Why Do REIT’s Have High Dividend Payout Ratios?
By: Jonathan Wolfgram,
Why do REIT’s have high payout ratios? Investors looking to invest in real estate investment trusts (REITs) may be intimidated by payout ratios of more than 100%, 200%, or even 300%.
Do not fret, since REITs are unique entities and an even better financial metric, Net Funds from Operations, can be used to assess their performance than payout ratios. A REIT is a company that owns, operates, or finances real estate that produces income that mostly goes to its shareholders.
REITs invest in a wide range of property types that include apartment buildings, warehouses, offices, retail centers, medical facilities, data centers, hotels, cell towers and farmland. Typically, REITs focus on an individual property type, but some REITs do have diversified property portfolios. Investors can buy shares in a REIT just like any other equity.
Why Do REITs Have High Payout Ratios? The Law Requires It!
REITs are required by law to distribute more than 90% of their earnings in the form of dividends, meaning all REITs should have a payout ratio of more than 90%. Some REITs, however, will distribute even greater portions of their earnings in which payout ratios climb to well over 100%.
Huge payout ratios sound nice, but this could mean a company is unlikely to increase its dividend and may be headed for an inevitable dividend cut. It also may indicate the company is taking on additional debt to pay its shareholders — an unsustainable practice at best.
But for REITs, the story is different. Let’s first consider what the dividend payout ratio means.
What is a Dividend Payout Ratio and Why Do REITs Have High Payout Ratios?
The dividend payout ratio shows how much of a company’s income is being paid out to shareholders in the form of dividends. It is calculated by taking the total dividends paid out over a period of time and dividing by net income, which can be written as:
If a company has a 10% dividend payout ratio, then — in theory — a tenth of the money it makes is being paid out in the form of dividends. If a company has a 50% dividend payout ratio, then half of its income is paid in dividends. If a company has a 100% dividend payout ratio, then every dime it makes is going to shareholders as dividend distributions.
A good dividend payout ratio is generally considered to be between 35 and 55%. That means the company is well established enough to pay substantial dividends but is still reinvesting about half of its income in growth, making it a more sustainable investment. It also keeps alive the possibility of further increasing its dividend distributions, where equities with higher ratios may be forced to decrease their dividends in the future.
Why Do REITs Have High Payout Ratios? Think Cash Flow…
REITs require investors to understand the difference between cash flow and net income.
REIT’s keep the majority of their assets invested in real estate, with many REITs operating as landlords who receive a constant stream of cash from rent-paying tenants. If REITs are managing those properties effectively, the assets likely will go up in value.
Consider the Generally Accepted Accounting Principles — also known as GAAP.
GAAP allows REITs to depreciate those properties, and do so very quickly. This means the REIT can mark off the depreciated amount as a loss and under report net income. Even though the properties may be increasing in value and providing the trust with a steady stream of cash, the books will show their value dropping year-over-year.
Refer back to our formula for dividend payout ratio:
Why Do REITs Have High Payout Ratios? Do the Math…
As net income — the denominator — decreases and dividends paid remain constant, the dividend payout ratio will increase. Underreporting net income does not mean the company pays lower dividends, as the size of the dividend paid has to do more with cash-on-hand than earnings.
In many REITs, the trust has considerably more cash influx than is reflected in its net income. This means there is plenty of cash to pay a substantial dividend distribution to shareholders — potentially larger than a REIT’s earnings, according to GAAP. When that happens and dividends paid are higher than net income, the REIT’s payout ratio will be over 100% even if it is not losing money.
Why Do REITs Have High Payout Ratios? Net Funds from Operations…
Since the dividend payout ratio won’t work for REITs the same way it works for other equities, we need a new metric to measure stability. That’s why instead of Net Income, we use Net Funds from Operations, also known as FFO. FFO is a little like a non-REIT’s free cash flow — cash available for a company to repay creditors or pay dividends and interest to shareholders. Thus, FFO gives a much more accurate picture of a REIT’s financial performance than payout ratio.
We calculate FFO with the following formula:
and use this to create a new payout ratio:
This payout ratio is far more reflective of the REIT’s overall efficiency and dividend safety than what our standard dividend payout ratio is capable of providing.
Why Do REITs Have High Payout Ratios? Here’s an Example…
As an example, take the REIT Realty Income (NYSE:O). Realty Income is a profitable, sustainable and effectively managed REIT with a dividend payout ratio of 229.8% — a number bound to turn some heads.
In another equity, that would be absurd! It looks as though the trust is paying out twice as much money in dividends as it makes during the year. Any reasonable investor likely would think the company is headed for an imminent dividend cut. In actuality, Realty Income has never cut its dividend. Because Realty Income is a REIT, we need to use our FFO Payout Ratio instead.
Even though the company has an earnings per share of $1.21 for the trailing 12 months, the FFO per share of Realty Income is $3.27. It pays out $2.81 in annualized dividends, meaning we divide $2.81 / $3.27 = 85.9%. This number is very close to the 90% payout ratio we expect from REITs, meaning our company is in good financial health after all.
Why Do REITs Have High Payout Ratios? Try This Online Screener
REITs are a powerful investment vehicle, but investors interested in including them in their portfolios should do their due diligence and research what the company in mind actually pays. Investors seeking out these more complicated metrics such as FFO should consider using a screener to assist. My favorite is Stock Rover, but there are other choices available, too.
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Jonathan Wolfgram is an editorial staffer who writes website content at Eagle Financial Publications. He graduated from the University of Minnesota with Bachelor’s degrees in Finance and Philosophy. Jonathan writes for www.DividendInvestor.com and www.StockInvestor.com.