The following is an excerpt from the video series Dividend-Stock Deep Dive, hosted by Morningstar DividendInvestor editor David Harrell. David spoke with Morningstar analyst Kevin Brown, who focuses on real estate investment trusts.
Watch the full interview.
Now, the other thing that you caution against in your report is simply buying REITs based on yield numbers alone. And I believe, looking back to the year 2000, of the 27 REITs under coverage, I believe 20 of them have had at least one dividend cut during that time period.
Correct. REITs, they generally try to not cut their dividend. And the big reason is that it just sends a terrible message to investors that the cash flows to the firm are significantly lower than their prior expectations, and that their current dividend is unsustainable. The dividend for almost all REITs is very, very sticky. And you build it up slowly over time at a sustainable pace. But if you have to cut, that's saying that cash flows are impaired. And so, part of the issue is that it causes many income-oriented investors that depend on the dividend to lose trust in the company. And it's really hard to re-establish that trust. It could take a decade to convince investors that we're not going to cut again as soon as our cash flows start to waver a bit.
So, really, there's only two major types of events that we've seen REITs over the past 20 years cut. One is if there's major company reorganizations. These are fairly rare--major divestitures, or you're spinning off various parts of your business, or just some major isolated events that are specific to you. But these are very, very rare events. It only happened in a handful of times across all of our coverage list over the past 20 years. So, really, the major driver of dividend cuts is recessions, economic recessions, that have happened over the past 20-plus years. So, the main ones, of course, are the 2008-09 financial recession and the most recent pandemic. We saw more than half of the REITs we cover cut their dividend in each of these recessions.
Now, generally, I think the market recognizes in a recession that your cash flow is going to be significantly lower than your prior expectations. And so, the penalty for cutting your dividend during a recession is far smaller, and you might as well lump in bad news altogether and just get it out of the way and say our cash flow is going to be lower because of the recession, and as a result, we are cutting our dividend. And that's what many of the REITs have done over the past 20 years.
Now, in the '08-'09 recession, the dividend cuts generally were caused more by frozen debt markets than necessarily the wavering cash flows. The issue was just that REITs were just not able to issue new debt to pay off existing debt, and so, they had to use cash on hand to pay off debt as it came due. Many just delayed their cuts. Even though the recession started in '08, most of the cuts, dividend cuts, didn't happen until 2009, because they just waited as long as possible to see if there were any other alternatives. But for many of these REITs, they were operating at very high leverage levels in '07 and into '08. And so, just they had significant amount of debt coming due in 2009. And so, they were forced to do a combination of things. One was major cuts to their dividend, and the other thing was many of the REITs had to sell off assets as their debt came due because they just weren't able to tap into the debt markets.
Now, more recently during the pandemic, we saw a recession where many thought that cash flows for these companies were going to be significantly impacted. And for a handful of them, say, the hotel companies in particular, they really were significantly impacted. But for a lot of the other ones, I think there was much more fear and uncertainty, and just, they wanted to get ahead of things and not wait till the last possible minute to cut. And so, almost all of the REITs who did cut--it's about half of the REITs under our coverage--did so within the first three months of the pandemic.
Now, some of this was done opportunistically. Remember, in the prior recession, where I said that many companies were forced to sell assets, they thought, well, this pandemic is going to cause many of our competitors to have to sell a significant number of assets. And if we have cash on hand built up, we're going to be able to pounce and get some great deals and acquire at some great cap rates. Now, that never really came to be. The impact to the cash flows were not nearly as great, and so there weren't the fire sales going on. And so, many of the companies have since reinstated their dividends or, at least, made it a little bit better than the initial cuts they had. They've raised it back up, maybe not fully, but they've reinstated similar dividend yields to what they previously were at.
You've seen some recovery in, if not the rates themselves, at least the yields that they're producing at this point?
Correct. I mean, the spread between, say, the average dividend yield for the average REIT in 2019 over the 10-year U.S. Treasury was about 75 basis points. And that spread today between the average dividend yield over the 10-year U.S. Treasury is about 75 basis points. So, it's about the same spread over your U.S. Treasury option today.
In your report, you also give one specific example of how a very large and quickly growing yield might point to a looming dividend cut. Can you share that example?
The reason I bring this up is I want to warn investors against just looking for the highest dividend yield as being the best possible investment. I mean, today, the best ones out there, the highest yields we're seeing, are in the office REITs. And I caution that like, just couple of years ago, we were looking at, say, Macerich had the highest dividend yield under our coverage. Historically, Macerich has always paid a high dividend yield. Over the past 10-plus years, they've averaged around a 4.7% dividend yield. So, a very healthy dividend yield over the long period of time. And going into 2018, they were slightly above that but not too concerning at 5%. However, the dividend yield is a combination of both the dividend payout per share but also the company's price per share. And so, since the dividend per share is very sticky but the price changes very quickly, you can see a rapidly moving price that drives a high dividend yield, and that's what was going on with Macerich.
The price in 2018 was slowly falling due to increased e-commerce pressures, thinking that brick-and-mortar retail was going to continue to lose sales to online sales. But, really, the big driver of the company's decline at the end of 2018 was the announcement of Sears' total bankruptcy. We had some long-term positive views on the Sears bankruptcy. Sears never paid a high rent to Macerich, and they weren't driving significant traffic to those malls. However, it's going to take a long time for Macerich to redevelop the assets and to re-establish the lost cash flow that Sears was paying to bring in the newer, healthier tenants who are going to pay more rent. And the redevelopment projects that they're going to do across their portfolio were going to total in the hundreds of millions of dollars in cash. And that cash is going to compete with other priorities for the company, which include continuing to make dividend payments. And so, while they have to pay out to redevelop these properties, and they had less cash flow, it made it more likely that the company was going to have to cut the dividend.
This was made even worse in 2019, when we saw a record number of stores closing in 2019. We had over 10,000 total retail stores close across the U.S. And so, Macerich continued to see its price fall, which led to the dividend yield continuing to go up.
Certain investors were probably attracted to this, right, as this yield is shooting up? You have some investors who are buying in based on that number alone.
Correct. So, you had the price go from the low 50s in 2018 to the low 20s in 2019, and it seems like a great deal. It's too attractive to be true. I mean, the dividend yield when it was down to the low 20s was now in the double-digit range. It was like 12%, 13% 14%, and this was prepandemic. And so, when the pandemic came along, that shot the dividend yield up to 30%, 40%, 50%, 60% as the price fell down to the single-digit range. And eventually, management had the excuse it needed to make a dividend cut. Now, if the pandemic hadn't happened, a dividend cut was still probably likely. It was getting away from itself. It needed to correct its course and needed to free up the cash to make the development of the Sears assets. So, it was probably likely, but the pandemic accelerated that and allowed it to course-correct. And so, now, the yield has been stabilized to a much more appropriate range that today is in the low 4%. And that's closer to the company's historic average.
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