Are REITs and Utilities Good Dividend Investments?

Dividend stocks. When you hear those two words what do you think of? Many people think of widows and orphans, along with their stereotypical investment in utility stocks. While others may think of maximizing income by finding the highest yielding stocks available like Real Estate Investment Trusts (REITs). But are utilities and REITs really good dividend investments?

I have been using my new evaluation model for about a month now. So far, I have been quite pleased with the results. It is helping me to efficiently review a lot of dividend stocks and identify those with strong financials, that are likely to continue increasing their dividends and that are fairly priced. As I was developing and testing the new model I noticed it had a distinct dislike of Real Estate Investment Trusts (REITs) and utilities.

This got me to looking at these classes of stocks and asking the fundamental question, ‘Are they really quality dividend investments?’ Sure both are known to have above average yields, but as any knowledgeable dividend investor will tell you, current yield is just one small part of what makes up a great dividend stock.

I currently own three utilities and three REITs. In addition to those, I follow three other utilities and three other REITs. Let’s take a look at some of them and determine if they are good dividend investments:

REITs
Health Care Property Investors Inc. (HCP) – 0 Stars
Debt to Total Capital: 52%
Free Cash Flow Payout: 131%

Realty Income Corp (O) – 0 Stars
Debt to Total Capital: 47%
Free Cash Flow Payout: -65%

Federal Realty Investment Trust (FRT) – 2 Stars
Debt to Total Capital: 51%
Free Cash Flow Payout: 101%

Kimco Realty Corporation (KIM) – 2 Stars
Debt to Total Capital: 55%
Free Cash Flow Payout: -1753%

National Retail Properties, Inc. (NNN) – 4 Stars
Debt to Total Capital: 39%
Free Cash Flow Payout: -144%

Utilities
SJW Corp. (SJW) – 0 Stars
Debt to Total Capital: 49%
Free Cash Flow Payout: -94%

Progress Energy, Inc. (PGN) – 1 Stars
Debt to Total Capital: 56%
Free Cash Flow Payout: -36%

Atmos Energy Corporation (ATO) – 1 Stars
Debt to Total Capital: 54%
Free Cash Flow Payout: 1045%

Black Hills Corp. (BKH) – 2 Stars
Debt to Total Capital: 48%
Free Cash Flow Payout: -105%

Integrys Energy Group, Inc. (TEG) – 3 Stars
Debt to Total Capital: 18%
Free Cash Flow Payout: -47%

Consolidated Edison, Inc. (ED) – 3 Stars
Debt to Total Capital: 52%
Free Cash Flow Payout: -40%

For a company to consistently raise its dividends, it must generate strong free cash flows sufficient enough to meet other obligations, such as debt, before paying a dividend. I look for a maximum of 45% Debt to Total Capital and a maximum of 60% Free Cash Flow Payout with the last 10 years positive.

With the exception of NNN, each of the above companies failed the Debt to Total Capital and Free Cash Flow Payout tests. NNN passed the Debt to Total Capital test while failing the Free Cash Flow Payout test. All the above companies had multiple years of negative FCF over the last 10 years thus their dividends are supported via non-operating cash such as debt issuances and property sales. Ironically, NNN was the only 4 Star stock and it just recently froze its dividend.

Most REITs and utilities may provide your income portfolio with an additional boost in yield, but may end up costing you more in the long run. I will continue to look at REITs and utilities, but they must measure up like any other stock.

Full Disclosure: Long HCP, O, NNN, PGN, TEG, ED. See a list of all my income holdings here.

Comments

[aber:]

Hi and thanks , like always, for your articles
why TEG did not pass the test ? you wrote :

"Integrys Energy Group, Inc. (TEG) – 3 Stars
Debt to Total Capital: 18%
Free Cash Flow Payout: -47%
I look for a maximum of 45% Debt to Total Capital and a maximum of 60% Free Cash Flow Payout"

is seems to me much better than NNN , or i'm missing somenthing ?
do you think the TEG's dividend is at risk ?
please explain , thanks a lot indeed
Alberto (long on TEG )

Jul 30 05:25 AM

[jeandit75:]

I like your model but for the Utilities I would use other debt metrics instead of the % of debt to capital. I'd use net debt to EBITDA levels instead and interest coverage. I'd make sure that the companies generage sufficient EBITDA to maintain their credit ratings. In the case of PGN you'd see the company is a little bit stretched over the next couple of years, especially given their nuclear projects coming down the road.

Jul 30 06:31 AM

[Dividends4Life:]

Aber: An oversight on my part, TEG did pass the Debt test, but failed the FCF test. I do have concerns about TEG's ability to sustain its dividend, but I am not yet selling my position.

