REITs over high-yielding value traps. History has shown that high yield investing is dangerous and can often lead to principal erosion.
Our stock selection practices are based on sound value investing principles in which dividend growth is paramount. Whenever we see a high-yielding security we begin to dig deeper into the sources of repayment and management team. Our record for success speaks for itself (the Durable Income Portfolio has returned ~11% annually since 2013) and anyone who looks to invest in stocks based upon the dividend yield alone should be extremely careful.
“Gambling can be separated from investing not by the type of activity but the skill, dedication and enterprise of the participant”. Peter Lynch
