Dividend stocks can be great for any income-seeking investor, but only if the payout is reliable and sustainable. A stock that has an attractive dividend yield but has an otherwise shaky business is commonly known as a yield trap. Not only can the income paid by a yield trap be in danger, but the REIT stock investment itself could lose significant value if the business isn't doing well.
Yield traps can be found in all areas of the stock market, and real estate investment trusts, or REITs, are no exception. Here are some pointers that can help you spot yield traps as well as three examples of REITs that sport some of the telltale signs.
How to spot a REIT that's a yield trap
There's no way to spot a REIT dividend trap with 100% accuracy -- at least not until it's too late and the dividend has vanished. However, there are some red flags to look for that can help you spot an equity real estate investment trust that might be a yield trap:
- High yield -- As an asset class, REITs are known for their high dividend income relative to the average S&P 500 stock, but some have really high dividend yields. A good rule of thumb is to compare a REIT's dividend yield with some of the dividend yields paid by its peers. If it's slightly higher, it's not a cause for alarm. But if the average REIT yields in that REIT sector are about 5% and you see one with an 11% yield, it should raise eyebrows.
- Low liquidity -- High-quality REITs have an easy time borrowing money. Most have significant amounts of cash on the balance sheet and access to revolving credit facilities. If a REIT has neither, it could be a sign of trouble.
- Excessive leverage -- There's no set-in-stone rule of what a healthy debt level is for a REIT, but I typically look for a debt-to-capitalization ratio of no more than 50%. As an example, a REIT with a market cap of $4 billion and total debt of $4 billion would have a 50% debt-to-capitalization ratio. More could be a sign of trouble. Debt-to-EBITDA is another useful metric, especially when used to compare a REIT with peers.
- Payout ratio over 100% -- REITs tend to pay out most of what they make. While many choose to pay out less, the typical REIT pays out 60%-90% of its funds from operations, or FFO. When it comes to REITs, a high FFO payout ratio isn't necessarily a red flag. However, an FFO dividend payout ratio over 100% is. If you see a REIT consistently paying out more than 100% of FFO as a dividend, it could be a sign that the current yield is unsustainable. (Note: Don't use net income as a basis for a REIT's payout ratio as it isn't a good indicator for real estate businesses.)
- Declining business -- This one can be both qualitative and quantitative. Some quantitative signs that a REIT might be in a declining business: falling revenue or rental income, diminishing FFO or cash flow, or rising vacancy rates. Then again, some industries are obviously not doing well -- for example, lower-quality regional shopping malls have been a declining industry for years, and most high-yield stocks in this space could easily be called yield traps.
To be clear, the presence of one or two of these factors doesn't necessarily mean that a REIT is a yield trap. In fact, there are many that have one or more of these red flags that can make solid long-term dividend stocks. However, it does mean that a REIT is worthy of further investigation before you hit the "buy" button, and we'll look at a few examples in the next section.
Three potential yield traps
It's getting a little tougher to find yield traps in the real estate sector. In the wake of the COVID-19 pandemic, many of the REITs that we'd expect to be in danger of cutting their dividends have already done so. Some have done this out of necessity, while others have suspended their dividends as more of a precautionary step to preserve capital.
With that in mind, there are still some dividend-paying REITs that have at least one of the red flags mentioned earlier, and this is especially true in the post-COVID market. Here are three in particular that have some of the troubling signs, so let's take a closer look.
Simon Property Group (Yield: 15.2%)
In full disclosure, leading mall REIT Simon Property Group (NYSE: SPG) is the only one of these three that I own in my stock portfolio. And I even added shares recently. So that should give you some clue about whether I personally think it's a yield trap.
Having said that, there are certainly some troubling signs. Aside from the fact that the current dividend yield is more than 15%, there are a few other red flags with Simon:
- Brick-and-mortar retail is a declining industry. Simon is the best-in-breed mall operator, but this is certainly still a concern.
- FFO and revenue are likely to fall dramatically due to the COVID-19 pandemic. Simon closed all of its properties in mid-March and about half are still closed.
- One company-specific red flag is this language from Simon's first-quarter earnings report: "Simon intends to maintain a common stock dividend paid in cash and expects to distribute at least 100% of its REIT taxable income." To me, this doesn't exactly imply that Simon anticipates keeping the dividend at its current level.
On the other hand, Simon looks to be financially strong. The company has nearly $9 billion of liquidity, which is excellent financial flexibility for a business with a $17 billion market cap. And the company owns some of the most valuable retail real estate in the world and has the business efficiency advantages that come with scale.
Ventas (Yield: 9.8%)
Healthcare real estate is typically one of the most stable subsectors, but that hasn't been the case during the COVID-19 pandemic. While most healthcare businesses remained open, healthcare REITs with exposure to senior housing or elective medical procedures have been hit pretty hard.
Ventas (NYSE: VTR) is one of the worst performers, and it isn't hard to see why. In its senior housing communities, move-in rates were 25% of normal levels in April, while move-outs remained at their typical pace. And there's no telling when demand will rebound -- in simple terms, people are hesitant to put their older relatives in senior housing facilities, many of which have been COVID-19 hotspots. In fact, as of May 3,942 residents in Ventas' senior housing properties had tested positive for the coronavirus.
However, Ventas doesn't seem to be in serious trouble business-wise. The company has $3.2 billion in cash and equivalents on hand, tenants in Ventas' medical office properties paid 96% of expected rent in April, and the company was quite profitable in the first quarter. And its 81% FFO payout ratio leaves some wiggle room if income takes a hit.
Host Hotels & Resorts (Yield 6.9%)
It shouldn't come as a big surprise that hotel REITs have performed quite poorly. After all, barely anyone has been traveling in recent months, and it could take a long time for demand to return to pre-pandemic levels.
Host Hotels & Resorts (NYSE: HST) is one of the few hotel REITs that hasn't suspended or cut its dividend yet. However, with 12% occupancy across its portfolio in April, there's reason to believe the company's FFO could plummet in the second quarter and beyond.
Although it has the lowest yield on this list, that doesn't mean Host Hotels & Resorts isn't a yield trap. In the first quarter, the company's FFO payout ratio was 87%, which doesn't leave much room to sustain the dividend with declining revenue. With $2.5 billion in cash, the company has the liquidity to make it through the tough times, but I wouldn't be at all surprised if the dividend ends up being put on pause.
Are they yield traps?
None of these three are clearly in financial danger, but one (or more) of them could certainly decide to cut or suspend their dividends for liquidity purposes during the pandemic. The main reason that all three have been beaten down and now have such high dividend yields is because they all have many unknowns for the time being. For example, a wave of retail bankruptcies -- which we've already started to see -- could cause Simon's revenue to take a hit. A long-tailed drop in senior housing demand or travel demand could do the same for Ventas or Host Hotels & Resorts. And in these situations, the dividends could be on the chopping block.
While I'd hesitate to call any of these three dividend yield traps, at least in the obvious sense of the word, I wouldn't suggest buying them simply because of their dividends. If you want safe and reliable dividends, there are certainly better options in the real estate sector. On the other hand, if you have a high risk tolerance and are willing to ride out the ups and downs (including a potential dividend cut), these could be good speculative plays.
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