Brad Thomas wrote this article and it has appeared previously on Seeking Alpha.
- It's much easier to predict the future value of a REIT due to the contractual make-up of the revenue streams.
- Over the past 20-plus years, listed equity REITs have provided 30% more dividend income than small-cap value stocks in the Russell 2000, with 43% less variability.
- I find the most gratification in finding REITs with above-average appreciation potential and safe and growing dividends.
The legendary investor Ben Graham explained in TheIntelligent Investor,
One of the most persuasive tests of high-quality is an uninterrupted record of dividend payments going back over many years. We think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company’s quality rating.
Graham went on to state that “paying out a dividend does not guarantee great results, but it does improve the return of the typical stock by yanking at least some cash out of the manager’s hands before they can squander it or squirrel it away.”
Remember though that REITs are special “squirrels” because there are no options for them to pay or not pay a dividend since by law they must payout at least 90% of their otherwise taxable income (in the form of dividends).
The dividends that REIT investors receive out of earnings haven’t been reduced by taxes at the corporate level, making REITs tax efficient conduits for real estate income. In other words, REITs are forced to do so the retain their REIT status.
Alternatively, non-REITs are less consistent in that they can decide to pay, sustain, or cut dividends. In other words, non-REIT payers can choose to conserve cash and very possibly cut dividends for a host of reasons; REITs simply have no choice in the way profits are paid to investors.
Another consideration with REITs is that they also have a history of consistently raising their dividends, resulting from cash ﬂow growth that can come organically from rising rents and occupancies, or externally from development and acquisitions. It's much easier to predict the future value of a REIT due to the contractual make-up of the revenue streams.
Over the past 20-plus years, listed equity REITs have provided 30% more dividend income than small-cap value stocks in the Russell 2000V, with 43% less variability (source: NAREIT).
The Power of Predictable REIT Income
The power of predictable dividends is a reflection of the same disciplinary concept that Harvard Professor Michael Jensen described in a research article (Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers) that has been cited over 13,500 times.
In the article, Jensen describes the free cash flow hypothesis whereby a company with too much free cash flow would result in internal insufficiency and waste of corporate resources, thus leading to agency costs as a burden of stockholder wealth.
Now, keep in mind, REITs don't have that problem since they are forced to pay out at least 90% of taxable income in the form of dividends (most payout nearly 100%). As Jensen explains:
Payouts to shareholders reduce the resources under managers' control, thereby reducing managers' power, and making it more likely they will incur the monitoring of the capital markets which occurs when the firm must obtain new capital. Financing projects internally avoids this monitoring and the possibility the funds will be unavailable or available only at high explicit prices.
Jensen's free cash flow hypothesis states that when a company has generated an excessive surplus of free cash flow and there are not profitable investment opportunities available, management tends to abuse the free cash flow in hand, resulting in an increase in costs. As Jensen went on to explain,
Managers with substantial free cash flow can increase dividends or repurchase stock and thereby pay out current cash that would otherwise be invested in low-return projects or wasted.
This leaves managers with control over the use of future free cash flows, but they can promise to pay out future cash flows by announcing a "permanent" increase in the dividend. Such promises are weak because dividends can be reduced in the future. The fact that capital markets punish dividend cuts with large stock price reductions is consistent with the agency of free cash flow.
Recent example in the REIT sector include Wheeler Real Estate (WHLR). This small-cap shopping center REIT recently declared asecond quarter 2017 dividend rate of $.34 per share, adjusted annually from $1.68 per share to $1.44 per share. This is the second dividend cut for Wheeler, the first one was in March 2015 when the company slashed the dividend from $.035 per share (monthly) to $ .0175 per share – around 50%.
It is never a logical decision to invest in a company that is likely to cut its dividend, one recent example of that is Spirit Realty (SRC). In a recent article I explained my SELL recommendation as follows,
I have been preaching this message for quite some time, and perhaps the SRC earnings call serves as a harbinger for REIT investors that “all that glitters is not gold.
Sprit has not affirmed the dividend (as of the earnings call) and the tight coverage (88% AFFO payout ratio) and continued dilution (further issues related to weaker tenants) provide the perfect storm for a dividend cut. As I learned from the “ARCP debacle” when there is smoke, there is usually fire,
Let me be clear, when you are willinglyinvesting in a company that is likely to cut its dividend, you are essentially gambling. As Professor Jensen reminds us, “the fact that capital markets punish dividend cuts with large stock price reductions is consistent with the agency of free cash flow.”
The Safest Dividend Is The One’s That Just Been Raised
An income investor should take advantage of the market opportunity to increase dividend income. An intelligent REIT investor should recognize that now is a terrific time to put money to work, and while REIT prices are down (for many companies…keep reading), fundamentals are strong and the economy is improving.
