When High Yield And Dividend Safety Become Mutually Beneficial

Feb. 03, 2020 7:00 AM ETEPD, HT, MPLX131 Comments

Summary

  • There are countless examples in the REIT sector of companies that have cut their dividend.
  • We believe that losses could be avoided if investors pay closer attention to dividend safety.
  • In our view, the secret sauce to high-yield investing is to find the balance between dividend safety and dividend yield.
  • Looking for a portfolio of ideas like this one? Members of iREIT on Alpha get exclusive access to our model portfolio. Get started today »

I know what you're thinking, "how can high yield and dividend safety be used in the same sentence?"

Well, guess what? I just used them in one sentence and you obviously clicked on the article, so I'll try not to disappoint.

First off, let's start with high yield.

Needless to say, and in general terms, the higher the yield, the higher the risk.

Source

As the above chart illustrates, investing boils down to one thing: finding the right balance of risk and return. I'm sure that many of you reading this article clicked to read it because you saw the word "high yield", but I'm certain that your definition of "high yield" is different for many others reading this article.

In other words, some of you may be thinking of "high yield" in terms of the average equity REIT yield today, of around 3.3%.

However, others may be thinking about "high yield" in terms of residential mortgage REITs like Annaly Capital (NLY) with a dividend yield of 10.5%, or mall REIT, Washington Prime (WPG), with a dividend yield of 33.2% (That's no typo).

Washington Prime is one heck of a "sucker yield" right now; I can hear the music now (my favorite Queens hit), "another one bites the dust".

So that raises the question…how far up the yield curve are you comfortable with?

What about Macerich (MAC) with the 13.5% dividend yield?

There's little doubt that this mall REIT owns some flashy high-quality trophies, but are you willing to invest your hard-earned capital into shares when the company cannot cover the dividend?

Based on out latest math (FAST Graphs), consensus dividend (per share) divided by consensus AFFO (per share) is 103%. What happens if Macerich provides similar "conservative" guidance for 2020 (like Tanger (SKT) did)?

Simply put: Why risk money when you can wait a few more days for Macerich to report earnings? (February 6, 2020)

I'm not expecting Macerich to announce a dividend cut this week, but chances are that guidance won't be good. And ultimately, I think shares could become cheaper when the dividend is cut, and we may even upgrade our recommendation to a buy, once we know there's adequate cash flow to support the business and pay the dividend going forward.

A REIT that yields 10% almost always means that investors perceive very low growth, or even worse, a potential dividend cut.

The Raised Nail Gets Hammered

In the book, Investing in REITs, Ralph Block wrote, "a REIT that yields 10% almost always means that investors perceive very low growth, or even worse, a potential dividend cut."

Numerous examples can be cited, in which the chase for yield has led to eventual disappointment. A notable recent example is CBL's (CBL) decision to suspend the dividend for both its common and preferred shares (the 7.375% Series D Cumulative Redeemable and 6.625% Series E Cumulative Redeemable shares).

Fortunately, we were highly skeptical of CBL's entire capital stack, but many yield-oriented investors opted to chase the glitter and became subjected to the allure of Fool's Gold: CBL-D (CBL.PD) and CBL-E (CBL.PE) have lost over 75% of the value over two years.

Yahoo Finance (CBL-D and CBL-E)

There are countless examples in the REIT sector of companies that have cut their dividend, and we believe that losses could be avoided if investors pay closer attention to dividend safety.

In our view, the secret sauce to high-yield investing is to find the balance between dividend safety and dividend yield. And that's precisely why we decided to build our own portfolio, in which we could mitigate risk through selectivity and diversification.

Howard Marks, author of The Most Important Thing, explained:

"Controlling the risk in your portfolio is important and worthwhile. It's the investor's job to intelligently bear risk for profit. Doing it well is what separates the best from the rest."

