David Harrell: I'm David Harrell, editor of Morningstar DividendInvestor newsletter. And I'm here today with Kevin Brown, who is a Morningstar analyst, who specializes in the coverage of REITs, or real estate investment trusts.
Kevin, thanks for being here.
Kevin Brown: Thank you for having me.
Harrell: Could you start off by just talking a little bit about your role and Morningstar's coverage of the REIT industry?
Brown: Sure. So, I've been covering REITs for my entire professional career for the past 18 years. And so, right now, at Morningstar, I cover all the core real estate sectors, all the REITs in them, so that includes office; retail, which includes malls, shopping centers, and the triple-net REITs; the residential REITs, which include both apartments and single-family rental homes; the hotel REITs, healthcare REITs, industrial REITs, and self-storage REITs. That is 27 total companies at the moment. And we do cover a handful of other REITs throughout Morningstar, but those are handled by some other analysts. That includes the cell phone towers, data storage REITs, and the timber REITs. So, my analysis today is going to be primarily focused on the core sectors that I cover.
Harrell: And those are all U.S.-based REITs, correct?
Brown: Correct. Yes, those are all U.S. REITs, and their portfolios are almost entirely concentrated in the U.S.
Harrell: Now, you recently released a great research report on REITs and dividends. So, there's lots there of interest for income-focused investors. But I wanted to start out with something else, and that's economic moats. And as you know, the Morningstar approach to equity analysis is sort of built around this concept of economic moats, or a firm's ability to defend themselves from their competitors, and the idea being if you're earning excess returns on capital and you can sustain your competitive advantages for at least 10 years, Morningstar analysts will award a firm a narrow economic moat. If they can sustain those advantages for 20 years or more, it will receive a wide moat rating.
Now, in your report, you're highlighting those 27 REITs under coverage, but none of them currently earn a narrow or wide economic moat rating. Why is that? Why do none of the REITs have these, sort of, sustainable competitive advantages right now?
Brown: That's a great question. It's because at Morningstar, we have a very strict definition for what constitutes an economic moat. We do a very rigorous analysis, each and every company that we cover, and just unfortunately, none of the REITs, their portfolios, meet that strict definition. And you can give different reasons for different sectors. For, say, hotels or for office companies, they only own a very small percentage of the buildings in their sectors in the markets that they're concentrated in. Some of the most concentrated hotel REITs only own maybe 10% of the hotel rooms in the markets that they're most concentrated in. So, not enough for them to actually generate pricing power. And that doesn't even include, say, the Airbnb type of shadows supply in those markets. So, a very small percentage of actual assets owned in the very large U.S. real estate market.
Another issue that many run into is that there's almost no barriers to entry for many of these sectors. For example, apartments in suburban settings, very easy to build new apartment buildings just down the street that will be very similar to what the REITs currently own. Same thing with, say, self-storage facilities. You can go down the road and build in just any plot of land a self-storage facility pretty much wherever you want. Another major issue is that they're limited by their ability to push rents on their tenants without having their tenants say, you know what, we could just do this ourselves. I'll give the example of the industrial REITs. They have some very large tenants that can afford significant rent increases each and every year, say, Amazon, FedEx. They can afford that to a certain extent, but they can't extract extravagant profits from them without having Amazon or FedEx to say we're better off with our own facilities. The REITs provide flexibility and can expand and allows their tenants to focus on other things other than owning real estate assets, which is why it's a great marriage, but you don't want to upset your partner. So, you can't push too hard. There's a limit.
And the final thing is, many operators or tenants run very thin margins. So, you're limited to how much you can push rents, even if you are the stronger one in the leverage dynamic. For example, retail REITs. You're only able to push rent to match what revenue growth is for your retail tenants, and the retail tenants are only seeing limited sales growth at brick-and-mortar locations. Same thing with, say, the senior housing REITs. You're only able to push it as much as the operator who you hire to run the property is able to withstand without sending your operator into bankruptcy, because they're the ones who are running the facility. So, that's a big concern there. However, we do think that they can make economic profits, and they are strong companies. The source of that is more from management teams, strong management teams, rather than economic moats. And so, management teams can turn over fairly quickly. And so, it doesn't meet the definition of needing 10 to 20 years. But they can do things like many operate at margins well above the rest of their peers.
