Investors looking at real estate investment trusts (REITs) need to consider the portfolio of properties that underpin the business. Diversification is important. And yet, sometimes, picking the wrong sectors can have a material and negative impact on a REIT's performance. Gladstone Commercial (GOOD 3.35%) is a good example of this. And despite a huge 9% yield and monthly pay dividend, most investors will probably want to avoid this REIT for now.

Not a bad plan

From a high-level perspective, Gladstone Commercial had a well-thought-out business approach. It uses the net lease model, which means that it leases individual properties to a single tenant that is largely responsible for the asset's operating costs. That helps to protect the REIT from inflation in things like maintenance and taxes. Across a large enough portfolio, the risk of any single property (which is high because of the single tenant) is materially reduced. Only Gladstone Commercial has a relatively modest portfolio of about 137 properties.

A bear trap with money sitting inside of it to suggest material financial risk.

Image source: Getty Images.

That said, the REIT is focused on the industrial and office spaces. Having exposure to more than one type of property helps to increase diversification. Industrial assets make up around 55% of rents, with offices at 40%. The rest of the portfolio is composed of retail and medical properties. So while the portfolio isn't huge, it is spread up at least a little bit.

Unfortunately, the two areas in which Gladstone Commercial chose to focus have been heading down wildly divergent paths. Industrial assets have been in high demand, while offices have been hit hard by the work-from-home trend. Both are tied to the COVID-19 pandemic, which increased the need for logistics-tied assets to accommodate increased demand as people worked from home to slow the spread of the illness. 

The bad overwhelms the good

With offices sitting vacant, Gladstone Commercial ended up cutting its dividend at the end of 2022. The monthly payment dropped from $0.1254 per share to $0.10, a painful 20% haircut. When the company reported fourth-quarter 2022 earnings, management highlighted that it doesn't see a return to pre-pandemic office demand anytime in the foreseeable future.

Given that outlook, the REIT probably made the right choice to cut the dividend instead of trying to limp along paying out more than it could afford. To put a number on that, the company's funds from operations (FFO) came in at $0.34 per share (down 20% year over year) in the final quarter of 2022, but it paid out $0.3762 per share in dividends. A REIT can only support an FFO payout ratio of more than 100% for so long. And if there was no expectation for improved performance from 40% of its portfolio, the cut was a necessary move.

Meanwhile, the company is moving, perhaps more aggressively than ever before, to increase its exposure to industrial assets. To be fair, this isn't a new direction, as it started down this path in 2018. In fact, industrial exposure has grown from around 35% of the business to the current 55% or so since that point. 

So, in some ways, Gladstone Commercial has probably saved investors a lot of pain that otherwise would have been caused by the office downturn. But, clearly, it didn't completely avoid the hit. The dividend cut is expected to free up additional capital for future investments in industrial assets.

More work needs to be done

A dividend cut is not something that a REIT wants to do, given that the entire corporate structure is designed to pass income on to shareholders. Generally, a cut happens from a position of weakness. For example, using Gladstone Commercial's fourth-quarter FFO as a run rate, the current dividend payment still amounts to a roughly 90% FFO payout ratio. That doesn't leave much room for adversity in the still sizable 40% of the portfolio tied to offices, which management has highlighted as an ongoing headwind. While the REIT is moving in the right direction, all but the most aggressive investors should probably be on the sidelines until there's clear evidence of a sustained improvement in performance.