3 High-Yield Picks

We recently added three new companies to our High Yield Portfolio that now offers an equal-weight yield of 8.2%. While we recognize that owning shares in higher-yielding stocks is a higher-risk proposition, our objective is to recognize the risks by carefully examining the quality of the business and the safety of the underlying cash flows and dividend. Marks added:

"When you boil it all down, it's the investor's job to intelligently bear risk for profit. Doing it well is what separates the best from the rest."

Source

High Yield Pick #1: Hersha Hospitality (HT)

Source: Yahoo Finance

We recently upgraded Hersha Hospitality to a Strong Buy based upon a number of reasons, and the most significant motivation was valuation. Shares in the lodging REIT are now trading at more than a 30% discount to NAV (net asset value) and a 36% discount to the company's five-year P/FFO multiple.

While we recognize that lodging REITs don't usually perform well during recessions, we could not ignore the discount being offered by Mr. Market. In addition, Hersha has done an excellent job of recycling properties achieving its goal of investing in major urban gateway markets. In addition, the portfolio is well positioned in 2020 to benefit from stronger convention and event calendars (i.e. the Super Bowl in Miami).

In addition, by refinancing near-term debt maturities, Hersha continues to improve its financial flexibility and has ample capacity with cash on hand and its $250 million revolver to execute business plans (the weighted average interest rate is 3.97% and 89% of debt is either fixed, capped or swapped).

Hersha has one of the lowest payout ratios in the sector (around 51%) and analyst forecast FFO growth of around 10% in 2020. We consider Hersha a local sharpshooter in markets like Miami, Boston, Philadelphia, Washington DC, and the west coast, and the strong insider ownership (around 11%) provides a strong shareholder alignment. Hersha yields 8.64% and is a natural fit for our high-yield portfolio.

  • Price: $12.97
  • Dividend Yield: 8.64%
  • Payout Ratio (using FFO): 50.9%
  • 2020 est growth (FFO): 10%
  • S&P: na
  • Dividend Growth Record: Flat (no increases since 2015)
  • Rating: STRONG BUY

Source: FAST Graphs

High Yield Pick #2: Enterprise Products Partners (EPD)

EPD is one of the highest-quality midstream stocks that offers a generous, safe, and steadily growing income, and the 6.9% yield is perfect for our high-yield income portfolio. We consider EPD's management team to be one of the best in the industry, based on the laser-like focus on long-term value creation and steady and predictable dividend history.

Source: Yahoo Finance

Enterprise has raised its payout 72 times since its IPO including 62 consecutive quarterly hikes (15 straight years and counting). The November 2019 payment was the 21st year of consecutive distribution growth, and as Dividend Sensei pointed out, "due to the S&P 500 rule against MLPs, EPD can never officially become an aristocrat. But that's a mere technicality that shouldn't cause any conservative income investors to avoid owning the old faithful of midstream stocks."

EPD's Q4-19 were solid, as the company beat analyst estimates: The company reported record net income for the full-year (2019) of $4.6 billion or $2.09 a unit, a 10% increase from 2018. DCF increased 11% to a record $6.6 billion and provided 1.7x coverage. The record cash flow generated in 2019 allowed EPD to increase the distribution for the 21st consecutive year.

EPD also announced that it was undertaking a buyback of around 2% of the company's full-year 2020 cash flow from operations (or around $140 million). There has been talk of the company converting to a "C-corp" structure and the buyback announcement could be the first step, but the co-CEO, Randall Fowler, remained guarded as he replied on the earnings call, "really no updated thoughts around that at this point in time, something that we continue to look at, but really no update on the vault."

Thus, we see strong upside for EPD, one of two MLPs in our high-yield portfolio. We like the strong model of repeatability that EPD has purposely designed, and we consider this MLP a welcome addition to the portfolio. Shares are trading at $25.77 with a dividend yield of 6.9%. (We consider the "C-corp conversion" a catalyst if the company moves forward in that regard). Maintaining a Strong Buy.

