REIT Sectors From The Lens Of A Dividend Investor

The aim for this article is to determine A) how attractive dividend yields offered by REITs are compared to the historical average and to the average S&P 500 company, B) the provided yields across various REIT sectors, and C) which particular sector could be considered the best pick for dividend oriented investors.

Before jumping right to the analysis, I would like to stress that viewing investments on a total return basis is of paramount importance rather than just picking some asset based on its provided dividend yield. By constraining the investment basket to just dividend yields, the probability of getting the best expected return per unit of risk is significantly lower.

However, I still consider this approach relevant, especially for such asset class as REIT:First of all, for REITs the portion of total returns is heavily skewed towards returns stemming from dividends. The capital appreciation and stock buybacks, compared to most other stocks, account for relatively smaller portion of the total returns, since REITs have to pay out at least 90% of their net profits. So assessing the dividend aspect for REIT is more appropriate than for other types of stocks.There are truly few individuals, who are able to invest without any behavioral biases. Personally, I have never talked with someone who strictly follows mean-variance-optimized portfolio and who is constantly evaluating its risk aversion coefficient to be incorporated constructing the right efficient frontier. To the contrary, majority of the individual investors have something like a goals based approach to investing, where the performance is measured by the success of investments meeting personal goals. I think that my focus to dividends is somewhat justified since receiving stable current income streams from the investment portfolio is very popular goal among many.

REIT Dividend Yield vs 10 year U.S. Treasuries vs S&P 500

The used proxy for REIT dividend yield in this case is FTSE Nareit All Equity REITs Index, which, in my opinion, is the best benchmark since it includes almost all of the publicly traded equity REITs. It accounts for 163 U.S. equity REITs that are weighted based on their market cap. The fact that this is a market cap weighted introduces a bias where the small cap REIT companies do not contribute to the overall FNER development to such an extent as the large caps. However, other index composition methods as, for example, the arithmetical average one in which each REIT is given the same weight come with their specific biases too. However, since market cap weighted indexes are the most widely used, and that FNER reflects total returns as opposed to just the underlying stock price moves as it is the case with S&P 500, the FNER is a sound and totally reasonable/relevant benchmark.

Source: Nareit, FactSet

As you can see, REITs tend to provide higher yields than 10 year U.S. Treasury bonds, making investments in REITs rather attractive for current income stream seeking investors. The average yield spread between REITs and 10 year U.S. Treasuries has been 1.23% in the 1990-2019 period. Currently, though, the spread has slightly widened reaching 1.79%. This is mainly driven by the increasingly accommodative monetary policy, which pushes the bond yields down and equity valuations up. In the chart you can see that both yields have went down recently, and that the REIT yield has not fallen at the same magnitude as the U.S. Treasury yield, ultimately leading to increase spread.

Generally, you will see the spread rising whenever there are elevated recessionary risks that cause “flight-to-safety” action, which sets an increased demand for bonds bringing the yields down sharply. However, for anyone who wants to get a stable cash inflows from its REIT portfolio and who has the nerves to experience huge swings in the share prices without having to sell at wrong time, this should not be a huge obstacle. As long as the investment portfolio`s REIT companies have healthy balance sheets and strong FFO or AFFO payout ratios, the chances are very small that dividend will get impacted.

Since currently REITs provide on average 3.58% dividend yield, it implies that REITs as a yield type investment vehicle are far more appealing than S&P 500 too. By investing in S&P 500 index, you would get 1.89% yield, which is by ~ 50% lower than what you can get from REITs. Obviously, this is a huge gap and for dividend investor it leaves a significant impact on the level of periodic cash flows received.

The key takeaway is that REITs provide much higher yield than 10 year U.S. Treasuries and even than S&P 500, and thus are highly attractive asset class for dividend investor.

REIT Dividend Yields by Sector

In total there are 12 REIT sectors each being exposed to different type of risks and with different sources of the underlying cash flows. I will, however, decompose further Retail in shopping centers, regional malls and free standing sector types. Similarly, I will delineate apartments, manufactured homes and single family homes from the broader residential basket.

Source: Nareit (compiled by the author based on data published on September 30th, 2019)

Clearly, the higher dividend yield a particular sector offers, the more cyclical the underlying cash flows are. For example, regional malls are not only sensitive to the overall business cycle fluctuations, but they are also experiencing some serious disruptive trends making it much harder to increase and even sustain the current level of generated cash flows.

The opposite applies for, say, infrastructure REITs, which yield significantly below the REIT average of 3.58%. The demand for infrastructure objects is much less elastic to changes in the economic activity, and the lease contracts are usually of long-term nature rendering increased predictability of future cash flows.

