REITs: The 90% Rule Isn't That Big A Deal

Summary

• REITs have to distribute 90% of their taxable earnings.
• That sounds like a guarantee of dividends.
• Only, dividends don't come from earnings.

I've written extensively about American Realty Capital Properties, Inc. (ARCP), a risky turnaround play that I've invested in. One of the most frequent issues brought up in the comments of my articles is the company's dividend policy - it currently doesn't pay one, but says it will at some point in the near future. One constant bone of contention is the fact that real estate investment trusts, or REITs, are required to pay out 90% of their taxable income as dividends to remain REITs. But that's less important for a REIT's dividend policy than many people think.

The 90% rule

According to the Securities and Exchange Commission, or SEC, "To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends." There are other rules a REIT must follow, but that 90% one is core to the structure.

On the surface, that means that any REIT making money has to pay investors a dividend. But there are two big flies in this ointment. The first is the use of the word taxable income. The second is that dividends don't actually get paid from earnings.

Taxable earnings

As investors we don't get to look at a company's tax returns, we get to look at the financial results according to generally accepted accounting principles, or GAAP. The two are different, but GAAP numbers provide enough information to explain the problem. Looking at ARCP's results since it came public just a few years ago, it hasn't actually made a dime of money according to GAAP.

In fact, if you take a quick look at the income statement provided in the company's recently issued preliminary 2014 financial results, you'll see that ARCP lost $1.36 a share in 2014, $2.41 in 2013, and $0.40 in 2012. Before you start to think that ARCP is unique, STAG Industrial, Inc. (STAG) lost $0.28, $0.10, and $0.51 a share in those same years, respectively.

STAG certainly doesn't have the same problems that ARCP does, but the pair share the distinction of red ink on the bottom line. Looking at GAAP earnings, neither REIT has to pay a dividend because they don't make any money. That said, STAG did, in fact, have taxable income in each of the past three years (it provides a reconciliation between GAAP and taxable income in its annual report), so it did actually have to pay dividends. That's not likely the case with ARCP and why it has been able to not pay dividends.

But GAAP losses aren't the norm at all REITs. For example Realty Income Corp. (O) earned $1.04 a share in 2014, $1.06 in 2013, and $0.86 in 2012. Unlike ARCP and STAG, Realty Income has to pay dividends. Using the 90% rule, Realty Income's dividend would have been $0.95 cents a share last year. That said, Realty Income paid over $2 a share in dividends last year.

It's a cash flow thing

So you understand how a money losing company like ARCP wouldn't be paying a dividend. But how did a company like STAG pay $1.29 in dividends last year? And how does a company like Realty Income that only made about a buck a share pay out two bucks or so a share in dividends?

The answer is that dividends don't have anything to do with earnings. In fact, dividends don't flow through the income statement. And if you do see them on a company's income statement, it's as a supplementary item, something the company included there just to be nice.

Dividends show up as a line item on the cash flow statement. The cash flow statement shows you what actually happens with the money a company has and earns. Earnings are more of a fictional thing that include certain accounting regularities that have little to no impact on cash.

The biggest example, and the one that's most important for REITs, is depreciation. This is a non-cash expense that shows up on the earnings statement to write down the carrying value of long-term assets over time. The logic being that long-lived assets become less valuable as they age. I won't argue the merits of this when it comes to real estate, it's just what companies have to do. (Yes, depreciation makes more sense for things like machinery that wear out over time). But for a REIT, since property is the single biggest asset, depreciation expenses tend to be very high.

Depreciation shows up on the income statement as a cost of doing business, even though it doesn't impact the company's cash. Take depreciation out and many companies that don't have any earnings would be making money. For example, STAG had a GAAP net loss of around $15 million in 2014, but its depreciation expense was a whopping $88 million. No wonder it not only paid a dividend but increased its disbursement last year. It's also why Realty Income can pay more out in dividends than it has in earnings.

This is the reason funds from operations, or FFO, in some form, is used in the REIT world. FFO basically adds back in depreciation to show what a REIT is really "earning" and, thus, what it is capable of paying out in dividends.

A useless rule?

I've simplified a lot, but the basic points are what you need to understand. Earnings alone don't tell the whole story when it comes to REITs. Going back to the 90% rule, the SEC doesn't say anything about FFO or cash flow, it says REITs must pay out 90% of taxable earnings. So, ARCP isn't currently required to pay dividends because it doesn't have taxable earnings. And while Realty Income and STAG do have to pay dividends, neither needs to be anywhere near as generous as they are being.

So while the 90% rule is important for REITs, practically speaking it has little impact on most REIT dividend decisions.

Disclosure: The author is long ARCP. O. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.