I'll give the example in hotels of Pebblebrook Hotel Trust. Their whole story is that they would buy hotels that were poorly run by other operators and come in and implement cost efficiencies and turn around operating margin from, say, the teens into the 30s. Same thing with Welltower, a senior housing, healthcare REIT. They operate with so many different senior housing operators, that they've learned best practices and know what works best in each and every market and region. And so, they're able to tell their operators, "We think you could improve margins by doing X, Y or Z that somebody else is doing." And because they have so many different relationships and operations going on at once, they can see what works best for everybody. And we push those efficiencies across our whole portfolio. But that's really expertise of management; that's not necessarily institutional to the real estate itself.
So, other things that the REITs can do is they have significant ability to develop new properties at high development yields. You have the industrial REITs that are very good at this. The apartment REITs for the past decade have been very strong at doing this. And so, a lot of what they're able to do is build at a development yield higher than the market average and create cash flow higher than the debt that they're funding it with. Then finally, many are able to secure relationships with outside developers and acquire off-market deals. For example, Invitation Homes, the single-family rental REIT, is able to work with homebuilders and buy entire communities from those homebuilders before they even hit the market. Because they can pay for the entire community up front, they're willing to cut Invitation Homes a deal and so are able to get it at better-than-market deals. And so, that's how they're able to generate cash flow. But again, that's a relationship that won't be necessarily transferred if the management team turns over. So, that's not really a moat, but it is where we think of exemplary stewardship and generates excess cash flows for many of these companies.
Harrell: Got it. So, you might look for something like the Allocation Rating or something else as opposed to looking for moats, because there's not going to be a moat rating for any of these firms?
Harrell: Now, in your report, obviously, by definition, REITs must distribute 90% of their net income as dividends each year in order to maintain their tax-free status. But you note that there's actually a fair amount of flexibility because cash flow can be quite a bit higher than net income. So, the 90% is, sort of, a floor in terms of distribution, and that could rise all the way to 100% of the REITs' cash flow. What do you like to look for in terms of the balance there in terms of how much a REIT is distributing?
Net income is a floor, but it's not really a floor that is frequently too big of a concern for most of these REITs because they do incur such large noncash charges, the largest generally being depreciation and amortization. While they're generating positive cash flow, many times they will see net income be near or close to zero. And 90% of something that's close to zero is basically not a requirement for many of these guys. And when times were good, they still are paying out well above net income.
The REITs all produce a metric, an industry standard metric, called funds from operation. And that's the REIT standard cash flow metric that everybody uses and adheres to a strict definition of how they calculate funds from operation, or FFO. However, one of the big noncash charges is depreciation, which the cash charge is capital maintenance expenditures. So, we like to take the FFO that the companies report and then add to it what we assume is the appropriate level of capital maintenance expenditures necessary to maintain the overall quality of the portfolio and to create something called AFFO.
And so, when we look at AFFO, we like to see companies typically pay out about 85% of AFFO over the long term in terms of dividends. If you get to 100%, you can go over 100% for a few quarters by taking a little bit of extra debt or using up cash on your balance sheet. But you can't sustain levels above 100% for a long time. But if you're well below that level, you're not really paying out to your shareholders. We often find that there's not that many excess uses of cash that are really going to generate value for shareholders. So, you might as well give shareholders that dividend that they are expecting. So, really, I think 85% is an appropriate level for them to be at. And in our analysis, this actually tends to be over the long term where most companies cluster. And the companies that fall outside of a range of, say, plus or minus 5% or 10%, from, say, the 85% target range, generally, there's something going on with that that company that can explain it, like a lot of variability, say, in the hotel industry, where there's big spikes or falls that causes them to fall outside of it for extended period of time.
