Image: The Dividend Cushion ratio is one of the most powerful financial tools an income or dividend growth investor can use in conjunction with qualitative dividend analysis. The ratio is one-of-a-kind in that it is both free-cash-flow based and forward looking. Since its creation in 2012, the Dividend Cushion ratio has forewarned readers of approximately 50 dividend cuts. We estimate its efficacy at ~90%.
By Brian Nelson, CFA
Times are tough for equity REITs (VNQ) and mortgage REITs (REM), with the VNQ and REM down 25% and 30%, respectively, so far in 2022. This is against a backdrop of Valuentum’s simulated Dividend Growth Newsletter portfolio and High Yield Dividend Newsletter portfolio that are doing far better. The lesson in 2022, as it has been every year: Don’t chase yield for yield’s sake. Business models, traditional free cash flow generation, and valuations simply matter.
There are a few fundamental long-term considerations working against REITs. For starters, the labor force is less-than-enthused about returning back to the office, and remote jobs are becoming more and more common, meaning the need for office space may, over the long run, not be as much as previously thought. Secondly, consumers are growing more and more comfortable ordering online, making many smaller retailers or mall-based retailers and their rents obsolete. These two trends, in particular, are worrisome for REIT investors.
But there’s more to the REIT story, and something that we include in every one of our REIT dividend reports:
REITs pay out 90% of annual taxable income and therefore are unable to meaningfully reinvest internally generated funds, resulting in external capital-market dependence. The weak internal cash-flow retention of most REITs translates into poor raw, unadjusted Dividend Cushion ratios, which could become severe during the depths of the real estate cycle. Even though a REIT’s operating cash flow may be robust, the lack of cash accumulation on the balance sheet and the massive debt needed to purchase/develop new properties can become restrictive. The adjusted Dividend Cushion ratio accounts for expectations of continued access to the capital markets, which while “normal,” cannot be guaranteed in times of tight credit.
Sometimes, a REIT paying out most of its taxable income in the form of dividends is spun to investors as a “good thing,” but we’d much rather have a corporate idea that has a strong net cash position on the books, so that it can cover the payout in the event that cash flow from operations, or free cash flow in particular, comes up short relative to expectations. Office REIT SL Green (SLG), for example, recently cut its payout nearly 13%, due in part to weakened net rent revenue on a year-to-date basis, but also due to balance sheet strain due to the REIT’s inability to build up stores of cash on the books. The Dividend Cushion ratio captures this dynamic, while FFO coverage ratios do not.
According to a report from the National Association of Real Estate Investment Trusts, as retrieved through Seeking Alpha, U.S. REITs raised a mere $1.46 billion in capital during November, a number that was down a staggering ~84%. According to the report, there were only three offerings during the month, which compares to more than 20 in November of last year. So far during 2022, the appetite for REIT investments has been abysmal given the pace of capital raising that took hold last year. Withdrawals from non-traded REITs have also been soaring, reaching more than $2 billion in the second quarter and $3 billion in the third quarter of 2022 (a huge increase from prior quarters which were far below $1 billion), according to data from Robert A Stanger & Co.
Many of our readers understand how cautious we are with respect to highlighting ideas that are capital-market dependent, meaning those ideas that do not generate sufficient free cash flow in excess of cash dividends paid, a situation that is often compounded by that company’s huge net debt position. We don’t include any REITs in the Best Ideas Newsletter portfolio, we include Realty Income (O) in the Dividend Growth Newsletter portfolio, and we include a few in the High Yield Dividend Newsletter portfolio, but the group is not one for the faint of heart. Rising interest rates have only compounded what has been a bad situation for REITs so far this year. Even Blackstone (BX) had to limit withdrawals from non-publicly traded $70 billion Blackstone Real Estate Investment Trust (BREIT) after redemptions soared from investors concerned about the health of commercial real estate.
Concluding Thoughts
Equity and mortgage REITs have been under considerable pressure during 2022. Institutional investors seem to be fleeing the sector, but retail investor interest still seems unusually high. We think this might be a tell-tale sign that retail investors could end up getting burned, if they haven’t been already by the terrible performance across the sector so far in 2022. Withdrawals on non-publicly traded REITs are soaring, and SL Green’s dividend cut may be the first of many in the sector to come. We only include a select few REITs across our simulated newsletter portfolios.
Tickerized for holdings in the SCHH and REM.
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About Our Name
But how, you will ask, does one decide what [stocks are] “attractive”? Most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth,”…We view that as fuzzy thinking…Growth is always a component of value [and] the very term “value investing” is redundant.
— Warren Buffett, Berkshire Hathaway annual report, 1992
At Valuentum, we take Buffett’s thoughts one step further. We think the best opportunities arise from an understanding of a variety of investing disciplines in order to identify the most attractive stocks at any given time. Valuentum therefore analyzes each stock across a wide spectrum of philosophies, from deep value through momentum investing. And a combination of the two approaches found on each side of the spectrum (value/momentum) in a name couldn’t be more representative of what our analysts do here; hence, we’re called Valuentum.
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Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson’s household owns shares in HON, DIS, HAS, NKE, RSP. Some of the other securities written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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