Mr. Market Cannot Be Relied Upon To Provide Dependable REIT Income

by: Brad Thomas

In Josh Peters book, The Ultimate Dividend Playbook, he writes:

Even though the market is made up of millions of individual buyers and sellers, it forms something of a collective consciousness of its own. Ben Graham, the father of value investing, understood this when he suggested the character of the mythical Mr. Market. He's the guy on the other side of your stock trades. When you buy, it's his shares you're buying. When you sell, you're selling to him. Every moment of every trading day, Mr. Market can be found quoting prices for publicly traded stocks.

Most of you know that I cover the Equity REIT sector, a reliable income class that is differentiated by the fact that all U.S. REITs are FORCED to payout at least 90% of taxable income in the form of dividends. REITs also must own "real estate" and that means that the majority (75%) of the assets should be in the form of "brick, mortar, land, improvements, or a combination thereof".

As such, REITs are known to provide reliable and consistent income - a quality that is often either under or over-estimated by Mr. Market. Truth is, Mr. Market cannot be relied upon to provide dependable REIT income; instead, the repeatable income provided by REITs are the single best side effect of a dividend growth strategy and ultimately that attraction shifts investors attention away from the volatile stock prices that Mr. Market produces. As Josh Peters explains:

…Mr. Market is not what you'd call a steady business partner. An incurable manic-depressive whose actions define the words fear and greed, Mr. Market will offer ridiculously high prices for a given stock at one point and insanely low prices the next. Mr. Market is the guy who does most of the obsessing about quarterly earnings, economic reports, and so-called technical trends in stock prices.

The Great REIT Sell-Off of 2013

More recently we have seen the fear of rising interest rates as the latest "obsession" by Mr. Market. It seems that from May 22nd through the end of 2013 REIT investors rushed to sell stocks that were perceived to be interest rate sensitive. Starting on May 22nd (when the Fed announced its intention to taper) through 2013 REITs fell by around 14%, while the rest of the stock market continued on its way to record highs and growing optimism.

However, the silver lining is that REITs derive a bulk of their value from dividends and that reliable and steady income stream is the ultimate source of the reward. Josh Peters summed it up:

Understanding the basic drivers of investment returns - specifically the concept that future returns are driven by the sum of current yield and future dividend growth - is essential to grasping the rest of the story.

REITs Can be Relied Upon for Durable Sources of Income

Fellow Seeking Alpha writer David Fish provides all of us with frequent article and charts about the "Dividend Champions" - companies that have paid higher dividends for at least 25 straight years; "Contenders" - companies with a streak of 10-24 years; and "Challengers" - companies that have streaks of 5-9 years. "CCC" refers to the universe of Champions, Contenders, and Challengers. You can read about the latest (February) Dividend Champions HERE.

The "CCC" universe is an essential list since stocks that pay consistent dividends perform the best. Josh Peters summed it up well:

Dividend cuts or eliminations are just short of a full-blown betrayal or trust, and may signal financial troubles to come.

Peters went on to see that "the dividend machine has 2 outputs: dividends and future dividend growth" and by analyzing a REIT based on these 2 outputs an investor can learn a tremendous amount about the quality (or lack of). Josh Peters explains:

…dividends speak louder than earnings. A company's pattern of dividend payments = its dividend record - can offer valuable clues to underlying corporate performance, clues just as valuable as those provided by earnings reports and other financial data, and definitely more useful than the conclusions someone might draw from looking at a three-month stock chart…Dividends ate more than mere information; they provide insight that any investor can use to make successful investments.

So a REIT is nothing more than a machine that turns investment capital and rent checks into dividends. Accordingly, capital is the investor's contribution to the enterprise and his reward is dividend income.

There are 11 REITs that have provided shareholders with the most durable dividend rewards - These list of 11 REITs are all differentiated by the way they turn shareholder capital into powerful sources of durability and reliability. What do I mean by durability? Here's how Josh Peters explains it:

Durability implies that the firm can take a financial punch in one year and come back swinging the next. Durability implies an earnings stream that, if not quite predictable in any one year, can be relied upon over a series of years, during which short-term fluctuations should average out.

Regardless of the drama associated with Mr. Market volatility, the list of 11 REITs have stood behind their promise - a commitment that many shareholders count on. Here is the list of 11 REITs recognized by their ultimate sign of corporate strength: DURABILITY.

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The Safest Dividend is the One's That's Just Been Raised

Earlier this week, Eddie Herring wrote an article suggesting that dividend increases provide the best possible evidence of dividend safety. As the author explained:

…A retiree that suffers a dividend cut must replace that dividend or live with less income. Accordingly it behooves the retiree, as well as other DG investors, to remain cognizant of how the companies in their portfolio have previously reacted to high inflation rates. Think of it like this, if inflation goes up 6% and your DGR only goes up 4%, you just took a pay cut of 2%.

I like to see REITs with good dividend records as that always prompts me to believe that management is strongly committed to maintaining and increasing the dividend. In the same above referenced article, Herring went on to say:

Obviously I want my income to stay ahead of inflation. My rule of thumb is that I want my DGR to be twice the rate of inflation. Since 1914 on average the annual inflation rate has been around 3.3% so I look for a dividend-growth rate of a minimum of 6.5%. Every one of the companies shown above exceeded that growth rate on average during the period of high inflation.

No one knows the future and no one in their right mind would want record inflation. High inflation makes life difficult for those with finite incomes, and especially senior citizens on social security or those with fixed incomes such as annuities. Of course inflation alone is not the only driver that can move the market during inflationary times and the astute investor will keep an eye on the business performance of the companies in their portfolio.

