by Barry Vinocur
In spite of their sharp run-up over the past roughly 18 months, real estate investment trusts still look attractive, especially to the growing throng of yield-focused investors. The list of reasons to explain investors’ newfound obsession with yield is short. Put simply, still reeling from last year’s tech wreck, investors want a security blanket. In a market beset by earnings shortfall after earnings shortfall and a lack of earnings “visibility,” and with non-REIT corporate dividends under pressure and near historic lows—REITs look mighty good.
No discussion of this year’s preoccupation with yield would be complete without mentioning two other factors that have played—and are likely to continue to play—an important role going forward. First, as Alan Greenspan and the gang at the Fed continue to ease interest rates (seven cuts in the first eight months of 2001, with an eighth possible before year end), investors are looking for a place to put the billions of dollars they have socked away in certificates of deposit and other yield-oriented investments. Needless to say, the thought of rolling over CDs at today’s low rates hardly seems inviting. Second, as the baby boomers approach retirement in a post-dot-com era, they are focusing on funding their golden years, and once again, REITs fit the bill.
Why? One reason is the single-mindedness with which most companies pursued a path to lower their payout ratios since the dawn of the modern REIT era in late November 1992, when Taubman Centers came public as the first umbrella partnership real estate investment trust, or UPREIT (see Glossary on page 78). As the graph on page 22 illustrates, payout ratios have steadily (and significantly) declined over roughly the past 10 years. The result is that most companies today have dividends that are all but bulletproof. Nothing short of an economic Armageddon could produce across-the-board REIT dividend cuts.
REITs accomplished this feat by keeping their dividend growth rates comfortably below their earnings growth rates (see graph on page 23). That seemingly straightforward strategy received a major assist from strong real estate fundamentals, which resulted in robust earnings growth in the years immediately following the dawn of the modern REIT era. So, while dividend growth rates were kept below earnings growth rates, dividend growth rates were by no means shabby.
Comparison Shopping
Another reason why REITs fit the bill today is that when investors look everywhere else in corporate America, the dividend picture is downright scary. In a recent missive, Arnold Kaufman, editor of Standard & Poor’s investment newsletter The Outlook, noted that 2001 will see one of the largest dividend drops on record for the Standard & Poor’s 500-Stock Index.
“The dividend slide Standard & Poor’s forecasts for the current year would be the steepest since 1942 and would make for the first instance of back-to-back years of dividend decline since 1970-71. President Nixon’s voluntary dividend freeze, an inflation-control mechanism, was in effect for much of 1971.”
For the first six months of 2001, Kaufman continued, dividends on the S&P 500 index fell 7.1 percent from the level a year earlier. For June 2001 alone, payments plunged 17.7 percent from June 2000. “Standard & Poor’s now estimates that dividends on the S&P 500 for all of 2001 will drop 6.6 percent from those of 2000, which in turn were 2.5 percent below those of 1999,” Kaufman added.
Also, notwithstanding the absence of significant appreciation from stocks lately, companies are not feeling pressure from shareholders to relax the low dividend-payout policies they adopted during the bull market. “We expect this year’s payout ratio (dividends as a percent of earnings) on the S&P 500 to come close to 2000’s all-time low of 33 percent, which was sharply below the 51 percent average of the postwar period.
“Corporations enjoy the flexibility afforded by paying modest dividends and using the freed-up funds for share buybacks and the like,” Kaufman added. “Investors aren’t rebelling yet,” Kaufman said, “because they remember how well that approach worked to generate appreciation on their holdings during the late 1990s and that the tax on capital gains is lower than that on ordinary income in the form of dividends. A prolonged period of market weakness, however, would be expected to increase the demand for dividends.”
In the first half of 2001, the number of dividend increases reported to Standard & Poor’s from a universe of some 7,500 publicly owned companies fell 12 percent to 764 from 867 in the first six months of 2000 (see table at the top of page 24). At the same time, unfavorable dividend actions accelerated. Dividend decreases in the first half of this year rose to 53 from 36 a year earlier, and dividend omissions climbed to 39 from 25.
