Late last week we posted another article on REIT Fundamentals, and while their price stability seems to be on solid ground, we are cautious about short-term price appreciation potential.
Prior to that article, we published another article in collaboration with The Belgian Dentist highlighting how sentiment towards REITs has been extremely high and how this is often a contrarian indicator.
We also did some work on 3M following an analysis we completed on the benefits of investing in high quality companies.
Lastly, if you missed the podcast where Jonathan Liss asks about my approach to investing, you can listen to it here. Just note, that's not what I really sound like in person.
To Play It Safe Or Not: A Comparison Of Two REIT ETFs
Co-produced by The Belgian Dentist for The Income Strategist
There is a bifurcation between safe, low yielding big caps vs risky, high yielding small caps. The old adage that higher returns only come with higher risk is as relevant with yield as it is with total returns. Many income investors tend to ignore stocks whose dividend yields are 'too low' – with the threshold for too low varying by individual investor.
Besides searching for and investing in specific REITs that meet the yield criteria, investors might also consider investing in an ETF that shares some of the same investment criteria they are looking for.
If you're looking for high yielding REITs, for example, you will likely not be terribly excited about the Vanguard Real Estate ETF (VNQ), with a dividend yield of 3.9%. It's decent, but might not be high enough to satisfy some investors.
The iShares US Real Estate ETF (IYR), with a dividend yield of just 3%, is even less appetizing.
However, the Invesco KBW Premium Yield Equity REIT Portfolio ETF pays out 6.8% and it even pays its dividend monthly to boot. It has much higher exposure to smaller cap REITs that are considered 'less safe' than their much larger and better capitalized peers.
So the question is, is this search for yield too risky or not?
Small cap REIT undervaluation
Exhibit 1 shows that based on P/FFO, small cap REITs are much cheaper than large cap REITs. One way to look at this is to say that investors are willing to pay a higher price for each dollar of FFO for a large cap REIT than they are for a small or micro-cap REIT. In exchange for the safety of a larger cap REIT, investors will only be receiving a 3.2% dividend yield, and likely not to have as much upside potential than the micro cap counterparts.
Exhibit 1: REIT Valuation by Market cap
Is this undervaluation a true mispricing or is it due to primarily to higher risks? REIT investors attach a lot of importance to dividends. So, one way to measure risk is to evaluate the safety of dividends.
The team at Simply Safe Dividends calculates their Dividend Safety Score, by taking into account more than a dozen fundamental metrics that influence a company's ability to continue paying dividends. Some of the metrics used are a company's:
Payout ratios Debt levels and coverage metrics Recession performance Dividend longevity Industry cyclicality Free cash flow generation Recent sales and earnings growth Return on invested capital
They divide companies into 5 categories, as shown below. Companies with a Dividend Safety Score rated Very Safe are extremely unlikely to have a dividend cut, while companies with a Dividend Safety Score of Very Unsafe have a high risk of being cut. There are three additional categories based on the likelihood of a dividend cut based on their respective scores.
Exhibit 2: Dividend Safety Score
Source: Simply Safe Dividends
When we apply this methodology to REITs included in the universe of coverage provided by Simply Safe Dividends, we can draw two conclusions.
The average REIT Dividend Safety Score is (only) borderline safe. There is a clear link between the size of a REIT’s market capitalization and its Dividend Safety Score.
The smaller the market cap of a REIT, the bigger the risk of a dividend cut. The average dividend safety of micro caps is very unsafe while at the other end of the spectrum the average dividend safety of large caps is Safe. (See exhibit 3 below)
There are 14 Very Safe REITs. Only one of them is a small cap - Urstadt Biddle Properties (UBA) - three are mid cap and 10 are large cap REITs.
Exhibit 3: Market cap vs Dividend safety
When there is a clear link between the size of a REIT and its valuation, as well as the size of a REIT and the probability of a dividend cut, we could assume a strong relationship between the Dividend Safety Score and valuation. The exhibit below confirms this theory.
REITs rated Very Unsafe have a dividend yield of 6.6% and an average P/FFO of 14.1. While REITs with a Very Safe Dividend Safety Score have an average P/FFO of 20.1.
Exhibit 4: Dividend safety & Valuation
If we refer to the previous table where we compared dividend yields and valuation to market cap, we can conclude that while most Very Unsafe REITs are smaller cap companies, not all Very Unsafe REITs are microcaps (even though the average dividend safety of micro caps is very unsafe). For example, the Very Unsafe bucket contains micro, small, mid & large caps. So while the relationship holds true, it is not absolute and investors shouldn't assume that all large caps have Safe dividends while all micro caps have Very Unsafe dividends.
A Comparison of Safety Versus Yield
The differences between lower risk, lower dividend yield and higher risk, higher dividend yield REITs are stark. To compare approaches of investing in one strategy versus another, we compare two REIT ETF’s:
The REIT market is very top heavy, where the top 25 names make up over half of the market and the top three sectors are just under half. Therefore, any index that is market cap-weighted or ETF that mimics that index, will be heavily concentrated in these larger names and sectors.
Most REIT strategies are very index-like, with active share in the 60% range on average, and are heavily concentrated in the largest REITs. The iShares U.S. Real Estate ETF belongs in this category.
If we conclude that many smaller cap REITs are undervalued relative to their larger peers, than we might suggest that attractive investments are getting overlooked. If this undervaluation is a true mispricing and not entirely due to higher risks, then we might be able to find attractive opportunities in the smaller cap space.
The Invesco KBW Premium Yield Equity REIT ETF focuses specifically on those small- and mid-cap equity REITs that have competitive dividend yields and lower P/FFO ratios. But is this search for yield purely driven by higher risk?