Harrell: And that's 85% of AFFO, or adjusted funds from operations?
Harrell: Now, the other thing that you cautioned 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.
Brown: 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 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 2008-09 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.
Harrell: You've seen some recovery in, if not the rates themselves, at least the yields that they're producing at this point?
Brown: 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.
Harrell: 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?
Brown: 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. We had over 10,000 total retail stores closed across the U.S. And so, Macerich continued to see its price fall, which led to the dividend yield continuing to go up.
Harrell: So, 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.
Brown: 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 pre-pandemic. 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 sort of 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.
Harrell: In your report, you did some great stuff. And one is you basically ranked all of the REITs under coverage by their historical dividends. You created a 1 to 5 rating based on multiple factors and rated all of the REITs and ranked them. And then, you did the same sort of looking forward in terms of sustaining and growing their dividends. So, then you have this ranking based on future dividends. You took the two of those rankings, added in the Morningstar Star Rating, I believe, and current yield to create sort of an overall ranking of your REIT universe. And you came up with your three top picks, and I was wondering if you could share those with us?
Brown: Sure. So, the first company I want to recommend is Federal Realty Trust. It's a shopping center REIT. So, it is one of the three members in our coverage list that is in the S&P 500 Dividend Aristocrats Index. It's a very strict standard to adhere to. You have to not only not have any dividend cuts, you have to raise your dividend each and every year for 25 straight years. It's very difficult for many companies to adhere to that strict list. Again, only three of the 27 companies we cover actually manage that standard, and Federal Realty stands out. It's a retail REIT, and many other retail REITs have had dividend cuts because of the pressures that they have faced from declining brick-and-mortar sales. However, Federal Realty has found a way to continue to raise it, and it's their top priority. They want to make sure that they are able to continue to pay a strong, consistent dividend. And even during the pandemic when you had the payout ratio go above 100% for a couple of quarters, they stuck through it and have emerged out the other side back to their historic level of around 85% of AFFO is where they pay out their dividend, and they raise it each and every single year. And so, they've had a great track record. And going forward, we think that they should be one of the top retail REITs in terms of overall growth, because they are focusing on some major development projects of mixed-use retail. So, you not only have a ground level of retail shops and big boxes, but on top of that, you're building office buildings, apartments, and hotels, which should give those retail shops a captured audience of somebody who always going to be there shopping at your stores because, frankly, one way that it's easier than online shopping is to go shopping in person if you're just have to go down to the ground floor to go to the store. So, you've got some very large projects, they've completed some and that had been really well-reviewed, and we think that Federal Realty is just a great opportunity for not only for income-oriented investors but anybody looking for a REIT investment.
The next company is Realty Income. This is a triple-net lease REIT, which means that they basically are not responsible for the vast majority of expenses toward maintaining their properties. They have retail tenants who lease their portfolio of assets that are all sort of the corner store, say, Walgreens and CVS on the corner of major busy intersections. They own those buildings, but the tenant is responsible for all the operating expenses and also responsible for all the maintenance of the property itself. They have to pay for the maintenance. And so, Realty Income just sits back and collects a simple rent payment from them without having any major expenses, and it makes it a very safe stable business, and even in recessions their cash flows are not changed very much because they have such a wide cushion between what the operator, the tenants', cash flows are versus the rent payments, that their rent payments are never at risk of being potentially cut. And so, because they have stable revenue growth, they're able to promote a stable income of dividend to shareholders. And this is another member of the S&P 500 Dividend Aristocrats Index, and they dubbed themselves the monthly dividend company, because, again, their top priority is paying out a dividend to shareholders.
Harrell: On a monthly basis, as they say?
Brown: Yes, they pay out a monthly dividend. Yes.
Harrell: Is that common within the industry? Or is that fairly rare?
Brown: No, that is fairly rare. They're the only ones in our coverage who pay out a monthly dividend. All the rest pay out a quarterly dividend.
