If you've ever seen an old-timey cartoon, you're doubtlessly familiar with the sight of dollar signs forming in a greedy character's eyes when they spot a lucrative (and often ill-advised) opportunity. Unfortunately, disaster tends to follow their attempts at realizing their ambitions, and often predictably so. Stocks with high dividend yields tempt investors to behave in much the same way, which often leads to them experiencing cartoonishly bad results when they do.
Meet AFC Gamma (AFCG 3.07%), a marijuana financing company with a ridiculously high forward dividend yield of around 13.5%. AFC's high dividend yield means that investors won't need to spend much to build a formidable passive income stream. But, investors should recognize that high yields are usually indicative of high levels of risk, and there are upcoming headwinds that might cause problems for this company relatively soon. Let's explore the trade-off between the stock's risks and its prospective returns so that you'll know whether to invest or look elsewhere.
How AFC Gamma affords its dividend
Cannabis businesses need capital to grow, but they have a hard time finding it from traditional financial institutions like investment banks due to the regulations that are part of federal marijuana prohibition. AFC Gamma solves that problem for them by offering them loans that are secured with claims to their real estate. If customers default, the company gets to keep their equity. If they pay up, and so far 100% of its debtors have, the earnings are then distributed to shareholders as a dividend.
The company reported $11.5 million in net income for the third quarter, which works out to earnings per share (EPS) of $0.57. At the same time, it paid out a dividend of $0.56 per share for the quarter. That puts its payout ratio at close to 100%, which means that further earnings growth will be necessary to avoid a dividend cut in the future, not to mention the prospect of additional dividend hikes.
Such a state of affairs is normal for real estate investment trusts (REITs) like AFC, and it isn't a cause for alarm, as it has plenty of deals it could sign to bring in fresh revenue and also because its market is projected to grow considerably over the next few years as well as through the rest of the decade. The point is that there will be tangible financial consequences for investors if there's an unexpected hiccup, like more than one of the company's debtors missing their payments at the same time.
An even bigger threat is if the cost of borrowing money becomes prohibitively high for AFC itself. The earnings margin it generates for each loan is roughly equal to the loan's yield to maturity minus the interest rate AFC needs to pay to borrow from its revolving credit facility. Its loan portfolio currently has an average yield to maturity of 20%. Right now, AFC's credit facility enables it to borrow $60 million at a floating interest rate of the prime rate plus 0.5%. And this is where the reason for the stock's high dividend yield starts to come into view.
Don't get distracted by dollar signs in your eyes
If the cost of borrowing is rising due to the Federal Reserve's war on inflation, and it is, the company needs to either pass the higher costs on via pricier interest rates on new loans or accept slower-paced growth. Once again, this is a common situation for REITs, but it is a headwind that investors need to appreciate.
The obvious catch-22 is that prospective borrowers will be less willing to accept worse terms, and they may take out smaller loans or avoid taking out debt altogether if they can avoid it. Yet another complication is that the cannabis industry in the U.S. is in flux. Ongoing legislative attempts at cannabis banking reforms that would make it cheaper and far easier for businesses to borrow from traditional financial institutions, rather than AFC, could be a threat.
Likewise, many of the leading cannabis companies in the U.S. are seeing their rate of sales growth taper off after a couple of hot years. It's possible that businesses may need to cut their excess overhead or production capacity moving forward rather than borrow more money to keep trying to penetrate saturated state-level markets. And that would lower the demand for loans, forcing AFC to offer more competitive rates, leading to thinner margins.
In short, the stock's dividend yield is a sign that investors will be shouldering considerable near-term risks if they buy it, as the required return for an investment rises when the certainty of getting a return falls. Therefore, AFC Gamma is a risky choice, and probably a poor one, for investors in retirement looking for passive income. The other side of the coin is that it's a juicy option for risk-tolerant people who want significant yield for their investment, and it's also one of the rare REITs with a solid chance of delivering their shareholders with significant near-term growth.
