Office REITs For The Income Investor: A Cash Flow Analysis

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Includes: ARE, DEI, DFT, DLR, POR, PSB
by: Bruce Miller

Summary

Office REITs are a source of income dividends.

Office REIT dividends do well in economic expansion, poor in economic contraction.

Few office REITs will meet an income investor's long-term dividend reliability requirement.

In my ongoing quest for reliable long-term dividend income, I thought I might take a look at Office REITs... so here they are.

NAREIT's web site lists 42 Office REITs, broken out as follows:

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Of the 27 Exchange Traded REITs, 19 have at least a 9-year dividend history while 17 of these cut their dividend over these past 10 years, and 14 of these dividend cutters have not returned the current dividend to the pre-cut level. This leaves 3 Office REITs that were able to restore their dividend: (NYSE:ARE), (NYSE:DFT) and (NYSE:DEI), and 2 that did not cut their dividends: (NYSE:DLR) and (NYSE:PSB). These are the 5 Office REITs I'll review.

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Dividend Growth

10-year dividend growth has been favorable for all of these REITs, showing the recovery of the dividend cutters and their comparative dividend growth.

A few things visible from this "Area" graph are the "special" dividend from PSB (distribution of realized capital gains) and the "flat" dividend from PSB between 2007 through 2013, which is a positive indicator of PSB management's commitment to the dividend when its peers cut theirs. Its also easy to see the slower, and slowing, dividend growth of DEI in comparison with others. It's taken 6 years for ARE to restore its cut dividend.

A more recent 5-year dividend growth summary shows the following. Here, I have taken out the "special dividend' of PSB for comparison.

10 Quarter Cash Flow Metrics

Dividend-to-Cash Flow from Operations (CFFO) Payout Ratio ((NYSE:POR))

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To obtain these ratios, I subtracted out the Preferred Stock dividend, if any, first from CFFO, as preferreds have first dibs on dividend payments from CFFO, and then divide this into the actual dividends paid to common shares. To smooth out the peaks and valleys of CFFO, I use a rolling 4 quarter total for each quarter's calculation over the most recent 10 quarters. Each of the PORs looks quite favorable for an equity REIT, which will typically run in the 60% to 70% range from most well managed REITs, with ARE running a bit high of late. PSB shows the most favorable POR, but I have taken out the $2.75 4Q14 Special (capital gain) dividend. I hesitate in doing this, as the $2.75/share was a real cash distribution, although it did not come from PSB's operations, but from the sale of assets. And the purpose of this CF metric is to show how well covered the dividend is from operations.

Interest Expense - to - [CFFO + Interest Expense]

This metric shows how much of the company's CFFO is being used to pay their interest expense BEFORE the interest is deducted as an operational expense.

This metric is important as the higher the debt load carried by the REIT, the higher (generally) will be the interest expense and the less operational cash will be available to REIT management to pay dividends and investing expenses. It also shows how sensitive the REIT will be to increasing interest rates. When this ratio exceeds 25%-30%, it is usually a red flag to excessive debt and usually will result in a slower dividend growth rate and greater risk for a dividend flattening (no growth) or even cut were interest rates to increase. For REITs, the best ratio will usually be in the 15% to 25% range.

10Q Annualized Return on CFFI to CFFO

This metric is not a trend metric, but it reflects the return management has gotten on its invested dollars to the company's "bottom line" of CFFO.

This metric uses the average annual Cash Flow (used for) Investing Activities (NASDAQ:CFFI) over the past 10 quarters, divided into the average annual growth of CFFO. For example, for DFT, the slope of the 10Q of CFFO calculates to an average of $1.7MM/Q and an average of $64.7MM spent on CFFI/Q. So the return on investments to CFFO is $1.7/$64.7 = 2.6%. This metric shows how well (poorly) the company has been able to convert investments into growing cash flow. The drawback to this metric is it assumes the growth in CFFO is due entirely to the period's investing activities, which may not be the case if investments made prior to the past 10Q are increasing CFFO during the past 10Q. However, when a company makes significant investing expense, I think it is reasonable the CFFO should grow due to these recent investments. If there is no or little CFFO growth following significant CFFI expense, this would certainly be cause for concern.

"Managerial Efficiency" of CFFO-to-Revenue

This metric demonstrates how well management converts revenues (the top line) into CFFO (the bottom line). This ratio will be dependent on the industry and how significant fixed costs are to the company... with REITs, primarily their interest expense. Equity REITs typically carry higher managerial efficiency ratios of 50% to 70%. Less than 50% suggests high fixed costs or management that does not run the REIT very efficiently. That is, it consumes more revenue in operational expenses than its peers.

Discussion

All of these Office Property REITs, except DFT, are providing yields under 4%, which may not be sufficient yield for many income investors. But all have demonstrated an ability to manage through a major economic recession with either no dividend cut or a dividend cut that it has been able to rebuild to pre-recession levels. PSB clearly comes out in front on every metric despite its flat $1.76 dividend per share from 2008 through 2013. But I consider DFT with its 4.5% current yield a good choice with low interest expense, an excellent payout ratio history, good recent dividend growth and a good return on CFFI. Close behind DFT would be DLR, with a better current yield of 3.9% and sound CF metrics. I find ARE the least favorable, with a long dividend recover period (7 years), a poor return on CFFI to CFFO, high interest expense and a high POR.

Conclusion

As always, dividend history and recent cash flow analysis should be used with other forward looking risks to company operations to build a complete picture of a company's ability to sustain and grow its future dividends. But how well a company has performed through a recession and how healthy its current cash flows are is probably the best indicator of how well it can support and grow its dividend going forward.

Disclosure: I am/we are long DLR.

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.