Best Wishes,
D4L


On Jul 30 05:25 AM aber wrote:

> Hi and thanks , like always, for your articles
> why TEG did not pass the test ? you wrote :
>
> "Integrys Energy Group, Inc. (seekingalpha.com/symbo...)
> – 3 Stars
> Debt to Total Capital: 18%
> Free Cash Flow Payout: -47%
> I look for a maximum of 45% Debt to Total Capital and a maximum of
> 60% Free Cash Flow Payout"
>
> is seems to me much better than NNN , or i'm missing somenthing ?
>
> do you think the TEG's dividend is at risk ?
> please explain , thanks a lot indeed
> Alberto (long on TEG )

Jul 30 08:22 AM

[The Hammer:]

Do not understand why you are long these stocks (disclosure) since you say they are rated low in terms freecashflow and star ratings?
It does not make sense.
Problem I have with utilities and reits is that cap ex requirements for utilities usually exceed cash from operations leaving no freecashflow to pay dividends and utilties continually increase debt levels. REITs must pay out 90% of income and leave little if any left over to fund operations. Then reits continually do dilutive stock sales to fund operations or acquisitions.

Jul 30 08:25 AM

[Alan Young:]

ROTFL! You've found the fatal flaw.

Some of these companies have been paying dividends since you were in diapers, but your model proves they can't sustain it.
I believe the flaw, sir, is in your model.

Jul 30 09:19 AM

[Steve20423:]

I don't doubt your analytical ability but your basic assumptions may be flawed. Warren Buffet bought Berkshire Hathaway many moons ago and so much as admitted it was a mistake. Hence he used the Cash the from that business to purchae higher quality businesses. Hence Berkshire has no more textile operations. HIs mistake was assuming the assets on the books were really assets. In this case the Looms.
At the time those looms had no value to anyone. Had he understood the business he would have understood that fact.
I'm sure you understand the mathemathics of your model but there is more to it than math. I think every business model may have it's own acceptable level of debt especially Real Estate and Utilities. At the end of the day what is really needed is an assessment of the business model and management 's ability to execute their plan. Execution of the plan is judged on whether management meets the stated plan objective.
Maybe I'm wrong but machine shops have different metrics that coffee shops and different metrics as compared to real estate or utilities etc etc.. If you want to invest in a market segment you need to compare all the companies in that segment to each other and select the best opportunitiy on the basis it will enable you to achieve your goals.

Jul 30 09:43 AM

[aber:]

D4L : thanks a lot indeed
all the best
Alberto


On Jul 30 08:22 AM Dividends4Life wrote:

> Aber: An oversight on my part, TEG did pass the Debt test, but failed
> the FCF test. I do have concerns about TEG's ability to sustain its
> dividend, but I am not yet selling my position.
>
> Best Wishes,
> D4L

Jul 30 10:01 AM

[Old Trader:]

Hammer,

The dilution due to additional issuance of shares by REITs depends on how efficient/effective they are in deploying the capital raised.

To the author,
Have you tested your model on MLPs yet? I'm referring to pipeline, as opposed to E/P MLPs. The midstream companies are very similar to utilities, in that they're fairly highly regulated, and also tend to have good to excellent yields.

Jul 30 10:04 AM

[The Hammer:]

Old trader,
Well how many of these reits effectively deployed capital in the last 5 years? Many of their assumptions have been proven overly optimistic and many carry to much leverage to begin with.
As for utilities, there are a few that have strong cashflows and have a reasonable payout ratio in order to handle the heavy cap ex requirements.

Jul 30 12:06 PM

[Foosie:]

I did a study awhile ago comparing 40 electrics on total return. This was the conclusion:
• The bulk of electrics had a median 100 percent capital gain over ten-year period while giving an average dividend yield of 4.82 percent per year.

Jul 30 12:47 PM

[Mad Hedge F...:]

Not for me. Chicago magnate Sam Zell thinks the big foreclosures won’t hit commercial real estate until the institutional holders run out of money in 2-3 years. From 2000 to 2007, half of the commercial properties in the US were sold and releveraged, and even the weaker holders have enough cash flow and reserves to last until then. Having peaked at a higher top, single family homes are now crawling off a much lower bottom, giving a crucial boost to an economy based on consumer spending. I’d call this a future green shoot, if I didn’t know that the grizzled property pro was talking his own book. After completing a brilliant sale of a huge portfolio of properties to the Black Rock Group at the absolute peak of the market, Sam is now suffering from buyer’s remorse with a turbocharger, having rolled the money into the bed ridden and nearly comatose Chicago Tribune/Cubs combo. Sam’s favorite overseas foray is Brazil, where a large, growing, educated population backed by rich natural resources, falling interest rates, and a strong currency provide a great backdrop for property investment. China looks good too, but you have to speak Mandarin.

