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You Call That a Dividend Hike?

By Jordan Wathen - Sep 12, 2013 at 3:34PM

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Realty Income's dividend growth may come to a screeching halt as it works down its payout ratio.

Source: tradingacademy.com

Earlier this week, Realty Income Corp. (O 0.40%) announced its 73rd dividend hike, pushing its monthly dividend higher by 0.2% to $0.1818 per share, up from $0.1815.

That's a small consolation prize to an investor base that may have paid up to $55 per share at the peak in May, only to see the stock fall by 27% to today. Realty Income typically reveals its largest dividend increases in August and September.

Is this dividend growth machine slowing?
Investors who are new to dividend growth investing, and to REITs in general, shouldn't lose sight of dividend growth because of modest quarterly increases in the dividend. The fact is, Realty Income Corp. -- and most REITs, for that matter -- do not experience robust dividend growth from frequent dividend increases.

When Realty Income celebrates its 19th year as a public company in October, it will have grown dividends by 142%, for a compounded annual growth rate of 4.7% during its publicly traded history. Most of those gains came from large, one-time increases in the dividend.

If we remove the effect of a 2013 acquisition to Realty Income's monthly payments, for example, we'd find the dividend growth rate would fall to 3.7% from 4.7%. Over a period spanning 19 years, a 1% difference in compounding really adds up.

Where dividend growth comes from
Ordinarily, REITs are not fast-growing dividend machines. Above-average dividend growth comes from above-average management – management that runs a REIT like an investor would. Luckily, Realty Income Corp. has excellent managers who have made several accretive acquisitions on the company's behalf.

Most recently, Realty Income closed a deal to acquire American Realty Income Trust in a $3 billion deal, paid for with stock and a very modest amount of cash. The deal was good for shareholders. Share count increased, but funds from operations increased faster, so the combined company could afford a 19% dividend increase when the acquisition closed in 2013.

Projecting future dividend growth
After acquiring American Realty Income Trust and ramping its distributions to shareholders, future dividend growth will likely come in below 1% for 2014 and 2015, failing any new major acquisitions.

At the end of 2012, Realty Income forecast a dividend payout ratio of 91% of adjusted funds from operation. At the time, then-CEO Thomas Lewis commented that management would "like to walk that back down," noting that 85%-90% of adjusted funds from operation (AFFO) would be a good payout target.

Using the recently increased divided on a run-rate of $2.18 per year, and AFFO guidance of $2.35-$2.40 per share, Realty Income's payout ratio would range between 90%-93% of AFFO. That's well above the historic range of 85%-90%.

Thus, without any new sizable acquisitions, investors will have to be satisfied with smaller dividend increases as the company's rents increase at a rough 1% annual clip, adding to funds from operations.

Worry about the 10-year note
Gradual increases in the dividend are unlikely to keep up with increases in interest rates, which could send the stock plummeting further.

Triple-net REITs have kept a fairly narrow trading range where their dividend yields are equal to the 10-year Treasury note yield plus 2%-3%. With the 10-year Treasury yield sitting just a shade under 3%, it's not surprising to find Realty Income Corp. paying a current yield of 5.5% and National Retail Properties (NNN -0.71%) paying 5.2%.

As we all know, rising rates would push the stock down, and dividend yields up. If you need current income and can ignore potential capital losses from rising rates, you'd be fine holding Realty Income and National Retail Properties as a source of current income. 

But if all you really want is income, preferred shares may be a better option. National Retail Properties has a Series D preferred selling below liquidation preference, yielding 7.1% per year -- a fat yield if you can tolerate capital losses in a rising-rate environment. Realty Income's monthly paying class F preferred shares yield 6.88%.

Fool contributor Jordan Wathen 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.

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Stocks Mentioned

National Retail Properties, Inc. Stock Quote
National Retail Properties, Inc.
NNN
$46.10 (-0.71%) $0.33
Realty Income Corporation Stock Quote
Realty Income Corporation
O
$72.76 (0.40%) $0.29

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