Last year, The Motley Fool's co-founder and CEO, Tom Gardner, sat down with Tanger Factory Outlets CEO Steve Tanger to discuss the company and his business philosophy, which was developed over nearly 30 years of building Tanger Outlets into one of the most recognizable real estate companies in the U.S.
During the interview, Gardner asked what Tanger would look for in a great dividend stock. "I would look for a company that has a steady stream of income, [...] a long track record of raising dividends, and paying dividends that are well covered," he answered. Today I am going to put that theory to the test.
1. Steady stream of income
Because I love simple businesses, I'm particularly interested in testing Tanger's theory on three self-storage real estate investment trusts: Public Storage (NYSE: PSA), Extra Space Storage (NYSE: EXR), and Sovran Self Storage (NYSE: SSS).
If any one thing crosses generations, it is that people accumulate lots of stuff. The problem is finding room for it all. These companies help solve this problem by operating hundreds, or thousands, of self-storage facilities across the U.S. -- and for Public Storage, internationally. They collect rent from customers and, as REITs, distribute 90% of their taxable income to shareholders in the form of dividends.
However, operating in this industry does not guarantee a steady stream of income. For that, investors should look for a company with a consistently high occupancy rate. As you can see in the chart below, all three of these companies have occupancy rates near or above 90%.
By keeping occupancy high, these companies ensure themselves a consistent stream of income, and investors a consistent dividend.
Of course we have to remember that high occupancy alone does not guarantee that all is lollipops and rainbows with our REITs. If a company wants to juice its occupancy rate it can do that by offering lower rents or promotions. Luckily, we don't have to worry about that here. Based on the most recent numbers, rent per square foot is higher today at all three of these REITs than it was in 2011.
2. History of increasing dividends
Because these companies pay out the vast majority of their earnings to shareholders, if earnings are consistently increasing, so will their quarterly payouts.
Consistently rising dividends also says a lot about the quality of the companies' properties, the acumen of their management teams, and their ability to acquire new properties and keep old ones occupied.
Two things in this chart really stand out. First, Public Storage's dividend per share has tripled in the last decade, and this growth has far exceeded that of both Extra Space and Sovran. Second, Public Storage was able to maintain its dividend through the financial crisis in 2008, which reflects its durability through recessions.
3. Dividend coverage
I mentioned earlier that REITs are required to pay out 90% of their "taxable income." So it would makes sense that each of these companies' payout ratio -- dividends paid divided by earnings -- would be 90% or more, but this isn't the case.
Taxable income includes accounting deductions taken against earnings for deprecation of real estate properties. However, real estate does not lose value like typical assets -- in fact, real estate can appreciate over time -- so these are referred to as noncash charges.
For this reason, REITs use funds from operation, or FFO -- net income with depreciation and amortization added back in -- as a more representative earnings number.
As an investor you want to make sure there is a cushion between FFO and the company's dividend payout. This helps to ensure that if earnings fall, the company can still support, or even increase, its dividend.
Looking back at how these companies battled through 2009 provides a wealth of information. For instance, Sovran's payout ratio crept all the way up to 94% as it attempted to avoid a major dividend cut. Conversely, Public Storage and Extra Space lowered their payouts and focused on strengthening their balance sheets.
Most interesting, following 2009, Extra Space Storage and Sovran kept their payouts near the minimum threshold necessary to qualify as a REIT. They did so to preserve resources which could be used to acquire new properties. Extra Space's management, in particular, has followed through on this strategy by doubling its total assets since the beginning of 2009; this growth far outpaces that of both Public Storage and Sovran.
Which are the top dividend stocks?
These might have been the first three indicators that popped into Tanger's head, but they are extremely telling.
Public Storage's durability through the financial crisis, its dividend growth, and high occupancy make it a strong and stable business. On the other hand, Extra Space's willingness to ratchet down its payout ratio and follow through on rapid growth seems to give it the most upside of the three.
Ultimately, if you are looking for stability, Public Storage's more proven track record is your best bet; but for investors focusing on better growth, I would go with Extra Space Storage.
Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.