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 for dividend investors to get enchanted by a fat yield, overlooking a company’s flaws in the search for big dividend payers. Today real estate investment trusts (REITs) Preferred Apartment Communities (NYSE: APTS), Annaly Capital Management (NYSE: NLY), and Simon Property Group (NYSE: SPG) all offer large dividend yields — but the risks and rewards are vastly different. Here’s what you need to know to figure out if these REITs are yield traps or high-yield opportunities.
1. Question unique approaches
Preferred Apartment Communities’ name doesn’t actually do a good job of describing what this real estate investment trust owns, since its portfolio includes apartments, shopping centers, and office properties. That said, the use of the word preferred is very descriptive, if a bit confusing. You might think that the company is saying it owns “preferred” properties, but in reality it’s a statement to the way in which the REIT funds its business — It sells nontraded preferred stock on a basically continuous basis.
This is not the normal way that REITs raise cash, and it comes with pitfalls. For example, preferred stock and preferred stock dividends rank higher than common stock and common stock dividends. Moreover, the REIT’s nontraded preferred shareholders can force Preferred Apartment REIT to buy their shares back, which would generally require the REIT to sell stock to come up with the needed cash.
That’s exactly what happened early in the coronavirus pandemic, diluting current shareholders at what was perhaps the worst possible time. It’s no shock that the REIT cut its dividend by roughly a third in 2020. And, even after that cut, the yield is still 9.4%. Could things get better from here? Sure. Do you want to own a REIT that has a funding approach that purposefully and regularly puts common shareholders low down in its priority list? Probably not, given how well that turned out in 2020.
2. Know what you own
Next up is Annaly Capital Management, one of the best-known mortgage REITs you can buy. This REIT cut its dividend in 2019 before the coronavirus was an issue and then again in 2020, after the pandemic started to spread. Even after two dividend cuts in two years, it still yields more than 10%. That smacks of a yield trap, if you don’t understand what this company and the mortgage REIT sector is all about.
Mortgage REITs are total return investments, which means that investors are expected to reinvest their dividends. You already know that the dividend has been cut twice over the past two years, but the stock was also down about 27% over the trailing three-year period. That’s terrible if you have been using the dividend to pay for living expenses. However, if you had reinvested the dividend, your total return over the past three years would have been 4.5%. That’s nothing to write home about, for sure, but it is a very different picture than you might have expected given the stock performance and dividend cuts.
The key here is understanding that Annaly, and most of its mortgage REIT peers, aren’t your typical property-owning REITs. They own portfolios of mortgages bought with leverage and make the difference between their financing costs and the income their portfolios generate. It’s a different model that has to be looked at in the right way or you’ll likely end up surprised by what you’ve bought. It wouldn’t be fair to call Annaly a yield trap, but it could end up being one if the only thing you look at is the fat yield.
3. A turnaround story
The last name up is Simon Property Group, which owns a collection of around 200 enclosed malls and outlet centers. It has been hard hit by the economic shutdowns used to slow the spread of the coronavirus pandemic. In fact, in the third quarter, it only collected around 85% of the rents it was owed. It cut its dividend in 2020 but still yields a fairly generous 6%. With peers like CBL & Associates and Pennsylvania REIT (NYSE: PEI) tumbling into bankruptcy, it’s fair to wonder if Simon has what it takes to survive.
That’s a legitimate concern; however, if you dig in you’ll see that Simon is not in the same position as CBL and Penn REIT. For starters, Simon’s leverage sits at the low end of its peer group, while the two bankrupt mall landlords had long struggled with burdensome debt loads. Further, Simon has a well-positioned portfolio of assets, with generally productive properties located in dense and wealthy regions. And it has been able to use this downturn to opportunistically invest in its business, buying a competitor and investing, with partners, in bankrupt retail businesses. So while it is facing headwinds, which resulted in a dividend cut, it actually looks like it is muddling through in relative stride and could actually come out the other side a stronger company.
There’s a precedent for this, too, if you look back to the 2007 to 2009 recession. Simon cut its dividend during that difficult period as well, but then it started increasing it again after reworking its portfolio. That’s not to suggest that muddling through the pandemic will be easy or quick but rather that Simon has managed to do this before. Investors worried that the REIT’s 6% yield is too good to be true should find Simon’s Great Recession backstory very comforting. And in the end, it’s likely that this high-yield REIT will end up working out well for more aggressive investors.
More than yield
A dividend yield is a very important piece of information, but it isn’t the only thing you should be looking at when deciding where to invest. Some high-yield REITs do, indeed, look like dividend traps. Others are simply different types of investments. And some are just out of favor for some reason even though they have great underlying businesses that have proven themselves in hard times before. That’s basically the landscape when you look at Preferred Apartment Communities, Annaly Capital Management, and Simon Property Group. In other words, investors need to dig beyond the yield.