REIT Dividends Still Blooming
[May/June 2006]
By Darlene Bremer
For investors looking to grow their portfolio's income,
REITs continue to be a logical choice
Dividends, those cash distributions paid to shareholders, send a message about both the company and its stock's future performance. A company's willingness and ability to pay steady dividends over time, and, more importantly, its power to increase them, provide important clues about its operating fundamentals and intrinsic value.
So, what direction will REIT dividends take in the coming years and what factors, issues, or trends will determine whether they strengthen or weaken? After all, in addition to their diversification benefits, the stable and often growing dividends REITs provide are one of their most compelling attributes.
Over the next three years or so, there should be a clear strengthening in underlying real estate operating fundamentals, such as reduced vacancy rates, and a selective and gradual increase in rental rates. These factors should strengthen REIT profitability and, correspondingly, REIT dividends, according to Amos J. Rogers, III, managing director of the Tuckerman Group/State Street Global Advisors.
Until occupancy rates firm up and increase, the pace of the rental rate recovery will be fragmented, with some sectors already rising and others just months to a year away from recovery. For example, the retail sector is currently experiencing rental rate increases, thanks to strong consumer confidence and sector expansion.
"In high employment office markets, such as New York and Washington, rental rates are increasing as the economy grows jobs. Lower growth markets, however, are just beginning to firm up their occupancy rates and won't see rental increases for six to 12 months," adds Fernando Diaz, Tuckerman's senior analyst.
Elizabeth Campbell, senior analyst at Standard & Poor's Rating Service, also sees increased cash flow for REITs allowing companies to support their dividends in the near future, depending on the property type. She adds the apartment sector to the list of those in recovery, with rental rate growth being the primary driver.
"However, we also could see increased expenses, such as energy, insurance and labor cost pressures compressing margins," Campbell says.
In the end, REITs' ability to drive revenues and mitigate expenses is what will ultimately strengthen or weaken their dividends.
Strength in the Numbers
What speaks to the overall strength of REIT dividends is, in fact, the struggle the industry had over the past three or four years with stagnant cash flow growth, decreased occupancy rates and rents, and assets being sold, according to Mike Coke, CFO of AMB Property Corporation (NYSE: AMB).
"Dividends mostly held steady during this period, demonstrating their strength. Now that the industry has gotten through that natural cyclical downturn and occupancy rates and rents are growing, the industry is entering an upswing period with potential for substantial dividend growth," Coke says.
Continued industry maturation and seasoned management teams that have demonstrated their ability to weather various real estate cycles are other factors that continue to contribute to the strength of REIT dividends, along with quality real estate assets in good locations that have proven to be consistent sources of growth and cash flows.
"I believe that the real estate assets owned by public REITs are generally of higher quality on average, which bodes well for strengthening dividends over time," says Terry Stevens, CFO for Highwoods Properties (NYSE: HIW).
REITs vs. Other Assets
REIT dividends still offer roughly twice the return of other equity dividends, according to Rogers and Diaz, with yields of around 4 percent to 4.5 percent. Broader market yields, such as the S&P 500, average around 1.5 percent to 2 percent. "It's actually the uniqueness of the REIT rules that account for their higher yields. REITs distribute a minimum of 90 percent of their taxable income in dividends," they explain. "And in return REITs do not pay corporate-level taxes on those distributions."
This is not to say that REIT yields have not, in fact, come down over time. In the early 1990s, the average REIT yield was around 7 percent. "But even with lower than historic yields, investors are looking more favorably at real estate assets today than they used to and they no longer require the risk-adjusted return they did 10 to 15 years ago," Campbell says.
While REIT stocks' volatility has been growing in recent years, they are still a relatively lower risk equity investment and backed by hard "brick-and-mortar" assets with focused management teams. Compared to fixed-income securities, REIT stocks provide upside potential in terms of both income stream and long-term appreciation, making them attractive to a wide class of investors. "I think that investors will continue to allocate an increasing share of their investment assets to REITs, or to funds that invest in REITs," Stevens says.
Although REITs have been paying higher dividend yields than most other non-REIT stocks, different sectors within the industry are paying different yields, based on the volatility of the particular segment's earnings, according to Howard Silver, president and CEO of Equity Inns, Inc. (NYSE: ENN).
"It's interesting to note, however, that it's the REITs' track record of growing earnings and dividends and their long-term maturity that has made them more attractive to both institutional and individual investors," he says.
The stability and promise of REIT dividends have been borne out over the past three years by the industry's market capitalization. From 2003 to 2006, total REIT investments have grown from $160 billion to $350 billion. "In 1990, total REIT investments equaled only $10 billion," observes Mike Colleran, CFO of Trizec Properties, Inc. (NYSE: TRZ).
REIT dividend performance, as compared to other investments, provides further evidence of their strength. The highest yielding equity investment outside of REITs is the utility sector, with an average of 3.5 percent. In the fixed income world, high-yield bonds yield approximately 8.3 percent, triple B corporate bonds yield almost 6 percent, and 10-year Treasury notes offer around 5.0 percent. It's true that yields on REITs recently declined more than yields on some other investments (narrowing the spread between them and indices such as the S&P 500). However, the risk premium has declined, due to the maturation of the overall asset class, as defined by improved quality of assets, management teams and capital structures, which make REITs competitive with fixed-income investments.
