There's nothing income investors hate more than a dividend cut. That's part of the problem facing SL Green (SLG 3.21%) today, after it announced just such a move in early December. Even after the cut, though, the dividend yield is still a huge 9.6%. What's going on?
An unpopular choice
On Dec. 5, the real estate investment trust (REIT) announced that its monthly dividend would fall from $0.3108 per share to $0.2708. The decrease puts the annual dividend at roughly $3.25 per share, down nearly 13% from the previous level. That's not something investors wanted to see, but given the headwinds in the office sector it isn't exactly surprising, either.
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Notably, the company's rental revenue fell a little over 11% year over year through the first nine months of 2022. So there are real issues here that need to be addressed. Add to that the ongoing headwinds posed by rising costs, thanks to inflation, and rising interest rates, thanks to the efforts to combat inflation. Simply put, a dividend cut makes some sense.
Ample room?
The complication when looking at SL Green is that the company's funds from operations (FFO) payout ratio seems pretty strong. The REIT's monthly dividend in the third quarter was $0.3108 per share. Multiply that by three and you get $0.9324 per share for the full quarter. The company's FFO came in at $1.66 per share, resulting in an FFO payout ratio of roughly 56%. That's pretty modest.
Office buildings cost more to operate than some other properties, so a lower payout ratio makes sense relative to other REIT sectors. That said, the company's FFO per share in the third quarter of 2022 was down nearly 10%. If things are getting harder, not easier as the office environment suggests, than results are likely to remain under pressure. Thus, SL Green appears to be taking a pre-emptive approach with its dividend.
The other factor is that SL Green is heavily focused on the finance-driven New York City market, which also increases the risk from a diversification standpoint. If there's a recession, having virtually all of the REIT's eggs in one basket could be a bigger problem relative to a REIT with exposure to a broader set of markets and industries. Investors clearly see this risk and are pricing it in.
Risk versus reward
The big question for long-term investors is whether SL Green can sustain the new lower dividend. Given the low payout ratio, it looked like the previous dividend would have been supported by FFO. The problem could be the company's balance sheet. SL Green's financial debt-to-equity ratio is roughly 1.7 times, notably higher than peers Vornado and Boston Properties, which are at 1.3 times and 1 times, respectively.
While leverage can help increase returns when times are good, it can also materially decrease financial flexibility when times are not good. The latter appears to be the situation today, with the REIT being forced to take an ultra-conservative stance (cutting the dividend despite a strong FFO payout ratio). For conservative investors, it might make sense to sit on the sidelines until there's more clarity on the work-from-home trend. If more people don't head back to the office, there's a very real risk that SL Green's leveraged balance sheet could lead to another dividend cut.
That said, for investors looking to maximize the income they generate, taking on the risk of another dividend cut might be worth the high yield. Just understand that the strong FFO coverage ratio may not be as robust as it looks.