Jul 30 12:59 PM

[stonebluff:]

To the author: some of your free cash flow/payment numbers have a dash or a minus sign in front of them, some don't.. Not being very smart, I had trouble figuring out what they say. I like the article and the conservative analysis of these income investments. But please clarify your free cash flow/ payment figures. Thanks

Jul 30 02:05 PM

[Old Trader:]

Hammer,

Both good points..regarding REITs, imo, the "best of breed" is O (a core portfolio holding).
Regarding utilities ( and also MLPs, btw), one has to evaluate the regulatory structure they're operating under. In some states, regulators are good about allowing utilities to add most, or all, of cap ex into their rate structure, meaning they can hike rates to recover the expenditures (obviously something the customers aren't thrilled by). SO would be a utility that operates in a very favorable rate environment ( not currently holding SO, but have, in the past).

Jul 30 04:15 PM

[Charles Cohen:]

REIT's are not _supposed_ to grow dividends.

A genuine, single real estate investment -- say, an apartment building -- is evaluated "as it stands". We look at _current_ rents, and mortgage payments, and reasonably expected maintenance expenses. And if the building looks like a sound investment -- without thinking about future growth, or how the cash flow will be reinvested -- we buy it.

There is an old "caper movie" in which the thief says to the Mafia guy:

"Hey -- this is only half of what I'm supposed to get!"

And the Mafia guy says:

"We've invested the rest for you."

That's how a corporation works -- it's supposed to grow, and it witholds much of its cash flow from its stockholders.

With a REIT, the stockholders get everything the REIT can afford to pay, and it's up the them to re-invest it.

So you might want a different model for REITs than for corporations.

Jul 30 10:43 PM

[Charles Cohen:]

A REIT (IMHO) should be a good proxy for direct ownership of real estate.

When I buy an apartment building, I don't expect it to grow. I evaluate it on the basis of _current_ income and expenses. If it throws off enough cash to justify the risk, I buy it.

If I want to own more apartments, it's up to me to re-invest the cash flow.

Similarly for a REIT -- if it wants to grow, it should issue more stock, rather than reducing its payout.

A "normal" corporation (whose stockholders _do_ expect growth) is fundamentally different. It seeks to keep its dividend stream as small as possible, and keep as much retained earnings as it can, to encourage internal growth.

The follow two fundamentally different business models. And they might need different models to evaluate them.

Charles

Jul 30 10:52 PM

[jessducky:]

you should differentiate property reits from residential MBS REITS. Whole different story. They have nothing to do with whether capital is deployed on the right projects, they just invest in portfolios of MBS, and the good ones are on fire right now and probably for sometime to come before the yield curve flattens. NLY for example...15% yield with relatively low leverage and completely govt backed MBS. Not riskless but in the sweet spot right now.

Jul 30 11:30 PM

[Old Trader:]

Charles,

"Hey -- this is only half of what I'm supposed to get!"
Btw, that line was delivered by James Caan in the movie "Thief"


On Jul 30 10:43 PM Charles Cohen wrote:

> REIT's are not _supposed_ to grow dividends.
>
> A genuine, single real estate investment -- say, an apartment building
> -- is evaluated "as it stands". We look at _current_ rents, and mortgage
> payments, and reasonably expected maintenance expenses. And if the
> building looks like a sound investment -- without thinking about
> future growth, or how the cash flow will be reinvested -- we buy
> it.
>
> There is an old "caper movie" in which the thief says to the Mafia
> guy:
>
> "Hey -- this is only half of what I'm supposed to get!"
>
> And the Mafia guy says:
>
> "We've invested the rest for you."
>
> That's how a corporation works -- it's supposed to grow, and it witholds
> much of its cash flow from its stockholders.
>
> With a REIT, the stockholders get everything the REIT can afford
> to pay, and it's up the them to re-invest it.
>
> So you might want a different model for REITs than for corporations.
>
>

Jul 31 01:16 AM

[Dividend Gr...:]

In my analysis of Reits, MLPs, BDCs and Utilities I have always bended my models to fit their unique structures and business models. Special entities which distribute almost all of their cash flow to stockholders should be evaluated on the basis whether or not they could sustain paying the same or a growing distribution over time.
Utilities are typically great for current income, but that's about it, they are not strong dividend growth players over the long run of 15-20 years.

Jul 31 08:51 AM

[Dividend Gr...:]

In my analysis of Reits, MLPs, BDCs and Utilities I have always bended my models to fit their unique structures and business models. Special entities which distribute almost all of their cash flow to stockholders should be evaluated on the basis whether or not they could sustain paying the same or a growing distribution over time.
Utilities are typically great for current income, but that's about it, they are not strong dividend growth players over the long run of 15-20 years.

Jul 31 08:57 AM