In sharp contrast to that picture, REITs (generally) are continuing to increase their dividends. According to the REIT research team at Goldman, Sachs & Co., the average REIT/non-REIT real estate operating company, or REOC, (101 companies in their data sample) boosted its dividend by 3.8 percent during the second quarter of 2001 (see table at the bottom of page 24). If one excludes four REITs that cut their distributions, the average increase climbs to 5.4 percent.
Just How Safe Are REIT Payouts, Really?
Dividend increases are welcome, no doubt. But the question our sister publication, Realty Stock Review, fields most often (with the possible exception of a net asset value-related inquiry) relates to dividend sustainability. Time and again over the past several years, subscribers have asked Realty Stock Review’s editors about the sustainability of REIT dividends. In recent months, those inquiries have focused on dividend sustainability in the face of softening real estate fundamentals.
In late 1998, analysts at Merrill Lynch & Co. published a report, “Are REIT Dividends Secure? We Say the Answer is Yes!” Since then, Realty Stock Reviewhas periodically updated their findings.
There are a number of things to keep in mind when looking at REIT dividends. At the top of the list, of course, is the question: Is the dividend sustainable? Using the same general methodology as the Merrill analysts, Realty Stock Reviewrecently analyzed the dividend coverage ratio (DCR) of the dividend-paying REITs in its Side-by-Side table (see pages 66-71 in this issue). The Merrill analysts defined DCR as a REIT’s cash available for distribution, or CAD, divided by its current dividend. (For its analysis, Realty Stock Reviewused 2001 consensus AFFO estimates. Realty Stock Reviewbelieves that number is equivalent to the Merrill analysts’ CAD.) As the Merrill analysts noted in their December 1998 study, “The higher a company’s DCR, the more sustainable its current dividend.” There are a couple of caveats to that statement, which we’ll address later.
The average DCR for the 96 dividend-paying REITs in Realty Stock Review’s coverage universe (see table on pages 28-30) was 128.6 percent. (When the Merrill analysts did their study in December 1998, they reported an average DCR for the companies in their coverage universe of 136 percent.) Put another way, there’s roughly $1.29 of cash flow standing behind every $1.00 of dividends (on average). The range of the average DCR—by sector—is rather large, from 139.2 percent for the nine office/industrial REITs to 111.7 percent for the two companies labeled as opportunity/diversified.
As the Merrill analysts underscored in their December 1998 study, when looking at DCRs, investors need to factor leverage into the equation. “Given that the average REIT is approximately one-third leveraged implies that the pre-leveraged cash flow figure (that is, the net operating income) would need to decline by 15 percent to 20 percent for the average dividend coverage ratio to reach 100 percent,” the Merrill analysts noted. They added that they viewed the likelihood of a 15 percent to 20 percent decline in net operating income (NOI) over the coming 12 months as unlikely. (Their assessment proved correct.)
On average, REITs are somewhat more levered today than they were in late 1998. However, as a result of the Fed’s easing this year, there’s an opportunity for many REITs to lower their interest payments. Put simply, the likelihood of an across-the-board decrease in NOI sufficient to jeopardize dividends—even in view of softer real estate fundamentals—seems extremely unlikely. That doesn’t mean that there might not be an occasional horror story. However, using the table provided (see pages 28-30), you should be able to steer clear of all but the unforeseeable calamity.
As the Merrill analysts noted in their 1998 report, the one sector that you’ll need to keep an especially close eye on is lodging. Given the short-term nature of hotel leases (guests check in and out every day), the current extremely soft lodging fundamentals with no rebound in sight, and hotels’ high degree of operating leverage, lodging companies are a higher risk proposition on this score than, say, regional malls, which historically have demonstrated very stable cash flows.
Using the Data
Dividend coverage ratios are but one metric. For instance, a highly levered company’s DCR is less sustainable than a company with the same DCR that has lower leverage. Though there are a variety of ways to gauge leverage, Realty Stock Reviewrelies on several metrics, the most important being fixed-charge coverage ratios (see Glossary on page 78).
For instance, if you compare Developers Diversified with Kimco Realty, you find that Developers Diversified’s dividend is 200 basis points higher than Kimco’s. Further, DDR’s dividend coverage ratio is higher than Kimco’s, 142.6 percent vs. 139.2 percent.