Most REITs are increasing dividend payouts, and that's the best possible evidence that the security is safe and management has an alignment of interests (with shareholders).
Typically, a company with an established trend of increasing its dividends will raise them again next year and the year after that and the year after that... unless it becomes impossible to do so. It's hard to stop a train!
History suggests that companies that consistently increase their dividends will outperform, and that’s the primary reason that I have designed the Durable Income Portfolio (commenced May 2013).
Keep in mind, I have set the bar high for the REITs that I consider durable, and my strategy has been to overweight names that I consider the most resilient.
To do so, I carefully examine each prospective REIT through a historical, current, and forward-looking lens – paying close attention to the underlying drivers and of course, the margin of safety.
Yesterday I wrote on an article on Realty Income (O) and I explained that this REIT was one of just a handful of REITs that increased the dividend during the last recession. While historical performance is certainly no guarantee of future results, the historical perspective offers one dimension of the company’s overall quality. Take a look at the 13 REITs that have increased dividends for at least 13 years in a row:
I already own a number of these dividend stalwarts include Realty Income, Digital Realty (DLR), National Healthcare Investors (NHI), Tanger Factory Outlets (SKT), Urstadt Buddle (UBA), W.P. Carey (WPC), Omega Healthcare Investors (OHI).
Here’s how the “lucky 13” REITs have performed since the last recession, based on their dividend growth per share:
Let’s compare this date based on percentage of growth:
This is helpful data (you will be able to obtain similar data on over 100 REITs on REIT Maven), as it allows you to filter out the top dividend growers over multiple years. Now let’s compare the average annual growth rate for the “lucky 13” REITs from 2009:
This is valuable information, but it’s also helpful to evaluate the “lucky 13” REITs based on their Total Return performance (since their lowest price in 2009). As you can see (below), the green boxes represent the average annualized return for each REIT compared with the average annual dividend growth rate.
Finally, as viewed below, I put together a 2018 divided growth forecast (using Fast Graphs) for the “lucky 13” REITs. As you can see, National Retail Properties (NNN), Realty Income, Essex Realty (ESS), Federal Realty (FRT), Digital Realty (DLR), and Equity Lifestyle (ELS) are forecasted to grow their dividends by at least 4.9% in 2018.
For comparison purposes, I also included a green box to highlight the average dividend growth rate for these REITs (since 2009).
Top 3 Picks
If you were smart enough to buy all 13 REITs at the bottom of the recession, your portfolio would have returned an average of 16.5% per year over the last 7 years.
I’m sure none of us were that smart, but part of my job is to help you build a stress-free REIT portfolio that produces above-average returns.
In my upcoming newsletter (Forbes Real Estate Investor), I intend to provide a broader list of a dozen deeply discounted REITs to BUY that includes a few of the “lucky 13” REITs as well as other carefully vetted REITs with a history of steady dividend growth. As I said earlier, historical performance is important, but it’s also important to consider current and future analysis.
Within the “lucky 13” list I find the most attractive names to be as follows: Omega Healthcare Investors (OHI), Tanger Factory Outlets (SKT), and Realty Income (O). I have recently written on all three of these REITs and you can read my latest reports by clicking on the name below….
Omega Healthcare Investors
In summary, I have found that there is no way to accurately and consistently time short-term market movements.
Part of my success in picking REITs is rooted in my ability to focus on fundamentals and to go against the herd, and even risk being called a dummy. That’s ok, I’ve been called far worse, and I find the most gratification in finding REITs with above-average appreciation potential and safe and growing dividends.
Always remember that getting in at the bottom of a cycle produces better returns than getting in at the top, and as Josh Peters reminds us,
The Safest Dividend Is The One’s That’s Just Been Raised
To get a first look at my upcoming article, "The Evolution of My Durable Income Portfolio," click here. Disclosure: I am on the Advisory Board of NY Residential REIT, and I am also a shareholder and publisher on theMaven (OTCQB:MVEN).
Source: FAST Graphs
*Author Note: Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors, if they are overlooked. Finally, this article is free, and the sole purpose for writing it is to assist withresearch, while also providing a forum for second-level thinking. If you have not followed him, please take five seconds and click his name above (top of the page).* Disclosure:** I am/we are long APTS, ARI, BRX, BXMT, CCI, CCP, CHCT, CLDT, CONE, CORR, CUBE, DLR, DOC, EXR, FPI, GMRE, GPT, HASI, HTA, IRM, KIM, LADR, LTC, LXP, O, OHI, PEB, PK, QTS, ROIC, SKT, SNR, SPG, STAG, STOR, STWD, TCO, WPC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.