REIT Stock Dividends: Boon or Bust?
We think the days are numbered for REIT dividends paid in stock.
If cash is king, then most real estate investment trusts are paupers. As the commercial real estate markets face fundamental declines, REITs are in a dire position as these leveraged companies scramble to pay down debt and refinance mounting maturities. Property sales, dividend cuts, and equity issuances have been all too common over the past few months as REITs work to improve liquidity in a difficult operating environment. Some companies have resorted to the controversial and widely debated stock dividend. Paying out stock in order to retain cash has helped some companies better traverse the tumultuous credit markets, but at what cost to shareholders? Furthermore, do the benefits outweigh those costs? As always, it depends.
A Brief History of REIT Dividends
The REIT structure was established in 1960, giving the average investor access to investments in large-scale commercial real estate projects. The modern REIT does not pay income taxes at the corporate level, but it is required to pay annually at least 90% of its taxable income in the form of shareholder dividends--although historically REITs have paid dividends well in excess of their required distribution. In 2001, the Internal Revenue Service began making private letter rulings, allowing some REITs to pay as much as 80% of required dividends in the form of stock, which fulfilled their distribution requirements under REIT rules. In January 2009, following the solicitation of the National Association of Real Estate Investment Trusts and other industry leaders, the IRS issued a ruling allowing publicly traded REITs to pay as much as 90% of their required dividends in stock through year-end, allowing those firms another avenue to improve liquidity. Many companies choosing to pay in stock have opted for cash distribution levels higher than the 10% floor.
The Good, the Bad, and the Aggressive
The onset of stock dividends has been welcomed by some and scorned by others. Some REITs have expressed no interest in paying in scrip, holding to their all-cash ideals, while some see the new ruling as an opportunity to retain capital and reduce debt. The practice has seen limited acceptance by the industry, with roughly nine REITs--only about 9% of publicly traded equity REITs--choosing to pay a portion of their quarterly dividends in stock.
In our opinion--all other things equal--we prefer a given REIT pay its dividend in cash, even if that means a reduced overall distribution. According to NAREIT, cash dividends have historically accounted for about 65% of total equity REIT returns. Given the importance of these cash returns to many income investors, we think it is important for the industry to stick to all-cash dividends when possible, lest some REITs alienate relationships with a long-standing and stable investor base. For those investors looking for a steady cash flow from REIT investments, equivalent stock dividends raise transaction costs and increase the risk of having to sell at an inopportune time. Additionally, even though current shareholders receive more shares as a result of stock dividends, their proportional share of the company does not change. The stock dividend is best equated to a forced dividend reinvestment policy. However, we think it is better to give investors the option of reinvesting in the company instead of forcing them to do so. The following companies continue to pay dividends in all cash, with no immediate plans to change this stance: Health Care REIT (HCN), Biomed Realty Trust (BMR), First Potomac Realty Trust (FPO), Public Storage (PSA), and Realty Income (O).
Despite our all-cash preference, we understand that these are unprecedented times in the commercial real estate markets. For REITs that may have overburdened their balance sheets with debt in boom times, underestimated the impact of tighter credit, or have immediate and substantial maturities, the use of a partial stock dividend may be warranted to the extent that the retention of incremental cash reduces outlier risk (for example, bankruptcy or highly dilutive equity issuance). When every little bit counts, we think paying in stock--although still wrought with the previously stated issues--may be a net benefit to shareholders. It creates a way to rightsize the company's debt, reducing the risk of owning common stock. We think the following companies have made effective use of stock dividends to preserve necessary capital: Developers Diversified Realty (DDR), CBL & Associates Properties (CBL), Cousins Properties (CUZ), and Macerich (MAC).
However, a few REITs are opting to pay partially in stock when the immediate need for capital is not apparent. We find their decisions unsettling, as the incremental benefit from retaining cash does little for their risk profile. These companies have largely chosen the stock dividend as a way of building their war chest for future, potentially accretive investment opportunities at the near-term expense of shareholders, which is a bit aggressive, in our opinion. A bird in the hand is worth two in the bush, and we believe most REIT investors would prefer cash in their hands to investment opportunities in the bush. Retaining cash through a stock dividend beyond what is necessary to keep the business afloat is an issue for shareholders, who are burdened with an incremental cost and also run the risk of their retained capital being misallocated by management. Worse yet, depending on the distribution mix, shareholders could be stuck with net cash outflow in order to maintain their proportional ownership interest. Some of the better-capitalized REITs that have chosen to pay in stock are Simon Property Group (SPG) and Vornado Realty Trust (VNO).
Pay to Play?
One of the more concerning issues surrounding the use of stock dividends is tax treatment. From our estimates, the aftertax result of a stock dividend could result in a net cash outflow for investors--depending on distribution mix and the investor's marginal tax rate. REIT dividends are taxed as ordinary income up to a maximum rate of 35%. Stock dividends are treated as cash for tax purposes and are not given preferential treatment. However, a portion of REIT dividends (about 40% in 2008, 47% in 2007, and 45% in 2006, according to NAREIT) qualify for lower tax treatment: 15%-25%, depending on their treatment. The higher an investor's marginal tax rate, the more likely that investor will burdened with a tax bill greater than cash received from his or her investments in a REIT paying partially in stock. If REIT investments are held in a tax-deferred account, the risk of a cash outflow scenario can be largely mitigated. Still, for income investors interested in a stable quarterly stream of dividend payments, the aftertax ramifications are a serious consideration. The following hypothetical example demonstrates this point.
Investor Josh owns 100 shares of a REIT paying $1 per share in dividends annually. The company has opted to pay 10% in cash and 90% in stock, and 100% of this dividend is taxed as ordinary income. Josh's marginal tax rate is 28%.
Cash received: [100 shares x $1 x 10%] = $10
Taxes: [100 shares x $1 x 28%] = $28
Net cash flow after taxes (assuming no stock sale): $10 - $28 = ($18)
In this example, Josh realizes a net aftertax cash outflow from the dividend distribution. If Josh wanted to sell the distributed stock in order to realize an annual positive cash flow, he would incur further transaction costs and his proportional ownership interest would then decline. To maintain his proportional ownership interest, Josh must hold on to the distributed stock, but is then forced to write a check to the IRS at the end of the year in order to maintain his stake in the company. Neither option is ideal.
The following table outlines companies we cover that choose to pay a partial stock dividend. The column on the far right high lights those companies which may leave investor with net cash out flow at the end of the year. This analysis is not intended to give tax advice, but rather point out potential costs to investors holding REITs with partial stock dividends.
What Does It All Mean?
We think the days are numbered for REIT stock dividends. Except in the case of REITs that need immediate capital to avoid bankruptcy risk, stock dividends are a betrayal to investors. The value proposition for REITs has historically relied on low correlation to general equity markets, high dividend yields complementing capital appreciation, and relatively low volatility. REITs are structured to pass through returns, giving investors the opportunity to participate in the stable income produced by commercial real estate investments. Stock dividends reduce cash yields and alienate income investors, increasing volatility as a previously stable investor base reconsiders its investment strategy. Additionally, paying in scrip could reduce a given company's ability to tap the equity markets in the future, as former investors remember being burned by previous stock distributions. Fortunately for investors, the stock dividend window closes at the end of the year--although given the weakened state of the commercial real estate markets, we think it is possible this ruling will be extended. The limited acceptance of the stock dividend by industry participants is favorable, as this indicates to us that most management teams understand the risk the practice poses to the long-term viability of REIT investing. Although we cannot be certain, we think it is likely that stock dividends will be a footnote instead of a new chapter in the history of equity REITs.
David Rodziewicz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.