  • Price: $25.77
  • Dividend Yield: 6.87%
  • Payout Ratio (EBITDA) 51.8%
  • S&P: BBB+
  • Dividend Growth Record: Excellent: 4.9% average increases since 2012
  • Rating: Strong Buy

Source: FAST Graphs

High Yield Pick #3: MPLX LP (MPLX)

Source: Yahoo Finance

MPLX LP is our third new addition to the all-new high yield income portfolio, and as we recently explained, this MLP (issues K1s) could be "the safest 12% yield on Wall Street)". Like EPD, MPLX also announced solid earnings that included 45% EBITDA growth (excluding the ANDX acquisition) with over $300 million in retained cash flow (or $1.2 billion annualized).

We added that "with a safe yield of nearly 12%, even 3% growth (outpacing long-term inflation by 1%) will make this an ultra-high-yield dividend dream stock. But MPLX is not just a safe source of 12% yield, it's also a source of steadily growing yield for the foreseeable future."

Anyone who invests in a stock yielding 10% or higher should be skeptical, but we consider it sustainable based on the fact that the company has "one of the lowest leverage ratios and strongest credit ratings of large, diversified MLPs". In 2019, the company generated an 80% DCF/EBITDA conversion ratio, which is very good in an industry where 60% to 80% is the norm. Furthermore, MPLX has $4.4 billion in liquidity under its two revolving credit facilities in addition to $1.2 billion in annual retained cash flow.

In our latest article, we explained that "the reward/risk ratio (for MPLX) has completely flipped, with the company priced for death, when in reality it's growing at a moderate rate and expected to continue to do so for the foreseeable future." We wouldn't back up the truck, but we consider this high-yielder a complementary addition to the high-yield basket.

  • Price: $24.05
  • Dividend Yield: 11.43%
  • S&P: BBB
  • Dividend Growth Record: Good (average 17% over six years)
  • Rating: Strong Buy

Source: FAST Graphs

In Conclusion…

Howard Marks reminds us that "risk is inescapable"…and "you're unlikely to succeed for long if you haven't dealt explicitly with risk". In our quest for yield, we have purposely researched the above-referenced companies to determine whether or not they are deemed candidates for a higher-risk investment strategy.

A skilled and sophisticated investor can look at a portfolio in good times and decide whether it's a low-risk and high-risk portfolio. By adequately diversifying the investor's portfolio, he or she can reduce risk without sacrificing returns.

As a reminder, always make sure to analyze the safety of the dividend, the ability of the dividend to grow, and the overall merit of the stock BEFORE you look at the dividend yield. Because nobody likes to be chasing Fool's Gold. Stay tuned for more articles titled, "When High Yield And Dividend Safety Become Mutually Beneficial".

Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

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This article was written by

Brad Thomas profile picture
104.91K Followers
Author of iREIT on Alpha
The #1 Service For Safe and Reliable REIT Income

Brad Thomas is the CEO of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 6,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.

The WMR brands include: (1) The Intelligent REIT Investor (newsletter), (2) The Intelligent Dividend Investor (newsletter), (3) iREIT on Alpha (Seeking Alpha), and (4) The Dividend Kings (Seeking Alpha). Thomas is also the editor of The Forbes Real Estate Investor and the Property Chronicle North America.

Thomas has also been featured in Forbes Magazine, Kiplinger’s, US News & World Report, Money, NPR, Institutional Investor, GlobeStreet, CNN, Newsmax, and Fox. He is the #1 contributing analyst on Seeking Alpha in 2014, 2015, 2016, 2017, 2018, and 2019 (based on page views) and has over 102,000 followers (on Seeking Alpha). Thomas is also the author of The Intelligent REIT Investor Guide (Wiley). 

Thomas received a Bachelor of Science degree in Business/Economics from Presbyterian College and he is married with 5 wonderful kids. He has over 30 years of real estate investing experience and is one of the most prolific writers on Seeking Alpha (2,800+ articles since 2010). To learn more about Brad visit HERE.

Disclosure: I am/we are long HT, EPD. 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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