As Josh Peters wrote "the dividend machine has two outputs: dividends and future dividend growth" and without the growth output, the machine is not as efficient. Accordingly, Dividend increases - even more than current earnings or earnings projections - are a forward-looking indicator of growth and total return prospects.

One REIT that's not on the "CCC" list is Ventas, Inc. (NYSE:VTR). In a recent article I explained that "Ventas NEVER cut its dividend, and with the exception of 2009 (where the dividend remained flat) the company increased every single year". However, I also explained that "throughout the previous three years Ventas has increased its dividend by an average of 8.5%, almost double the growth of either of the two diversified health care REITs, HCP Inc. (NYSE:HCP) and Health Care REIT". The primary reason that I own Ventas is because I believe that the management is strongly committed to maintaining and increasing the dividend. That helps me "sleep well at night".

Josh Peters sums it up:

For companies with meaningful yields, I take dividend increases as the loudest and clearest message that management can send.

Here's a Sucker Yield REIT

A few days ago I wrote an article on Gladstone Commercial (NASDAQ:GOOD). For those who missed it, don't worry. Gladstone isn't a "dividend champion" and more importantly, the high yielding REIT looks "too good to be true". In his book, Josh Peters describes the term: "sucker-yield stock":

A ridiculous yield combined with an inherently vulnerable business model sends ominous signs of doom.

My "take away" for Gladstone is that I question the durability of the dividend revenue. The last time that Gladstone increased its monthly dividend (of $.125 per share) was January 2008. In addition, there is minimum dividend coverage and the quality of the income (the sub investment grade tenants) don't provide me with promising forward-looking signs or competitive total returns prospects.

Dividends allow the investor to harvest cash returns that are fully and completely independent of market prices. It isn't Mr. Market who pays dividends; only the underlying corporations can do that.

What Does Mr. Market Know About the Real Estate Market?

As Josh Peters wrote, "dividends allow the investor to harvest cash returns that are fully and completely independent of market prices. It isn't Mr. Market who pays dividends; only the underlying corporations can do that". Yet, Mr. Market has effectively given REIT investors new life by recharging the dividend batteries. In other words, risk has been baked into REIT shares and dividends are much more attractive today.

It's important to recognize that the sentiment of the market is much different from the sentiment of Mr. Market. I asked Dr. Brad Case, Senior V.P. of NAREIT about the overall US real estate economy and he explained:

The great early real estate economist Homer Hoyt first noted in 1933 that commercial real estate markets seemed to follow a fairly predictable 18-year cycle. It's not perfect, but the last cycle was 17 ½ years (measured in the listed equity REIT market from a peak in August 1989 to another peak in January 2007) and the previous one was also 17 ½ years (September 1972 - August 1989).

That doesn't mean REITs don't have corrections in the middle of the real estate cycle: there was a severe one in 12/97-11/99 because people sold REIT stock to buy tech stocks during the bubble, and there was another one last summer. But real estate bull markets historically have lasted 1-2 years, meaning that real estate bull markets have been closer to 16 years. The current real estate bull market started in March 2009, so we're less than five years into it.

I then asked Dr. Case about the overall supply and demand fundamentals for commercial real estate. He explained:

The long real estate market cycle is determined more by the supply side-capital market conditions and construction-than by the demand side. It's not that demand isn't important, but the demand cycle is much shorter (the economic cycle, which is generally more like 3-4 years) so it doesn't determine the length of the commercial real estate market cycle.

I would characterize the current demand situation as one in which demand for all types of commercial real estate is strengthening, but slowly: slow growth in employment driving slowly increasing demand for office space, slow growth in consumer spending driving slowly increasing demand for retail space, slow growth in domestic and foreign trade driving slowly increasing demand for industrial space, slowly increasing business and vacation travel driving slowly increasing demand for hotel space, and especially slowly increasing household formation driving slowly increasing demand for rental apartment space.

On the supply side, in general we've seen very slowly increasing new construction in all property types (with the exception of apartment development in very specific markets, such as Washington DC). Construction has been held back by the continuing lack of construction and mortgage lending capital.

It's not every day that I get to talk with an "Intelligent REIT Investor" who finished Yale so I had to squeeze in one last question. After all, it was my one chance to soak up that necessary "trace of wisdom" in hopes that I could find a clue as to whether Mr. Market can be reliable. So asked Dr. Case about the future and he said:

So, I don't know whether 2014 will be a good year or whether February will be a good month, but I suspect that the next several years will generally be more good than bad because I think macroeconomic conditions will continue to improve. Equity REIT total returns averaged 17.31% per year during the entire duration of the last real estate bull market, almost 16 ½ years from 10/90-1/07, even including the REIT downturn of the late 1990s.

In closing, I believe now is a good time to take a more tactical approach to dividends; based upon the premise that REIT prices are down but the economy is not (employment is up and REIT prices are down). Mr. Market cannot be relied upon to provide dependable REIT income; however, a powerful model of dividend repeatability can enhance your investment portfolio by providing sustainable growth utilizing the power of compounding.

I warn the "market timers" to "be prepared for increasing volatility," and don't expect REITs to go straight up to new highs like we saw prior earlier this year. Those days are over, at least for a while. Successful investors should have a disciplined approach that is critically important for all investors no matter what type of strategy they use. Take heed of the advice from John B. Rockefeller:

Do you know the only thing that gives me pleasure? To see my dividends coming in.

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Source: SNL Financial, FAST Graphs, and NAREIT.

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.

Disclosure: I am long O, DLR, VTR, HTA, STAG, UMH, CSG, GPT, ARCP, ROIC, MPW, HCN, OHI, LXP, KIM. 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.