If Congress enacts legislation to reduce the tax on corporate dividends, as the Bush administration and corporate lobbyists hope, real estate investment trusts would instantly lose some of their appeal. Many investors buy REIT stocks for their hefty dividends (by law the trusts must pay out 90 percent of their net income to shareholders). With an across-the-board tax cut on dividends, all kinds of companies would have an incentive to increase their own payout ratio, offering yield-hungry investors a much wider array of choices.
Not surprisingly, in the wake of President George W. Bush's proposal, Morgan Stanley's RMS index of REITs declined some 7 percent, from 438 in mid-January to 408 at the end of the month.
The prospect of added competition for investor attention is just one of the dark clouds appearing on the horizon for REITs. Stellar double-digit total returns in 2000 and 2001 narrowed to a 3.6 percent gain in 2002. And the scramble to invest in high-yielding REITs -- regardless of possible new offerings for dividend-seeking investors -- could prove to be a mistake, say some industry observers. That's because earnings pressure may force many REITs to cut their dividends. Some have already done so.
David Shulman, head of REIT research at Lehman Brothers, points out that dividend coverage for 33 leading REITs is running at a modest 1.12 times adjusted earnings before interest, taxes, depreciation and amortization, divided by all payments to capital. A 1.2 ratio is currently seen as the minimum for a quality mortgage lender. Shulman believes the dividend coverage ratio could decline further if the recovery stalls and earnings remain under pressure. Overall, the average REIT was yielding 7.5 percent in late January.
Says Mike Kirby, a principal at Newport Beach, Californiabased Green Street Advisors, "People have overpaid for high yields." In the main, Kirby says, these yield seekers tend to be retail investors, while institutions pay more attention to the quality of underlying earnings. "Most institutions don't care whether they receive the dividend today or the company reinvests it and they make it back in growth tomorrow," he says.
All of the REITs that have cut their dividends had payout ratios above 100 percent. They were not earning their dividends, but funding them largely through property sales or debt issues.
In October, for example, Richmond, Virginia, apartment REIT Cornerstone Realty Income Trust announced that it was cutting its dividend by 28 percent. Two months ago, Charlotte, North Carolinabased Summit Properties cut its quarterly dividend by 29 percent.
Atlanta's Post Properties, sporting a 12.4 percent yield on November 12, announced that it would slash its dividend by 42 percent in the first quarter of 2003. In mid-December Associated Estates Realty Corp. announced that it was cutting its dividend 9 percent. "I am disappointed in our performance, which has necessitated this dividend reduction," CEO Jeffrey Friedman said in a statement.
For the moment, REITs with plump yields sport multiples that are considerably higher than the industry average. According to a survey of 175 REITs by SNL Real Estate Securities Weekly, as of mid-December 2002, the quartile of REITs with the highest yields also carried the highest median price to funds from operations multiple, at 10.3, compared with 8.1 for the quartile of REITs with the lowest yields.
A handful of REITs have enough free cash flow (after capital expenditures and dividend payments) to defy the trend and raise their dividends, says Lehman's Shulman. In October Chicago-based mall owner General Growth Properties, which Shulman is recommending as an investment, announced a 10 percent dividend hike."Even after that increase they are still only yielding 5.6 percent, suggesting investors believe there could be future dividend increases," Shulman says. He expects another mall owner, Columbia, Marylandbased Rouse Co., now yielding just 5.2 percent, to announce a dividend increase in the first quarter of this year.