When you see a stock with a high dividend yield, the first question to ask is whether that yield is too good to be true. But the answer can get a bit complicated if the stock also happened to be a real estate investment trust (REIT).
Because of how REITs are structured, they tend to have high dividends. A REIT is required to distribute the vast majority of its earnings to shareholders as dividends in order to qualify for special tax treatment. This allows these companies to avoid paying income tax at the corporate rate. It also means the dividends tend to naturally be higher, and not necessarily for a bad reason.
But given the current state of the economy and the rapid rise in interest rates we've seen over the past year, some REITs' dividend yields are raising concerns. REITs generally struggle in a rising rate environment, and office REITs get hit particularly hard.
SL Green Realty (SLG -0.53%) is one such office REIT and it's currently generating a massive dividend yield. Is it a value stock or a value trap?
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Falling occupancy rates have kept the stock under a cloud
SL Green focuses on Manhattan real estate, primarily office buildings and shopping centers. It also has some suburban properties, but the focus is generally on Manhattan. The company owns or has interests in 52 buildings totaling 27.9 million square feet. The financial sector accounts for 40% of office leases, with technology, advertising, media, and information businesses accounting for 18%.
With the introduction of the pandemic, the efficacy of the work-from-home model was put to the test and seemingly passed. That put the entire office REIT sector under a cloud, worrying investors. As a result, SL Green has seen its stock price fall 75% since the end of 2019.
The U.S. labor market remains tight, with nearly 10 million unfilled positions nationwide and an unemployment rate hovering around 50-year lows. Workers are generally in the driver's seat, and that makes it hard for corporate executives to insist that everyone return to the office. In New York City, with its arduous commuting times, work-from-home has been stubbornly resilient.
Falling occupancy rates tell the story. Prior to the pandemic, SL Green had an occupancy rate of 94.3%. At the end of 2022, occupancy had fallen to 90.3%. A decline in occupancy rates for REITs is not an uncommon story. Retail REITs generally still have occupancy rates below 2019 levels but have continued to trend upward, and they are within striking distance of previous levels. SL Green's occupancy levels continue to fall, and that is weighing on the stock.
SL Green recently cut its monthly dividend from $0.311 per share to $0.271. Even with the reduction, it still has a 13.6% dividend yield. The company reported 2022 funds from operations (FFO) of $6.64 per share. REITs tend to use FFO to describe earnings instead of earnings per share (EPS) as reported under generally accepted accounting principles (GAAP). This is because real estate companies have a lot of depreciation and amortization, which is required to be deducted under GAAP. Since depreciation and amortization are noncash charges, EPS as reported under GAAP makes cash flow look smaller than it really is. This is why a REIT could look expensive on an EPS basis and still be cheap.
Low multiple, high yield
SL Green is guiding for 2023 FFO per share to come in between $5.30 and $5.60. At the midpoint, this is a decrease of 18%. That said, the annualized dividend of $3.25 per share is still well covered. At current levels, the stock trades at 4.4 times guided FFO per share, which is extremely low.
SL Green stock is priced for the worst-case scenario. That said, investors will remain wary of the stock until occupancy levels start going back up again. Until then, investors should not view the current dividend as a sure thing.
