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
REITs are higher-yielding investments by nature. These entities must distribute 90% of their taxable income to shareholders to maintain their special tax status. That's why the typical REIT currently yields nearly 3%, more than double that of the average stock in the S&P 500.
Some REITs offer even higher yields. While that might seem appealing, investors need to determine whether those payouts are sustainable, because a high yield can also be a sign of a dividend yield trap. With that possibility in mind, here's a look at whether Gladstone Commercial (NASDAQ: GOOD), Global Net Lease (NYSE: GNL), and Sabra Health Care REIT (NASDAQ: SBRA) are compelling income options or dividend yield traps.
Too good to be true?
Gladstone Commercial is a diversified REIT that primarily owns office and industrial properties. The company pays a monthly dividend that currently yields 6.5%. Overall, the REIT has a solid dividend track record -- it hasn't missed or reduced its cash distribution since its initial public offering in 2003.
However, there's one big red flag with Gladstone Commercial. The REIT pays out nearly all its income to support its high-yielding dividend. For example, in 2020, Gladstone produced $1.56 per share of funds from operations (FFO) while paying out a total of $1.50 per share in dividends, giving it a 96% payout ratio.
While a REIT can technically distribute 100% of its FFO, most pay much less. That's because doing so allows them to retain cash to reinvest in expanding their portfolio. However, since Gladstone pays out nearly everything it takes in, the REIT has barely grown in recent years, only increasing its FFO from $1.54 per share in 2015 to $1.56 per share last year.
So, while the company could continue paying its current dividend, it might better serve investors by retaining more cash and using that to fund new acquisitions.
Is another cut on the way?
Global Net Lease is also a diversified REIT that primarily concentrates on office properties and industrial real estate. Further, as its name suggests, the REIT takes a global approach while focusing on net lease real estate.
The company pays a much higher-yielding dividend at 8.8%. That's despite cutting its annualized rate from $2.13 per share to $1.60 per share last year to preserve its liquidity during the pandemic.
However, even at that reduced rate, the REIT still has a high dividend payout ratio of around 90% of its adjusted funds from operations (AFFO). Because of that, like Gladstone, Global Net Lease has struggled to grow its AFFO per share over the years, which is why it might need to make another dividend cut to retain even more cash to fund growth.
Is it healthy yet?
Sabra Health Care REIT, as its name suggests, is a healthcare REIT. The company has a diversified portfolio of properties in that sector, including skilled nursing/traditional care facilities, specialty hospitals, and senior housing. It net leases most of its properties, though it does operate a portion of its senior housing portfolio under a management structure.
The company currently pays a hefty dividend that yields 7%. That's even after cutting its payout last year to preserve cash amid the pandemic. On a positive note, that reduction put Sabra's payout ratio at a reasonably comfortable 75% of its AFFO in the second quarter.
That lower payout ratio alone makes Sabra less of a dividend yield trap.
Meanwhile, the company recently announced plans to sell its 49% interest in a managed senior housing joint venture. That business has experienced pandemic-related hardships, impacting its occupancy and net operating income (NOI). By selling its stake, Sabra will improve its already solid balance sheet, giving it additional flexibility to finance future acquisitions to grow earnings. Because of that, the dividend looks to be on solid ground these days.
Not all high yields are traps
On the one hand, questions remain about the long-term sustainability of the high-yielding dividends currently paid by Gladstone Commercial and Global Net Lease. The biggest issue is that they have high dividend payout ratios, which limits their abilities to retain earnings that they could use to help fund acquisitions. Because of that, there's a high risk they could reduce their dividends, making them potential dividend yield traps.
On the other hand, Sabra's dividend doesn't look like a trap. The REIT already reduced its payout to a comfortable level last year. Meanwhile, it recently started the process of selling its interest in a joint venture, which will improve its financial flexibility. That makes it a potentially appealing option for yield-seeking investors.