For investors seeking to capture above average dividend with high degree of stability and perhaps even some growth component attached to it, it is vital to assess the underlying strength of fundamentals supporting the juicy yield. Otherwise, the chances are that you will be exposed to sucker yield - a dividend that doesn't match up with its company's fundamentals.

Which Sector Looks Most Attractive For Dividend Investor?

To determine which sector has the most attractive combination of the offered dividend yield and the fundamentals backing it, I will incorporate debt ratio and FFO payout.Debt ratio is calculated by taking the REIT’s total debt and dividing it by the total market cap. And here the total capitalization is the sum of implied market cap and total debt. In my opinion, debt ratio gives a good understanding on whether the company is financially healthy and whether there is a high risk of additional share issuance, forced property divestitures or unexpected dividend cuts in case of an economic slowdown.Now, I totally believe that AFFOs are much better measure than FFOs for evaluating REIT performance. However, not all REITs publish AFFO figures and more importantly Nareit does not provide monthly data on dividend coverage on AFFO basis. So, I will stick to FFO payout to judge whether the dividend yield is sustainable and whether the company provides some potential growth.

Source: Nareit (compiled by the author based on data published on September 30th, 2019)

The yellow horizontal line separates REITs with FFO payout exceeding 100%. Where the blue columns do not exceed 50%, it means that those REITs pay out more cash than they are able to generate from normal business operations. The red horizontal line, shows the average REIT debt ratio.

Diversified, regional malls, free standing and specialty sectors have their FFO payouts very close to 100% (even slightly above). In addition, with an exception of free standing, the red horizontal line indicates that their balance sheets carry higher debt burden than REIT average. This is clearly not a good sign for investors seeking stable current income streams.

On the flip side, single family homes, infrastructure and office are the three REIT sectors, which on average pay out approximately half of their FFOs. This gives investors a solid sense of comfort that during recessionary times, the dividends will most probably not get cut, and that there is a notable internal investment capacity to increase FFOs and dividends in the future periods.

The pattern is clear for the top three highest yielding REITs (regional malls, specialty and lodging) - they are significantly more indebted than average REIT and have excessive FFO payouts. The only exception in terms of potentially unsustainable dividend coverage are lodging REITs, where their average FFO payout stands at healthy 63.5%.

To boil down to single best REIT sector for an dividend investor, we have to eliminate all sectors with 90% and above FFO payouts. This way we will make sure that the risk of experiencing a dividend cut is not too high - critically important for the late stage business cycle. Plus, let's not forget that we analyze based on FFOs and not AFFO, which #A are better indicator for measuring the sustainability of dividends, #B usually are lower than FFOs. For instance, there is a high likelihood that Free Standing sector, which pays out 97.4% of the FFOs, would have AFFO payout exceeding 100%.

Now, the highest yielding REIT sector after omitting the 90% + FFO payout REITs is lodging/resorts - it provides 6.02%, with super conservative 63.5% payout. Next highest yielding sector is shopping centers, however, its provided dividend yield is considerably lower, and the FFO payout is somewhat more aggressive - 4.96% and 70.2%, respectively. Moreover, the debt ratio for lodging REITs is only 5% above the REIT average of 29%. Also, from the top three REITs (excluding those with excessive payouts), the debt level on the balance sheet is the lowest for Lodging sector as well. For example, shopping centers have debt ratio of 37% and diversified, third highest yielding REIT, have it on a level of 35%.

This highly attractive circumstance is driven by depressed valuations, which in turn are explained by the fact that there is a consensus in the general public that currently we are in the very late stage of the business cycle. Hence, majority think that the likelihood of suffering a recession in the nearest future is high and thus investors naturally incorporate the previous downturn consequences in pricing the hotel REITs. Back in 2008, REITs truly got crushed and saw their share prices declining at a far greater magnitude than other REIT companies.

In my previous article "Depressed Hotel REITs Provide Opportunities For Dividend Investors", I argued that #1 hotel REITs are significantly undervalued despite growing cash flows and relatively low levels of debt on their balance sheets #2 cap-rates provide an attractive ground for capturing profitable long-term growth #3 while the hotel industry is subject to systematic risk (overall market moves), suffering gigantic drawdowns as in 2008 is unlikely.

The sum it up

- by investing in lodging/resort sector, a dividend oriented investor will get a great exposure to above average dividend yield that is backed with strong FFO payout and with reasonable financial risk.

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Disclosure:

I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.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.