When the coronavirus pandemic hit in 2020, senior housing was on the front lines. Operating performance has improved since the worst of the industry downturn, but Omega Healthcare Investors (NYSE:OHI) is starting to show increasing signs of stress. It just made one notable dividend decision that shouldn't be ignored. That's especially true when you look more closely at the dividend coverage numbers from the third quarter.

Purpose-built

The big problem for senior housing properties is that they are specifically designed to bring older adults into a group setting. That's the perfect environment for the coronavirus to cause the most damage, since it is particularly deadly for older adults and spreads easily when people congregate in one place. Add in the fact that nursing homes generally house residents that are infirm, and nursing home-focused real estate investment trust (REIT) Omega Healthcare got hit particularly hard.

A doctor standing over a patient in a bed.

Image source: Getty Images.

Occupancy dropped thanks to a mix of increased move-outs (an industry euphemism that often includes resident deaths) and falling move-ins. Many senior housing properties simply shut their doors to anyone, even visitors, in an effort to slow the spread of the illness.

Omega's occupancy fell sharply, hitting a low of 72.3% in January 2021. Although that number has been improving all year, it is still only up to around 75.5%. Management believes it needs to get above 80% to "...meaningfully mitigate the cash flow reductions from a pandemic," as it noted during Omega's second-quarter 2021 earnings conference call.

The REIT uses a net lease approach, so lessees have to pay rent regardless of the performance of the properties they operate. (Net lease properties generally require the lessee to shoulder most of the costs of the property.) That helped Omega get through 2020 in relative stride, though it chose to keep the dividend flat all year long. Also benefiting the company was the fact that operators of senior housing received financial support from the government. 

It's getting tight

While occupancy trends are improving, they remain below the level that Omega believes is necessary over the long term. And as government support dries up, several operators have now gotten to the point where they are no longer paying rent. Omega has chosen to keep the dividend flat all year in 2021 at this point, which puts an end to the company's 18-year streak of annual dividend increases. That's often the first step a company takes before cutting a dividend. 

But the third-quarter funds available for distribution payout ratio was pretty strong, at 83%. Doing the math on this number, funds available for distribution in the quarter was $0.81 per share and the dividend was $0.67 per share.  In most instances, this wouldn't be a worrying metric. But these aren't normal times.

OHI Dividend Yield Chart

OHI Dividend Yield data by YCharts.

Management made a point of noting during Omega's third-quarter 2021 earnings conference call that included in the funds available for distribution number were things like cash deposits that are generally held to protect against nonpayment. Think of it like an apartment rental where you provide a security deposit that the landlord will take if you don't pay your rent. That amounted to $0.07 per share of funds available for distribution. Pull that out, and funds available for distribution drops to $0.74, reducing the payout ratio to 90% or so. That's a lot less comforting.

What's notable is that the cash the company can tap to offset nonpayment is finite, so it's probably best to view the payout ratio as 90%, not 83%. There's no reason why Omega can't support a 90% payout ratio, or even higher, if it chooses to use debt to temporarily fund a distribution that's not fully covered by its operations. However, the leeway it has for further adversity is getting smaller, and the risk of a dividend cut is clearly increasing. Investors need to pay extra attention here.

Worry and watch, but don't run for the hills

Omega has a long record of commitment to the dividend, so it clearly believes returning cash to investors is a high priority. Moreover, it is a generally well-run REIT, so even if there's a dividend cut, which appears priced into the stock price, noting the historically high 9.2% dividend yield, you will still own a good REIT.

That said, the dividend is more at risk today than it has been in a very long time. Omega has targeted 80% occupancy as an important dividing line, and investors should watch this metric closely. But increasingly, the payout ratio also needs to be top of mind, too.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.