REITs: Why The Dividends Are A Mirage

by: Heisenberg Principle

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.

Don't get me wrong. REITs can potentially make great investments. Just be cautious when relying on dividend yield for many of them. 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. If only it were that easy for a company to raise money in a private placement, then pay out dividends with that same money. The reality usually becomes that the dilution experienced has reduced shareholder value in a similar amount to the dividend.

To illustrate, I will present what happens to be my five favorite REITs that I believe are worthy of investment but their dividend yields should be ignored:

1. PennyMac Mortgage Investment Trust (NYSE:PMT)

PMT invests primarily in residential mortgage loans and mortgage-related assets. PMT pays a quarterly dividend that's currently around a 9% yield. But in 2012 alone, PMT had two major equity raises which helped drive the share count up from 28.4 million to 58.9 million or over 107% dilution. So of course PMT can afford to pay a 9% dividend - all it is doing is return a portion of the money it raised, expense of shareholders. The capital raises themselves paid off with record results, but the dividend is a mirage. It's a necessary evil to save on taxes, but as an investor bear in mind that PMT is diluting your investment in order to pay you that dividend. Discount it.

2. Starwood Property (NYSE:STWD)

STWD is focused on originating, investing in, financing and managing commercial mortgage loans and other commercial real estate debt investments, commercial mortgage-backed securities ("CMBS"), and other commercial real estate-related debt investments. STWD pays a quarterly dividend that's currently around a 6.3% yield. During 2012, the share count ballooned up 45% mostly as a result of equity raises. Again, the capital raises themselves paid off with record results, but the dividend is a mirage. Discount STWD's dividend.

3. American Realty Capital Properties (ARCP)

ARCP is an externally managed real estate company that owns and acquires single tenant free standing commercial real estate properties that are primarily net leased to investment grade tenants. ARCP pays a quarterly dividend that's currently around a 6.8% yield. It's actually somewhat humorous that ARCP takes it a step further than others and brags in its press releases about returning dividends to shareholders. Problem, of course, is it's only a fraction of the money it took in from equity raises that diluted shareholders. As an example, here management brags about returning $8.4 million to shareholders in 2012. Meanwhile, here the same management raised over $30 million at the dilution expense of shareholders. I understand to save on taxes that you have to rob Peter to pay Paul, but investors should know better. There's no such thing as a free lunch, and when you see an exceptionally high dividend yield there is a probably a reason for it. In total, ARCP saw its share count rise 52% during 2012 while paying back a dividend at a fraction of that.

4. AG Mortgage Investment Trust, Inc. (NYSE:MITT)

MITT invests in, acquires and manages a diversified portfolio of residential mortgage assets, other real estate-related securities and financial assets. On December 6, 2012 MITT announced a $0.80 per share dividend, returning nearly $20 million back to shareholders. Sounds great, right? On an annualized basis that's a 12.2% yield. Exactly two weeks later though it announced the pricing of 3.75 million shares, raising $89 million or more than a year's worth of dividends taken back in the form of dilution. Investors have to be careful. I do like MITT for its fundamentals and prospects, but once again investors need to ignore the high dividend yield. It's a mirage.

5. Apollo Commercial Real Estate Finance, Inc. (NYSE:ARI)

ARI is a commercial mortgage real estate investment trust that primarily originates, invests in, acquires and manages senior performing commercial real estate mortgage loans, commercial mortgage-backed securities and other commercial real estate-related debt investments throughout the U.S. ARI pays a consistent $0.40 per share per quarter dividend. Like the others, those dividends only get declared and paid as a result of equity capital raises. Here's an example of a $0.40 per share dividend declared and paid, returning only a fraction back to shareholders that had been raised just the month prior.

With all this in mind, it's remarkable that each of these REITs have been able to leverage their capital raising into results that still showed increases in earnings per share even after the dilution. Their performance has been remarkable, and I believe stands an excellent chance of continuing to do so. Investors should still discount the dividend yields. Normally a relatively high dividend could be used as a fundamental reason to expect a rise in a stock price, but I believe in the case of REITs that also dilute, that thinking should be avoided. Earnings per share and its growth should be all investors consider when it comes to diluting REITs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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