The breakdown of the portfolios of both KBWY and IYR are shown below. IYR has just 1% in Small Cap REITs, while KBWY has 64% combined in both Micro and Small caps.
Exhibit 5: Market cap allocation
It's no surprise then, that KBWY holds a high number of REITs whose dividends are considered either Very Unsafe or Unsafe based on their Dividend Safety Scores. In fact, 61% of their holdings fall into this category. Meanwhile, only 8% of holdings in IYR are in those two categories. In fact, 70% of holdings in IYR are in the two highest rated buckets for safety.
Exhibit 6: Dividend safety allocation
Looking at financial metrics that measure financial stability and ability to service debt, we can also conclude that KBWY holds much riskier positions, with an average debt/EBITDA of 11.7, an average debt ratio of 57, and an average FFO payout ratio of 79%. By comparison, all three metrics are more favorable for holdings within IYR. The riskier ETF is clearly KBWY – now the question is whether the valuation gap is enough to make up for that additional risk.
Exhibit 7: Key ratios
Based on P/FFO, the holdings in KBWY have a P/FFO ratio that is half of those REITs held by IYR, while the dividend yield is more than double.
Exhibit 8: Valuation
So to figure out if the higher safety of holdings IYR is worth paying twice as much and getting less than half of the dividend yield, we have to estimate a fair value or breakeven valuation for both ETFs.
Fair dividend yield
Let’s first take a look at IYR. Given its composition we can compare this ETF with REITs with a safe dividend safety score and with large cap REITs.
Exhibit 9: Key ratios
IYR’s debt and payout ratios are more or less in line with those of safe and large cap REITs and the ETF hence deserves a valuation in line with those REITs.
Exhibit 10: Valuation
We set our fair dividend yield target at 3.4%. This leaves only a limited upside potential of 4% to reach the fair value target.
Now let’s do the same exercise for KBWY. Given its composition we can compare the ETF with REITs with an unsafe dividend safety score and with small cap REITs.
Exhibit 11: Key ratios
KBWYs debt and payout ratios are a bit worse than those of unsafe and small cap REITs so we can adjust its valuation to reflect a discount compared to those REITs. The table below summarizes the dividend yield and P/FFO for KBWY, as well as both Unsafe and Small Cap REITs.
Exhibit 12: Valuation
We set a fair dividend yield target at 6.5%,which is at the high end of both the market cap comparison and the dividend safety comparison. This results in an upside potential of almost 30% based on KBWY's current yield and valuation.
Do we have a winner! Or are we jumping to conclusions?
Taking dividend cut risk into account
Unsafe REITs have a bigger risk of a dividend cut compared to safe REITs so we have to take this risk into account.
When we look at the historical breakdown of all dividend cuts since 2016 we get the following picture. Of all the companies that announced a dividend cut since 2016, 75% of them had a Very Unsafe Dividend Safety Score prior to the announcement, and another 19% were rated Unsafe.
Exhibit 13: Breakdown of Ratings of Companies with a Dividend Cut
Since companies with Very Unsafe Dividend Safety Scores are more likely to cut their dividends, it would make sense they deserve some kind of penalty in their valuation.
The question is how to incorporate this risk in our valuation? One approach is to use the historical breakdown and the historical average dividend cut and calculate an expected dividend cut.
Of the companies that cut their dividends since 2016, 75% were previously rated Very Unsafe, as I already mentioned and is shown again in exhibit 14. The average dividend cut for these companies was 53%, and the table also highlights the average dividend cut and expected dividend cut for all of the other categories as well.
Exhibit 14: Expected dividend cuts – All Equities
Our expected dividend cut percentage is simply the probability times the average dividend cut percentage. So we assume an average dividend cut of 39% for very unsafe REITs. While this may sound arbitrary, to some extent, we evaluated other methodologies to calculate an expected dividend cut, and they too were very arbitrary.
Note that average dividend cut data above is for all equities, not just REITs.
The REIT specific data for dividend cuts is shown below. As shown, all REITs that had a dividend cut since 2016 were previously rated Very Unsafe or Unsafe and their average dividend cuts were smaller than those of broader equities.
Exhibit 15: Expected dividend cuts - REITs
We prefer however to be conservative and hence we will take the expected dividend figures of exhibit 14 into account and apply those to our two ETF’s.
For IYR this leads to an expected dividend cut of 2.70%. We get this figure by multiplying the percentages in exhibit 6 and the expected dividend cut figures in exhibit 14. A dividend cut of 2.70% would lower the actual look-through dividend yield from 3.53% to 3.44%. This leaves only a limited upside potential of 1.5% to reach the fair value dividend yield target of 3.38%.
For KBWY this leads to an expected dividend cut of 17.8% which would lower the actual look-through dividend yield from 8.4% to 6.9%. This leaves an upside potential of 6% to reach the fair value dividend yield target of 6.5%.
So while the valuation gap seems make up for differences in safety and yield, it is not as pronounced as it seemed when we did not consider a potential dividend cut.
When REITs experience price weakness the riskier ones tend to fall more than the safer ones and that means smaller cap REITs as REITs whose dividends are at risk of being cut. However, sometimes, the valuation gap between those higher risk, higher yield REITs and the larger, safer REITs is high enough that it might be worthwhile to take on additional risk for the higher yield and return.
At today's valuation levels, it seems that on a relative basis, it might be worth taking on additional risks inherent in KBWY. I wouldn't necessarily sell all of IYR to invest in KBWY but if my entire allocation to REITs was divided into these two REITs, I'd shift more of my allocation to KBWY.
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