Dividend investors tend to flee stocks where there is an increasing risk of a dividend cut, and for good reason. So when a dividend stock starts to fall hard, you need to start paying extra attention.
Shares of warehouse landlord Prologis (PLD 1.22%) are down 30% so far in 2022. Here's why you don't need to worry about a dividend cut, and should probably be expecting the payment to keep growing.
The dividend basics
Real estate investment trust (REIT) Prologis paid a third-quarter 2022 dividend of $0.79 per share. It posted core funds from operations (FFO) of $1.73 per share. That means the core FFO payout ratio was roughly 45%. That's a very strong payout ratio for any company -- and a REIT has to pay out 90% of its taxable income as a dividend in order to maintain its REIT status (and avoid corporate-level taxation).
Simply put, there doesn't seem to be much reason to believe that Prologis is on the verge of cutting its dividend. The stock price drop is really related to other factors, including a big price run-up in 2020 and 2021 because online shopping got a big boost from the social distancing used to help slow the spread of the coronavirus. That meant a need for more warehouse space, which is the REIT's specialty.
That trend has now reversed to some degree, with online retail giant Amazon announcing that it would pull back on warehouse space. Other big names followed suit, but the announcement from Amazon really highlighted the shift in consumer spending patterns as people were able to go back to physical stores more freely. That worried investors that future growth at Prologis, which counts Amazon as a major customer, may not be as strong as originally expected.
More dividend growth ahead
For starters, investments in physical structures like warehouses tend, like most other things in the business world, to go in cycles. So demand will wax and wane over time, and for the most part, it probably isn't something to get overly excited about. Prologis' occupancy was 97.7% in the third quarter of 2020, so there is clearly plenty of demand for the company's warehouses. And with roughly 1 billion square feet of leasable space across 19 countries, the REIT is very diversified. Most of its locations, meanwhile, are in key transportation hubs, so they are highly desirable.
The REIT is pulling back on growth plans as it monitors the current market environment. Management intends to be more deliberate with investments, which suggests that most construction will be build-to-suit, meaning there's a tenant ready to move in, rather than speculative, where there's no tenant lined up. That, however, is exactly what you'd expect a prudent management team to do. It is hard to be upset about this shift in direction.
But here's the really important fact, and the reason why dividend increases are likely to continue: During the third quarter Prologis was able to increase rents by nearly 60% on expiring leases. That's a sign that demand for the REIT's space remains strong, but it also highlights an important fact about the business today. Multi-year leases are ending, and the rents for these leases are clearly well below current lease rates. The lessee has to sign a new lease at the current rate, or at least at a much higher rate, or Prologis will go out and find another tenant. There is no sign that this trend is slowing down, and in fact, it appears to be accelerating as the "net effective rent change" (which is what management calls it) hit an all-time high during the third quarter.
Add the lease rollover benefit to the strong core FFO dividend coverage ratio and the dividend looks highly likely to keep going up.
An opportunity for dividend growth
Prologis cut its dividend during the Great Recession, so it isn't unreasonable to worry about the risk of a dividend cut. The business is in a very different position today, however, with strong business fundamentals suggesting ongoing dividend growth is way (WAY!) more likely than a dividend cut. After the big stock drop, Prologis' dividend yield is around 2.75%, which isn't huge on an absolute basis, but it is the highest it has been since the worst of the 2020 bear market. And since the 2022 dividend increase was a huge 25% and the quarterly dividend is still very well covered, dividend growth investors might want to take a close look here before the next hike is announced, likely in early 2023.