Income investors want to collect great dividend yields, but don't want to worry about whether or not a generous payout will get cut -- or, even worse, eliminated -- because the company can no longer afford it. That is why investors often steer clear of yields anywhere near 10% -- they may be too good to be true.
But there is a way that you can earn 10% in recurring income from your original investment without taking on a big risk, and that's through the power of dividend growth. Below, I'll show you how investing in a stock like Innovative Industrial Properties (IIPR -0.82%) can lead to you earning 10% or more of your initial investment back each year.
Image source: Getty Images.
Don't aim for a 10% yield right off the bat
Searching for double-digit yields is a good way to find bad investments. However, while Innovative Industrial doesn't pay anywhere near 10% today, that doesn't mean you can't be earning that much after holding on to it for several years. The real estate investment trust (REIT) currently pays its shareholders a quarterly dividend of $1.32. With a share price of $175, you will be earning more than 3% per year in recurring income, which is still above the S&P 500 average of just 1.4%. If you invest $25,000 into the stock, that would mean you are collecting about $750 in dividends annually.
But that's just the start. With a company like Innovative Industrial that raises its payouts aggressively, that income could quickly become much bigger.
Stick with dividend growth stocks that have room to grow
Not every dividend stock is going to grow its payouts, so it's important to be cognizant of not just which companies have shown persistence in doing so, but if their opportunities over the long term look promising. In Innovative Industrial's case, the stock ticks both boxes. Its $1.32 quarterly dividend payment in April was nearly three times the $0.45 that it was paying out just two years earlier.
REITs have to pay out at least 90% of their earnings back to shareholders, and a key reason Innovative Industrial can afford to keep boosting its dividend payments is that profits have been growing; in 2020, its funds from operations (FFO) per share totaled $4.75, rising 63% from the previous year. FFO is typically used by REIT investors to assess profitability, as it excludes non-cash items. On an FFO-basis, the company's payout ratio currently sits at 95%. Innovative Industrial reported a diluted FFO of $1.39 in its most recent quarter for the three-month period ending March 31.
But profits are likely to continue rising as more states legalize marijuana and more companies grow cannabis. The REIT's sale-and-leaseback agreements can provide cannabis companies with a valuable source of cash flow while giving Innovative Industrial some recurring income in return. For investors, that makes the business one of the safer ways to invest in the cannabis industry. Analysts at research company BDSA project the U.S. pot market to grow at a compound annual growth rate of 18% until 2025, when the industry will be worth $34.5 billion.
How long will it take for the dividend to grow?
The trickiest part is to estimate how quickly a dividend may increase over time. Much of that is going to depend on the REIT's profitability and the strength of its business. Let's assume that Innovative Industrial will remain a high-growth business, and that on average it will grow its dividend by 10% per year. Under that assumption, here is how much the REIT's quarterly dividend might look like in the future, how much annual income you would be earning, and what percentage of your original investment (in this example $25,000) that would represent:
| Year | Quarterly Dividend | Annual Income | Percent of Original Investment |
|---|---|---|---|
| 0 | $1.32 | $755.04 | 3.02% |
| 1 | $1.45 | $830.54 | 3.32% |
| 2 | $1.60 | $913.60 | 3.65% |
| 3 | $1.76 | $1,004.96 | 4.02% |
| 4 | $1.93 | $1,105.45 | 4.42% |
| 5 | $2.13 | $1,216.00 | 4.86% |
| 6 | $2.34 | $1,337.60 | 5.35% |
| 7 | $2.57 | $1,471.36 | 5.89% |
| 8 | $2.83 | $1,618.50 | 6.47% |
| 9 | $3.11 | $1,780.34 | 7.12% |
| 10 | $3.42 | $1,958.38 | 7.83% |
| 11 | $3.77 | $2,154.22 | 8.62% |
| 12 | $4.14 | $2,369.64 | 9.48% |
| 13 | $4.56 | $2,606.60 | 10.43% |
Source: Yahoo! Finance, Company Filings.
This is a hypothetical example, and will obviously fluctuate depending on how well Innovative Industrial performs over the years. But the important takeaway from this is that patience combined with a solid dividend growth stock can lead to significant recurring payments for your portfolio. As shown in the table above, by year 13, you will be earning more than even 10% of your original investment. It's not a guarantee, but by buying dividend growth stocks in industries that possess attractive long-term prospects, you can increase the odds that you will be earning a double-digit yield years down the road.
Should you invest in Innovative Industrial?
Innovative Industrial is an attractive investment for income investors, and the only reason I would hesitate to buy the stock right now is that, with gains of 130% over the past 12 months (the S&P 500 is only up 46%), it may be too expensive. It is currently trading at a forward price-to-earnings multiple of 35 -- a year ago, the stock was trading at less than 25 times its future profits.
Pot stocks in general have become inflated -- even the Horizons Marijuana Life Sciences ETF has risen by more than 70% during the past year as the excitement surrounding the possible legalization of marijuana has gotten cannabis investors into a frenzy. If that hype dies down, Innovative Industrial could become a much better buy.
However, for long-term investors, the stock still makes for an attractive investment, and waiting for a drop in price (which may not happen) could mean missing out on some valuable dividend income.
