There are some clear patterns to notice here.
The top four stocks on the list all have a great deal of retail exposure. The first two are all retail, while the two single-tenant REITs have lots of retail tenants. There is a great deal of chaos in the retail industry right now, with bankruptcies, store closures, and a general uncertainty about how the rise of e-commerce will ultimately affect the industry.
Skilled nursing is another industry with a lot of uncertainty, as well as many financial problems among facility operators.
Avoiding dividend traps
Of course, the five stocks in the list aren’t the only equity REITs with too-good-to-be-true dividend yields. Far from it. So here’s a quick list of ways you can avoid investing in dividend traps.
Check the payout ratio
A stock’s payout ratio is its per-share annual dividend as a percentage of its earnings. For REITs, the best method is to compare the dividend to the REIT’s funds from operations, or FFO.
For example, a REIT that pays $0.80 per year and earns $1.00 would have an 80% FFO payout ratio. High payout ratios are common with REITs: 70%–90% is normal. Anything above 100% could be a red flag.
Slowing (or negative) growth
It's important to not only take notice of a REIT’s current revenue or FFO, but also to check the recent trends. For example, if a REIT earns more than enough money to cover its dividend, but FFO has declined for the past two years, it could be a sign of trouble to come.
The average REIT has a debt-to-capitalization ratio of about 32% as of May 2019, and excessive debt could be a sign of trouble. Interest coverage and debt-to-EBITDA are two other good metrics to compare with peers in order to evaluate a REIT’s debt situation.
The market often discounts stocks that operate in industries with significant headwinds.
For example, the senior housing industry is dealing with oversupply problems, and several facility operators are facing financial troubles of their own. Non-discretionary retailers are also facing difficulties as e-commerce continues to grow.
Be very cautious before investing in an industry that’s facing a lot of trouble or uncertainty.
Compare the yield with peers
One of the least technical, yet most reliable, ways to detect dividend traps is to compare a REIT's yield with that of its peers.
For example, if the average telecom stock pays 5%, one that pays 6% may not be too alarming. However, one that pays 11% is a different story. Using our REIT examples in the chart, notice that there are two companies that invest in single-tenant properties, both of which yield more than 10%. If you’re thinking about investing in one, consider that the average single-tenant REIT pays about 4%. That should make you think twice -- or at least take a closer look.
Proceed with caution
Not every high-yielding REIT is a dividend trap. If it doesn’t fail any of the tests above, it could be a perfectly safe above-average dividend yield. However, if a high-yield REIT raises even one of the red flags discussed, approach it with extreme caution.