Why REIT Dividends Are Not A Mirage

by: David Van Knapp

A couple of days ago, an article put forth the proposition that REIT dividends are a mirage.

Many real estate investment trusts (REITs) can be quite tempting as the housing market seems to be on the mend and experiencing a revival. What appears to be a bonus, a huge bonus, is that many of these REITs are flashing what looks like exceptionally high dividend yields. There's only one catch, and it's a biggie: many of these dividend yields are a mirage.

…Often the reason for the high dividend yield is because it's fake value. REITs, by their structure to save on taxes, have to pay out their net incomes in the form of dividends to shareholders. But then the same REITs turn around and raise capital at the expense of the very shareholders they are paying a dividend to, but an amount equal to or even greater than the dividend itself! The end is a wash, and no value is created for shareholders….The reality usually becomes that the dilution experienced has reduced shareholder value in a similar amount to the dividend.

The author elaborated his point in a comment.

[REITs] do capital raises at the same time as dividends. I know EXACTLY how REITs works. The portion of the capital raise that isn't paid out in dividends tends to be accretive, yes, but not the portion that is immediately turned around and paid back out. Yes, they have to pay out 90% to save on taxes which I explain in my article and 400,000 times in the comments section: a necessary evil. But there is no free lunch. The dividends are indirectly paid out from the capital raises and are a mirage. All those people think they've been getting a free lunch all this time while the rest of the market didn't have a clue about these giant dividend yields. LOL of course they knew. They just knew it was all B.S. too mathematically speaking.

While the author confined his point about dividends being a mirage to REITs, his reasoning is actually quite similar to anti-dividend charges that have been leveled at dividends for several years here on SA. There are at least two flaws in the reasoning:

  • It is presumed that the dividends, had they been retained by the company, would add to the value of the company in the same proportion that the dividends retained by the company do.
  • It is presumed that the stock market would therefore value the stock more highly, in direct proportion to the earnings not paid out as dividends.

I own two REITs - Realty Income (NYSE:O) and Omega Healthcare Investors (NYSE:OHI) - as well as many other dividend paying stocks, and I can say for sure that the two propositions are false.

The first proposition - that unpaid dividends add to the value of the company - is theoretically correct if one looks only at book value. At the instant that dividends are paid, book value drops by exactly the amount of the dividends.

But this academic fact misses the point of what companies do. They use capital - raised in various ways - to finance their businesses, hopefully profiting from their activities and thereby increasing the value of the company well beyond the dollar amount of the financing received.

The book value of any company is changing continually as money flows into and out of the company and the company conducts its affairs. To single out one single activity at the end of the process - the payment of dividends - for special attention as to its presumed effect on the overall value of the company is to ignore the fact that all companies have a capital structure, business plan, strategies, tactics, and activities, and that all of them impact the value of the company.

With REITs, it is rather a moot point, because their capital structure is extremely impacted by the fact that they are REITs. The choice by a company to be a REIT carries with it the obligation to distribute at least 90 percent of its taxable income (excluding capital gains) to shareholders annually. That allows it to deduct dividends paid to shareholders from its federal tax bill. The responsibility for taxes is passed along to shareholders.

Because of this high distribution requirement, REITs need to generate new capital to grow. Various papers have explored how REITs raise capital, but suffice it to say that often capital is raised by issuing new shares. In other words, the repeated raising of new capital by REITs is an essential part of their business model, and the distribution of dividends is required by law.

Every company has a capital structure, and every dividend-paying company has less capital available internally precisely because it pays a dividend. But to stretch that fact to mean that such companies are less efficient growers, or that everyone would be better off if no company paid a dividend but instead retained all earnings, is an academic abstraction, and for some it has become something of a religious issue. Most of the research I have read that actually examined data tends to debunk the academic argument. Indeed, some of the most efficient, growing, and profitable companies on Earth pay dividends.

In any event, REITs have no choice. To draw a one-to-one correspondence between new capital and dividends, and then to conclude that the dividends are therefore a mirage, strikes me as silly. Judging from the comments on the article, it struck many others as silly too. As many commenters pointed out, the far more logical correspondence is between Funds from Operations (FFO, the standard measure of REIT profitability) and the dividends. If all a REIT did was raise capital and then pay it out as dividends, the REIT would die. That is not sustainable, and capital raised is not the source that the law specifies for the dividends. The dividends come from FFO, the profits that the company generates.

The second flaw - that the company's market price would be higher proportionally to the dividends not paid out - should be self-evident. It ignores Mr. Market. Share prices are determined by market trades, not by algorithm or formula. It is amazing how often this reality is simply ignored in favor of academic theory.

Last year, Chuck Carnevale demonstrated in two articles (here and here) that investors value stocks based on their earnings and prospects for earnings growth, and they do this whether or not some of those earnings are paid out as dividends.

If you examine two companies with equivalent rates of earnings growth, where one pays a dividend and the other does not, the dividend payer will provide their shareholders a higher total return. In other words, we're suggesting that both stocks will provide equivalent capital appreciation when measured over a time period when the market is behaving rationally…. Consequently, the stock that pays a dividend to its shareholders is providing them a return bonus or kicker.

In the case of REITs, their share prices have been and will continue to be correlated to their profits (Funds from Operations) and their prospects for growing those profits. The two REITs that I own, O and OHI, have certainly followed this pattern since I have owned them.

I also refer the reader to Brad Thomas's article on Tuesday (here) that examined the "mirage" article in the context of a particular REIT, American Realty Capital Properties (ARCP). He reached similar conclusions.

Disclosure: I am long O, OHI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.