Whoever said that there's no such thing as a free lunch must not have ever heard of investing for passive income. While it's true that there are very few paths to completely passive income, buying high-yielding dividend stocks and sitting on them is as close to the ideal as you can get.
And that's why income investors should know about Advanced Flower Capital Gamma, which is better known as AFC Gamma (AFCG -0.09%). Though it might seem like competing in the cannabis industry makes this company an unlikely contender for producing a lot of passive income, it's definitely ripe for investment today -- here's why.
Image source: Getty Images.
It takes money to make money
AFC Gamma's business model is to issue loans to cannabis companies that need capital to grow. Then, when debtors repay the loans, it pockets some of the money and distributes most of the rest to shareholders. Right now, the weighted average yield to maturity of its loans is around 18%, and it can use a revolving credit facility to borrow money at a rate as low as 4.5%. That means as long as it can keep issuing loans with a yield to maturity near its current average, it'll be able to keep generating value and growing by using debt even if its borrowing costs continue to rise.
Shareholders also get a cut of the inflows from its loans, of course. And in Q1 of this year, its loans produced $11.9 million in distributable earnings from its total interest income of $16.9 million. Right now, its forward dividend yield is near a sky-high 14.5%, making it above and beyond many of the other real estate investment trusts (REITs) out there. If you invested $5,000 at that rate, you'd have an extra $725 in cash after a year's time, and it'd be made entirely passively.
AFC Gamma is also a great pick for long-term holding because its dividend payout is likely to rise over time. In the handful of quarters since its initial public offering (IPO), management hiked the dividend every time. As long as there's a supply of cannabis businesses needing capital to finance expansion, these interest payments will keep rolling in, and investors will get their share.
What to be careful of when investing in this stock for passive income
As stable as AFC Gamma's core business is, there are a few things that investors should be wary of if they plan on starting a position.
First, it'll need to keep utilizing debt and also new stock issuance to raise significant capital and continue to loan out larger and larger sums of money, at least for the time being. For example, on May 2, management announced the initiation of a new senior secured revolving credit facility worth as much as $60 million. There's nothing remotely worrisome about the company's current level of leverage, but investors should realize that eventually the cost of borrowing could rise, which would subsequently reduce returns. Unless, of course, the higher costs are passed on to prospective borrowers, who may be less interested in taking out new debt as a result.
Second, investors need to realize that this is a new business which is operating in a relatively new and highly immature industry. If cannabis is legalized and industry players no longer need AFC Gamma's services because traditional financial institutions are willing to work with them without fear for the first time, it'll be a big problem. Still, it's possible that the company could use its special expertise to retain its niche in the industry in such a situation, as traditional banks would have a lot less experience with underwriting loans for cannabis organizations specifically. And legalization could be a significant boon to the marijuana market overall, so the risk of losing business isn't necessarily a foregone conclusion.
Finally, while AFCG has steadily hiked its dividend payment in its lifetime so far, it might not be able to sustain its current pace of dividend growth in the long term. Though its highly predictable inflows from interest payments make it quite unlikely that the dividend will actually get cut anytime soon, the chance of a slowdown in growth is quite significant, especially as the liabilities on its balance sheet grow over time. Therefore, investors should be comfortable with the dividend being roughly near where it is now before making a purchase.
