Making the REIT move for dividends and dividend growth

By Steve Bergsman

Since the Jobs and Growth Tax Relief Reconciliation Act of 2003 was enacted, corporate America has upped its dividend payouts and many companies have begun paying dividends for the first time. In 2004, U.S. companies paid out a record $181 billion in dividends, according to a report in The Wall Street Journal. In addition, the average yield on the S&P 500 has increased to roughly 1.8 percent.

The "Jobs and Growth" Act attempted to make dividend-paying stocks more attractive and resulted in dividends paid by constituents of the S&P 500 Index and the Dow Jones Utilities Average (DJUA) being taxed at capital gains rates, or a 15 percent maximum rate.

Some within the REIT industry were concerned that the "Jobs and Growth" Act would encourage general equity investors looking for yield to pull money out of REITs. Instead the additional spotlight on dividends served to highlight the benefits of listed REITs. And even though a majority of REIT dividends do not qualify for the reduced tax rate, more than one-third of REIT dividends in 2004 still qualified for the lower tax treatment afforded by the "Jobs and Growth" Act. In short, when it comes to dividends there is only one equity category that is king: REITs.

REITs Remain Dividend Kings

"In the short run you saw some REITs trade off and there was some concern there would be movement out of real estate stocks to more tax-efficient yield vehicles, but that quickly reverted itself within a couple of weeks," says Christopher Haley, a managing director with Wachovia Securities.

"Since most REIT dividends didn't get to participate (in the lower tax rates), everyone thought they would get hurt, which didn't happen," notes Richard Moore, a managing director at KeyBanc Capital Markets.

Moore puts a positive spin on the whole tax relief act concept. "As opposed to saying let's not buy REITs, what the act did do was increase the excitement around dividends and showed there were lots of choices," he says.

The key reason why income-seeking investors didn't leave REITs was that even after the tax changes for other investments REITs remained the dividend kings. The REIT dividend yield for the NAREIT Composite REIT Index at the end of 2004 was 4.97 percent, while the S&P was 1.7 percent. At the end of January, all three indices had shifted a bit with the NAREIT Composite REIT Index still on top. The S&P 500 rose to 1.94 percent, the DJUA slipped to 3.03 percent, while the NAREIT Composite sported 5.37 percent.

Source: NAREIT

Taking into account both historical and current yields, Jeung Hyun, a principal with Adelante Capital Management LLC, compares REITs as measured by the Morgan Stanley REIT Index (RMS) to the S&P 500 and DJUA. Going back almost 10 years, dividend yield as of June 1995 for the RMS was 5.09 percent, better than the S&P 500 at 2.44 percent, but less than DJUA at 5.95 percent.

However, on a 10-year average (June 30, 1995 to Jan. 31, 2005), the S&P 500 dividend yield averaged 1.57 percent, the DJUA was 4.31 percent, while the RMS averaged a whopping 6.55 percent and the NAREIT Composite posted 6.98 percent. Partly the 10-year average payout by REITs was skewed by what Hyun calls the "mispricing" of 1999 and 2000. The highest REIT dividend yield, 9.28 percent, in the past 10 years was recorded in November 1999.

For one REIT, the dividend is so important to its market presence that it declares a monthly dividend. In fact, Realty Income Corporation (NYSE: O), which acquires single-tenant retail properties, calls itself the "The Monthly Dividend Company," a slogan it has registered.

The reason Realty Income decided to declare dividends monthly instead of quarterly was for its investors, many of whom were over the age of 60 and viewed dividends as a necessity not a luxury. Also, retail properties are net-leased on 20-year contracts, so the revenue stream is consistent and it's easier to forecast dividends on a monthly basis.

The need for dividends will only get stronger in the years to come, maintains Thomas Lewis, Realty Income's vice chairman and chief executive officer.

"Dividends were out of favor because we went through a 20-year bull market where a huge portion of the population was in their accumulation years. However, over the next 25 years, the baby boomers are aging and the number of people in the 65 to 69-year-old bracket will grow by 100.6 percent. The demand for dividends will rise exponentially."

On the other hand, for James Keagy, managing director at Barclays Global Investors, dividends are only one component of value.

"We pay more attention to total return," Keagy says. "Nearly all of our REIT holdings are in index strategies, and investors have been well served by taking a passive approach. So, we hold REITs based on their cap weighted value in a benchmark. Unlike an active REIT manager who has to overweight or underweight and where dividends might be a factor in security selection, we do not have to do that because clients are hiring us for benchmark exposure. Institutional investors are more focused on total returns, not on dividends as an individual might be."

Analyzing Dividends

In order to qualify as a REIT, companies must pay at least 90 percent of their taxable income in the form of shareholder dividends. As a consequence there isn't significant latitude as far as dividend payout is concerned. As long as operating fundamentals for REITs continue to improve, dividend growth will follow.

That's a key point for some REIT analysts.

Wachovia's Haley weighs earnings growth, FFO (funds from operation) growth, returns on investment capital and direction of NAV (net asset value) growth when scrutinizing stocks.

"Now we have most REITs trading at premiums to NAV, so trying to find those companies that are going to see earnings accelerate earlier and return on investment capital pick up earlier can sometimes be first seen in dividend policy," he says.

