Ever since the COVID-19 pandemic began, things have been brutal in the office real estate investment trust (REIT) sector. Work-from-home proved to be a viable model for some companies, and employees generally prefer it. Bosses generally do not, but with a super-tight labor market, employees have the upper hand.
As the office vacancy rates crept up, office landlords suffered. The recent tightening of monetary policy from the U.S. Federal Reserve also negatively affected mortgage REITs. There were dividend cuts across the board with the mortgage REITs, and more may be coming.
Here's how the current economic situation is messing with the financials of two particular dividend stocks.
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1. Office vacancies bedevil SL Green
SL Green (SLG -0.53%) is known as Manhattan's Landlord. The REIT owns and operates office properties primarily in New York City. SL Green has some of the best properties in Manhattan; however, the trend toward working from home increased office vacancies. Estimates of the NYC office vacancy rate vary, with some reporting rates in the high teens and others putting the rate in the low 20% range. At least one study predicts the vacancy rate will stay above 20% through 2026.
SL Green's occupancy rate at the end of the first quarter of 2023 was 89.6%, which is much better than the average rate for New York City. Because SL Green has higher-quality buildings (mainly Class A), it is seeing better occupancy. Unfortunately, while most REITs have yet to see occupancy rates return to pre-pandemic levels, occupancy isn't recovering for SL Green, and it's falling consistently over time. As leases expire, any renewals will likely be for lower square footage to account for working from home being entrenched in U.S. corporate culture.
As a result, SL Green cut its dividend in November. However, the stock price continues to drop, which pushed the dividend yield up to 12.5%. Funds from operations came in at $1.53 per share in the first quarter, which covers the dividend (which is paid out monthly and currently runs at $0.2708 per share). However, the fundamentals for office properties exhibit no indications of a turnaround. As SL Green is forced to roll over maturing debt at higher rates, the increased interest expense will take a bite. SL Green might be OK for now, but the current dividend probably isn't sustainable if things don't turn around.
2. Mortgage REITs are struggling with rising interest rates
Two Harbors (TWO 1.38%) is a mortgage REIT that focuses on mortgage-backed securities (which are guaranteed by the U.S. government), mortgage servicing rights, and other financial assets. Times have been especially tough in the mortgage space over the past year as the Federal Reserve embarked on an extremely aggressive money-tightening program which included raising the Federal Funds Rate from close to 0% up to 5.07%. This affected all sorts of programs, including mortgages to Treasuries. Mortgage-backed securities now underperform Treasuries by a wide amount, contributing to declines in book value per share.
This phenomenon has affected mortgage REITs across the board. And the liquidity issues among several regional banks this spring exacerbated the problem as it has put additional mortgage-backed securities on the market.
Two Harbors also invests in mortgage servicing rights, which have helped offset some of the losses on the mortgage-backed securities. Mortgage servicers handle the administrative tasks of a mortgage on behalf of the investor. The servicer sends out the monthly bills, collects payments, sends the principal and interest to the bondholders, and works with the borrower in the event of delinquency. Generally, the servicer is paid one-quarter of one percent of the mortgage's outstanding balance as compensation. The right to perform this service is worth something and is capitalized on the balance sheet as an asset.
Two Harbors cut its quarterly dividend from $0.68 per share to $0.60 a share last fall. The problem is that conditions deteriorated further in the mortgage-backed securities market since then. In the first quarter of 2023, Two Harbors reported a loss of $0.69 per share; although, if you strip out mark-to-market losses on the portfolio, the company made $0.59 per share. Earnings available for distribution were only $0.09 per share. At current levels, Two Harbors yields over 17%, and that is usually the level at which mortgage REITs make dividend cuts. The yield is too good to be true.
