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Are These 3 REITs Yield Traps?

Are these three high-yield REITs offering dividends you can count on, or are their payouts too rich to support?

[Updated: Mar 10, 2021 ] May 22, 2020 by Reuben Gregg Brewer
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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 easy to fall in love with a high dividend yield, making excuses for why a company can continue to pay you even in the face of contradictory facts. Right now, investors looking at The GEO Group (NYSE: GEO), American Finance Trust (NASDAQ: AFIN), and Macerich (NYSE: MAC) should tread very carefully. Here's a quick look at why you should be worried about the dividends from these three real estate investment trusts (REITs).

1. One important customer

The GEO Group owns and operates prisons. That makes the government, at various levels, its primary customer. That's a positive in that Uncle Sam can raise taxes to ensure it can keep paying the rent, making for a reliable tenant. However, it also means politics can play a big role in The GEO Group's performance. And right now, the policy winds are blowing against the REIT's business.

Specifically, as the company noted in its fourth-quarter 2020 earnings release, "On January 26, 2021, President Biden signed an executive order directing the United States Attorney General not to renew U.S. Department of Justice ('DOJ') contracts with privately operated criminal detention facilities." The GEO Group counts two agencies of the DOJ, the Federal Bureau of Prisons and U.S. Marshals Service, as customers. But the bigger issue is that this could mark a material shift in the way the government, at all levels, makes use of for-profit prison operators.

The company has already cut the dividend and noted it needs to trim debt. With a huge 12.9% yield, investors are betting there's more bad news to come. That's likely because the company declared a first-quarter dividend (the second consecutive quarterly cut), but made a point of highlighting that the board had the discretion to make further changes. Right now, most investors should probably assume there will be more bad news ahead.

2. Barely covered

American Finance Trust owns retail assets with a service focus, which is perfectly fine. It makes use of the net lease structure, in which lessees are responsible for most of the costs of a property -- that's good too, as it reduces risk. However, there are some very clear negatives here that investors should worry about. And one could put the hefty 8.2% yield at risk.

The first big concern is that American Finance Trust is externally managed. This can create conflicts of interest between what's best for the manager and what's best for shareholders. As an example, the REIT cut its dividend in 2020 because it was at risk of paying out more than its adjusted funds from operations (FFO), a metric similar to earnings for an industrial company. That makes total sense.

However, it continued to buy new assets despite the clear headwinds it was facing, noting that the percentage of investment-grade tenants in its portfolio dropped from 82% at the end of 2019 to 62% at the end of 2020.

You could argue that American Finance Trust is investing opportunistically, which might very well be true. However, even after the dividend cut, the adjusted FFO payout ratio was roughly 85% in the fourth quarter. That's pretty high and suggests investors should be worried that management is pushing the accelerator pedal, perhaps a little too hard. There are other net lease REITs with high yields and better dividend track records.

3. A long recovery

Macerich owns some of the best-positioned malls in the country, with locations in highly populated areas with wealthy residents. That's important today, because malls are facing material headwinds. As 2020 began that was largely driven by the so-called "retail apocalypse" but very quickly expanded to include the coronavirus pandemic. There are a lot of moving parts here, but, basically, retailers are struggling and closing stores as consumers shift more toward online shopping. Highly leveraged names are falling into bankruptcy, and the pandemic sped up the pain.

Macerich has already cut its dividend twice. The dividend in the second quarter of 2020 was $0.10 per share in cash and $0.40 in company shares, down from $0.75 per share in cash. The third-quarter dividend was $0.15 per share in cash, which is the level where it's stayed since that point. The yield is around 4.2%. That's not all that high, but there's a caveat here.

Macerich's leverage is two to three times higher than its key peers. And there are reports it's hired an outside advisor to help it negotiate with lenders over its revolving credit facility. That's not usually a good sign and suggests lenders are getting nervous.

Now add to this the fact that a recovery in the mall REIT space is likely to be slow and drawn out, since re-tenanting a mall can take a material amount of time. The risks are higher than they may seem here. Macerich could very well hold the current dividend, but most investors would probably be better served looking at other options in the space.

Tread carefully

Sometimes, a big yield is a warning sign that a company's business is in flux, as is the case with The GEO Group. Other times, you need to dig into the story a little, like with American Finance Trust, where a high yield coupled with management decisions is suggesting risk is on the rise. And then there are times when you have to weigh all of the options in front of you, and even a more modest yield may not be worth the risk, like with Macerich.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.