Interest Rate Impact
There are varying schools of thought regarding the impact interest rate fluctuations play on real estate stocks and their dividends. Many within the industry agree that interest rates will play a key role in the relationship between REIT dividends and other income-producing investments.
"In the next few years, long-term interest rates will be the single most important factor," observes Collin Bell, senior product manager for Goldman Sachs Asset Management. As bond yields rise in the coming years, as expected with rising interest rates, the gap between the dividend yields of REITs versus bonds or other yield investment alternatives will narrow. "This has largely already happened in the past couple of years and, if it continues, the trend could make REIT dividends less attractive on a relative basis."
If interest rates were to go down, then, of course, it would have the opposite effect on REIT dividends. However, Bell thinks it's important to note that this scenario should exist for only a short period of time, since REITs actually perform well during long-term periods of economic expansion. "The conditions that typically cause higher interest rates and lower bond prices, such as economic growth, job creation, and inflation, are generally positive for real estate fundamentals," he explains.
Most REITs feel comfortable that earnings will continue to grow at annual rates of 5 percent to 10 percent per year. If pay-out ratios remain constant, the industry will see dividends rise at those same rates, according to Scott Wolstein, chairman and CEO of Developers Diversified Realty Corporation (NYSE: DDR). A near-term opportunity for dividend growth derives from the fact that prices for real estate assets are very high right now by historical standards.
"To the extent that REITs take advantage of market prices by selling assets, they could generate some extraordinary gains, which, under REIT law, will require paying the taxes or distributing 90 percent of the gains to shareholders," Wolstein says.
However, Wolstein cautions that any precipitous increases in interest rates will put pressure on REIT earnings and any subsequent increases in the cost of borrowing money will have a direct reducing effect on the bottom line as well as on dividends.
For those sectors that have adjustable rate debt, a rising interest rate environment could cause them to actually have trouble covering their dividends, particularly when too much was paid for properties.
"Interest rates have been at historic lows and are destined to rise if for no other reason than as part of the natural business cycle," Silver says. However, he adds optimistically, continued improvement in REITs' bottom lines, the acquisition of property at good capitalization rates, and fixed interest rates for money borrowed, are factors that will help strengthen REIT dividends, even if interest rates rise.
Two other factors that can impact the direction REIT dividends take are the condition of the general economy, including job growth, and a REIT management's strategy. "Recovery and expansion of the economy in general will naturally drive up REIT dividends," Colleran says. Likewise, if REITs' assets are disposed of in slower growth markets and acquired in faster growth markets, the result will be increased rents at lower costs.
Dividends Remain Safe
REIT management teams are well aware that many investors are attracted to their companies primarily due to their dividends. As a result, REITs have historically been reluctant to cut their dividend. However, some REITs, such as Equity Office Properties (NYSE: EOP), have cut their dividends for strategic business reasons. But does that signal anything for the industry as a whole? The general consensus among analysts and REIT management is no.
"It's typically not good for a REIT to cut its dividends because it's an important component of a REIT's return, but there are situations where the company may be repositioning or restructuring itself, or where earnings have slowed and it has to sell assets or borrow money to maintain historical dividend levels," Diaz says. In those cases, Diaz says it is more of a short-term phenomenon and the company is better off bringing its dividend in line with its long-term earning potential.
Stevens also sees EOP's dividend cut to be company-specific and not an industry-wide issue or trend. In fact, the discipline REIT management teams have shown in keeping financial leverage at reasonable levels, combined with the high quality of the real estate assets held in public REITs, have provided general industry stability and dividend growth.
"Sometimes a company just has to cut its dividend to make up for any short-term cash flow weakness caused by natural business cycles," Silver says.
Most companies are not under the same earnings pressure as those in the office sector with declining occupancy rates and revenue streams. "I would expect that the pendulum will swing back for the office sector and, in fact, investors are already beginning to bet on its recovery," observes Wolstein.
If one company's dividend cut is not an industry trend, then more REITs are probably not likely to follow suit. "Any cuts that do come, and of course there may be some, will be the exception and not the rule and will be based on the company changing its strategy rather than on the economy or on an industry-wide problem," Colleran says.
However, if some newly formed public companies, especially those with a great deal of adjustable rate debt, find interest rates rising, it is possible that they would have to cut their dividends in the short term to cover their cash flow, according to Silver.
Bell also says he believes that there are still a few companies that might be forced to cut their dividends, but sees little concern that it could rise to an industry-wide problem. "We expect REIT dividends to generally grow and become more stable over time as real estate fundamentals continue to improve."
Those improving fundamentals, even in those sectors that haven't completely begun their recovery, means that any gaps between cash flow and dividends should be closed in a relatively moderate period of time, according to Campbell.
"We don't anticipate any dividend cuts at this stage of the business and real estate cycle," Campbell says.
There are a number of reasons investors should feel confident continuing to look toward REITs for reliable sources of income. The inherent limited risk of REIT investments and their resistance to inflation, their improving fundamentals in terms of occupancy and rental rates, the value of the underlying real estate assets, disciplined management teams, and industry maturation all indicate that the state of the REIT dividend is, and will remain for the foreseeable future, very strong.
Darlene Bremer is a regular contributor to Portfolio.
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