However, Developers Diversified is substantially more levered than Kimco. According to a recent analysis by Green Street Advisors, Developers Diversified’s leverage ratio was 68.9 percent vs. 42.7 percent for Kimco. Green Street defines that ratio as total liabilities as a percentage of its estimate of the current value of a company’s assets. Assets and liabilities include a pro rata share of all joint venture debt, and preferred shares are treated as debt. Convertible preferred stock is not included as leverage in this calculation.
Another way to get a handle on leverage is to look at fixed-charge coverage ratios. Here, as in the case of Green Street’s calculation, you find evidence of the difference in the two companies’ leverage. At 3.3x, Kimco’s fixed-charge coverage (see table on page 28) is roughly twice Developers Diversified’s.
Put simply, when gauging dividend sustainability—DCR by itself isn’t enough!
The "Dividend-Pop" Thesis
One question facing investors is: How do I translate the data on dividends into a tool that can assist in my investment decisions? For the past several years, a number of market veterans have suggested that focusing on companies bumping up against their minimum payout ratios (REITs are required to pay out 90 percent of their otherwise taxable income to maintain their tax-favored status) might be a worthwhile strategy.
Early this year, Larry Raiman and his fellow analysts at Credit Suisse First Boston (CSFB) noted the merits of investing in REITs likely to “pop” their dividends in their 2001 Outlook piece. Recently, the CSFB analysts provided an update on their dividend-pop investment thesis.
To come up with their list of dividend-pop candidates, Raiman and his colleagues analyzed seven years worth of data for 137 REITs. Specifically, the CSFB analysts analyzed FFO payout ratios, dividend growth rates, and the recent tax status of dividend payments. They also spoke with many of the companies to confirm their findings.
Based on these quantitative and qualitative measures, the CSFB research team identified 24 dividend-pop-candidate REITs. All of the REITs in their list (see table at the top of page 27) have recently demonstrated at least 8 percent dividend growth and declining FFO payout ratios. Further, Raiman and his fellow analysts underscored, in each of the past two years (i.e., 1999 and 2000) dividend distributions for most of these companies represented close to 100 percent of ordinary income, thus indicating payouts equal to “earned income.” Finally, they noted that each of the companies in the list (the lone exception is Host Marriott) is expected to generate above-average FFO growth over the next two years.
Impressive Outperformance
Why zero in on dividend-pop-candidate REITs? In each of the past four years (1997-2000), so-called dividend-pop REITs have outperformed the overall sector by a whopping 905 basis points per year, Raiman and his colleagues reported.
“However, given the topsy-turvy nature to this year’s stock picking environment, dividend-pop REITs have fallen short of the aggregate REIT universe by nearly 600 basis points,” underscored the CSFB analysts. They noted that while over 77 percent of dividend-pop REITs had beaten the REIT index in each of the past several years (see graph at the top of page 26), only 21 percent of dividend-pop names have beaten the REIT index thus far in 2001.
Raiman and his team believe the fact that dividend-pop-candidate REITs have underperformed the overall sector thus far in 2001 creates an interesting investment opportunity. “At some point, trading within the REIT market should prove more efficient, which would reward those companies generating the greatest value for shareholders,” they added. Those companies are likely to be the ones with the highest FFO per share growth, and many of those names are on the CSFB list of dividend-pop-candidate REITs.
A Final Note
Though the REIT dividend story hardly qualifies as news, going forward, investors are likely to focus on it even more (and in greater numbers) than in the past because the REITs likely to pop their dividends are more likely to outperform. However, it’s important to remember that no single metric is sufficient to drive an investment thesis.
For the past couple of years, Realty Stock Reviewhas recommended a “getting-paid-to-wait strategy” that includes the premise that companies with solid and growing dividends that are dominant—or destined-to-be dominant—in their sectors are likely to provide superior total returns over a three- to five-year time horizon.
Though there will always be moments in time when the “dark horses” will win the race, over the long haul, those investors who rely on metrics such as the ones summarized here will produce solid investment returns and avoid the sleepless nights that go hand-in-hand with more risky investment strategies.