Haley does note that REITs in general have increased the use of special dividends, but mostly with companies that have been selling assets. That's a good thing. However, some REITs have been paying the basic dividend by asset sales and not FFO. That's not such a good thing.

"In the first scenario, the company is saying it's in an excess capital position and it is going to create a special value for you, the shareholder," Haley says. "In the second scenario where sales are helping to pay the regular dividend, that's a negative."

The relationship between FFO and dividends is known as the payout ratio and, generally speaking, if the dividend is not being paid from FFO on a sustained basis, it is probably indicative of a problem, observes Rich Jeanneret, a partner and mid-Atlantic area industry leader of hospitality and construction with Ernst & Young LLP.

Source: SNL Financial

Think of the payout ratio this way: if the company's dividend is $1.00 and FFO is $1.50, then the dividend payout ratio is 67 percent. If the payout ratio is less than 100 percent, the company has cash left over for other uses plus it has room to push the dividend forward. Obviously, if the dividend is higher than the FFO, there could be problems.

"We have found that REITs with a low dividend payout ratio outperform the REIT index on a consistent basis," observes Philip Martin, a REIT analyst with Stifel, Nicolaus & Co., Inc. Martin points to Alexandria Real Estate Equities, Inc. (NYSE: ARE), Equity One, Inc. (NYSE: EQY), Ramco-Gershenson Property Trust (NYSE: RPT) and Realty Income as examples of companies with low dividend payout ratios.

Minding Payout Ratios

When analysts look at dividend growth, one of the key components is going to be a payout ratio that is lower, which means there is a greater ability for the REIT to grow its dividend at a higher than average rate, Martin says.

There are definitive benefits of a lower payout ratio, notes Jim Sullivan, a managing director and senior REIT analyst with Prudential Equity Group LLC, in a January research report. "The two key benefits are that the lower payout ratio improves dividend safety and provides companies with free cash flow that can be reinvested into new or existing assets, debt reduction or share repurchases. All things being equal, companies that have a lower-than-average dividend payout ratio should be able to generate above-average FFO per share growth."

Companies that have lower payout ratios are less likely to issue new equity to grow their portfolios when share prices increase, according to Sullivan.

"If you are a REIT and I am a REIT and you have 100 percent payout ratio, it means you are paying out all of your cash flow. If I am at 85 percent, I'm not paying out all my cash flow. For an investor, you would feel more comfortable buying my REIT with potential dividend growth and dividend safety," Martin says.

That 85 percent number seems to be the dividing line between safety and concern.

"It's best to have a margin of safety so that you are able to retain some free cash flow to fund other needs, such as capital expenditures," says Sara Grootwassink, chief financial officer at Washington Real Estate Investment Trust (NYSE: WRE).

Washington REIT prefers to fund recurring capital expenditures out of cash flow as retained cash is less expensive than borrowed capital. "When you exceed the 85 percent payout ratio range, it is likely that a REIT would have to borrow to fund capital expenditures," Grootwassink says.

On a historical basis, the average equity REIT dividend payout ratio fell from 86 percent in 1993 to 65.2 percent in 2001, but it has been moving up the last few years and in 2004 hit 72 percent, reports Sullivan.

Although the increase in the payout ratio appears small since 2001, the resulting impact on free cash flow is actually quite substantial. Sullivan estimates FFO must be reduced by approximately 15 percent for non-revenue generating capital spending and other appropriate adjustments to calculate "Adjusted FFO" or cash available. Thus, he wrote, "an 85 percent FFO payout ratio leaves the industry with no free cash flow. As a result when the dividend payout ratio increased from 65 percent in 2001 to 72 percent in 2004, free cash flow as a percentage of FFO declined from approximately 20 percent to only 13 percent—a decline of 35 percent."

Both Martin and Sullivan assert investors clearly distinguish between companies that just increase dividends and those that increase dividends while reducing payout ratios.

Theoretically, Grootwassink says, dividend growth should be 70 percent to 75 percent of FFO growth over time. However, as a result of weaker underlying fundamentals, in recent years many REITs have maintained higher than normal payout ratios with dividend growth marking a higher percentage of FFO growth. This trend should reverse as fundamentals improve for most sectors.

Source: NAREIT

The average REIT dividend growth rate has been higher than FFO growth since 2002. According to Sullivan, the cash dividend growth has been 1.9 percent in 2002, 2.1 percent in 2003 and an estimated 3.5 percent in 2004. Martin sees a change ahead.

Over the last few years, the annual dividend growth has been in the 2 percent to 4 percent range for REITs, he observes, "but the sector is improving and that could ratchet up to 4 percent to 6 percent."

While there may be a number of REITs being scrutinized for their payout ratios, investors shouldn't be overly concerned that trouble lies ahead.

"It's a little too simplistic to say a REIT is in trouble by keeping dividends at the same level but their FFO goes down a quarter or two, because there may be specific issues involved," avers Lawrence Jones, a partner with PricewaterhouseCoopers. "Companies across the board are being reasonably prudent about how much cash they have to pay out in regard to long-term financing plans. Boards of directors spend a lot of time focused on their dividend policy because they know they don't want to get in trouble by putting out a bigger dividend than is prudent."