Brown: But they give themselves their own name of the monthly dividend company. I mean, they say dividend company, because paying a dividend is, again, one of the top priorities for this company. That's why they also are at the top of our overall rankings.
Harrell: And, Kevin, your third pick was a was a firm that its cash flow was definitely impacted during the pandemic, correct?
Brown: That's correct. So, our third recommendation is Ventas, which is a healthcare REIT. They focus on three separate healthcare sectors: senior housing, which saw a very big impact from the pandemic, but also, they own medical office and life science. And one of the things that we like about them is that they do have their life science and their medical office portfolios, which were not impacted by the pandemic and generally should be relatively defensive during most recessions. Medical office is a portfolio that just should continue to grow at 2% to 3% every year and is insulated from most economic impacts. Life science is a sector that should have a significant growth ahead of it, as many pharmaceuticals continue to invest in their overall research capabilities and many universities are expanding their research campuses. And so, Ventas is the partner that can provide the clusters of life science buildings necessary to continue to fuel that growth. And they're seeing significant 4%, 5%, 6% overall growth every single year from that segment.
So, those two segments were not impacted by the pandemic. However, their largest, which represents about 40% of the overall company's cash flows, senior housing was impacted by the pandemic, but we think this provides a significant opportunity for growth going forward. Now, senior housing was one of the biggest things impacted by the pandemic, because seniors were very sensitive to the virus. It wasn't that there was any major outbreak at the facilities of Ventas. It was more so that there were issues with the facilities being quarantined if there was any contact tracing that led to the facility. So, if a visitor had the virus or if somebody who worked there may have had the virus, they would have to shut down the entire facility for an extended period of time. And that meant that you were not bringing in new residents. And so, doing that several times throughout the pandemic led to occupancies falling from the mid-80% range to the mid-70% range in about a year's time.
Now, since the vaccine has been developed and started rolling out among the senior population, we've seen a significant recovery in occupancy, with occupancy growing month over month, every single month over the past year since about March 2021. And it's even continued to see positive growth through the delta and the omicron variants. Now, it's not back up to its prior levels, but it's encouraging to see occupancy start to get back up close to where it previously was. However, we think that occupancies are going to continue to reach that level and then push through as we see the overall 80-plus population continued to grow. The baby boomers are just starting to age into the target age for these facilities. And so, while the past decade, we saw the 80-plus population grow at an average rate of about 1.5%, we're at about 3% right now. And that rate of growth is only going to continue to accelerate up to around 7% by 2027. So, that's a huge amount of demand growth.
Meanwhile, supply growth, which had been above historical average prior to the pandemic, construction starts went to about zero during the height of the pandemic, and even today is still well below historical average. And since these facilities take anywhere from two to three years to build, we see out several years that we're going to have very low supply growth. So, with rapidly expanding demand growth and low supply growth, we think that occupancy is going to continue to push northward into around the 90% range, which is where we were at back in the 2010-11 time frame. And back then, we saw rent growth of 4%, 5%, 6%, 7% on an annual basis. And I think with that you're going to see some very strong growth from senior housing. And that should therefore, you know, fuel strong cash flow growth, which should also fuel strong dividend growth. And so, we think that this is going to be a company that's going to see lots of growth going forward. And should be a good investment for all investors for both those looking for strong growing dividends but also for investors looking for a company just growing its cash flows.
Harrell: It's one of the firms that did have a dividend cut during the pandemic, but your outlook is very positive for the firm right now?
Brown: Correct. And historically, I mean, over the past 20-plus years, that pandemic cut, just because of the uncertainty of senior housing cash flows, that's the only time that they have cut their dividend. They made it through the 2008-09 time frame without cutting their dividend. Even though the majority of companies we cover did cut their dividend during that time period, Ventas did not. So, this is the one exception to Ventas' history.
Harrell: That's great insight, Kevin. Thank you for being here.
Brown: Well, thank you for having me.
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