In a prior article we saw that REIT (real estate investment trust) valuation multiples have climbed as investors are desperate for dividend and interest income. This article will reveal that with only two possible REIT exceptions, investors cannot ignore these expanding valuations because the dividend return alone cannot justify these investments.
Even though the REITs are favorites among dividend investors, the payback periods of these securities are much too long to justify focusing on dividends alone. Unfortunately, the hope that dividend investors should "buy, forget, and cash the check" is fantasy since the shortest payback periods for REITs were projected to be longer than a decade.
Real Estate Investment Trust Payback Period Calculations
The number of years it takes for an investment to pay you back is called the payback period. It is a simple and crude measure of risk. Other investment metrics like required return do not always match up to the calculated payback period. This is because required return takes into account how dividend distributions in earlier years are worth more than the same dollar value paid out in the future. (You would be able to reinvest the earlier distribution and earn a return on it, making earlier distributions worth more.)
Since many dividend investors are attracted to high-paying dividend companies on the premise that they can ignore what the markets do and simply focus on their dividend income, the payback period provides a reality-check for how long payback based on dividend payments could take.
Payback period estimates depend on earnings growth and dividend payout ratios. Payout ratios were assumed constant, and yield was projected by taking the minimum of the following:
- Earnings growth over the past five years
- Analyst estimates for earnings growth for the next five years
- Return on equity times the earnings reinvestment rate
The minimum of these measures was then used to estimate dividend growth for the next three years.
REITs were screened for dividend payback within two decades, dividend yields in excess of the 10-year treasury yield and payout ratios at or below 100%. The values of these inputs are provided below:
Ticker | REIT | Div Yield | Payout Ratio | EPS growth past 5 years | EPS growth next 5 years |
Colony Financial | 7.0% | 0.88 | 0.0% | 4.5% | |
CYS Investments | 13.6% | 0.66 | 61.7% | 5.0% | |
Newcastle Investment | 11.2% | 0.58 | 3.1% | 4.0% | |
PennyMac Mortgage Investment | 8.8% | 0.75 | 0.0% | 25.0% | |
Universal Health Realty Income | 5.1% | 0.40 | 15.0% | 2.4% |
Abnormal growth will not last forever, and analyst estimates, as informed as they are, are not predictive indefinitely. To address this limitation, a terminal 3% dividend growth rate was applied for every security in the list after three years of projected growth rates. (Predicting economic growth many years out is impossible, and 3% seemed like a reasonable value.)
Why aren't most REITs on this list? Some of them have yields that are too low. In addition, many high paying dividend REITs like Annaly Capital Management (NLY) have huge payout ratios in excess of 100%. Though this might be a temporary problem for one trust here or there, in aggregate payout ratios in excess of 100% are unsustainable.
After filtering out such high payout ratios, there are five REITs have distribution rates which are high enough that the sum of future dividends would equal your initial investment inside of two decades:
Ticker | Industry | P/E | P/B | Return on Equity | Payback Period |
CLNY | Diversified | 12.94 | 0.89 | 7.5% | 13 |
CYS | Residential | 4.09 | 0.98 | 23.4% | 7 |
NCT | Diversified | 5.52 | 1.93 | 45.7% | 8 |
PMT | Residential | 8.7 | 1.29 | 13.2% | 11 |
UHT | Healthcare Facilities | 7.8 | 3.29 | 48.2% | 16 |
Conclusion
If you want to ignore what prices your securities fetch in the markets, you could make a case for some of these rapid-pay back REITs. However, with the exceptions of CYS and NCT, all REITs would require more than a decade for payback from sustainable dividends. Thus, investors should rethink a singular focus on dividends before investing.
What can dividend investors do with all these other REITs? Since they cannot "buy, forget, and cash the check" they are stuck considering total return including capital appreciation. Fortunately, many of these REITs offer compelling low price-multiples, which are promising for future market prices. However, to avoid value traps, investors should weigh how cheaply these trusts are trading against measures of quality. In short, prudent investment for income requires more than chasing yield.
Disclaimer: This article was written to provide investor information and education, and should not be construed as investment advice. I have no idea what your individual risk, time-horizon, and tax circumstances are: please seek the personal advice of a financial planner. This article uses third-party data and may contain approximations and errors. Please check estimates and data for yourself before investing.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
