Yesterday I dug into an ad for the new Dividend Investor Canada newsletter from the Motley Fool, and today comes part two — in which I toss the clues for their second hinted-at pick into the Thinkolator and see what comes out.
If you want to start at the beginning, yesterday’s article is here — the ad is a pitch about the next great opportunity in “retail” being the industrial/warehouse REITs who make e-commerce possible (they might own the distribution centers that Amazon leases, for example)…
… the first stock hinted at was WPT Industrial, a Canadian REIT whose assets are all in the US (and which trades in US$, despite being listed in Toronto), and what’s the second one?
I thought you’d never ask! Here are the clues:
“Meanwhile, the second one…
“Sports an even more impressive 99.7% occupancy rate…
“Recently acquired six new fully-leased properties — including several in Quebec and Alberta, in addition to the Greater Toronto Area…
“Announced on its most recent quarterly conference calls that it has been able to raise rents on new leases in the 10% to 15% range…
“Is managed by a team with a wealth of experience and expertise in the company’s target markets. In fact, many of the managers helped to build the largest industrial Real Estate Investment Trust (or REIT) in Canada before it was acquired and taken private in 2006 for roughly $3 billion.
“Also has a high level of insider ownership — with insiders currently holding 11.4% of outstanding shares…
And currently boasts a whopping 7.3% yield — which Bryan and his team believe is sustainable given the fact that the company’s payouts have been fully covered by operating cash flow since its inception.”
And the Thinkolator says…
This one is Summit Industrial Income REIT (SMU.UN.TO in Canada, SMMCF OTC in the US) — all of those clues are essentially lifted straight from their last quarterly earnings press release.
This one pays an even higher yield than yesterday’s Canadian industrial REIT, with an annualized yield at the current ~$7 a share of about 7.3%. Like many Canadian dividend stocks, they pay the dividend monthly.
It’s also quite a bit smaller than WPT Industrial, which itself ain’t so big — Summit has a market cap of about $300 million… and that’s Canadian, unlike WPT Industrial it doesn’t trade and report in US$. Their balance sheet is a little bit less attractive than WPT’s, and the payout ratio is also high at 90%ish of Funds From Operations (FFO) — and, like WPT, their debt is primarily mortgages (not corporate debt), so that debt service is cheaper than some competitors but the terms are also perhaps more onerous (in general, you’d rather have unsecured debt than mortgages… but mortgages, since they’re directly secured by property, typically have lower interest rates).
They claim a pretty nice capitalization rate, with buildings they’ve acquired at cap rates of 7% or so — well above the 5% that many industrial buildings seem to go for these days, so maybe there’s a little avenue for growing cash flow if you consider that their cost of new capital is some average of the 7.3% they’re effectively promising when they sell new equity shares and the 3.5% or so they pay on their secured mortgages (so if they go 50/50 for acquisitions between mortgage debt and new equity sales, the effective cost of expansion capital is something like 5.4%… for last year, ).
The escalators they mention in their leases are not huge, though, around 1.5%, and that sliver of a couple percent between the cost of capital and the cash flow yield of their buildings doesn’t leave a lot of room for paying down debt or investing in growth… so, like most REITs, they’ll have to keep selling a lot of stock to fund their growth, and the more stock they sell at an effective dividend yield of 7% to fund acquisitions that have a cash income stream of 7% the more you might expect them to spin their wheels and stay pretty stuck near this share price.
Unless, of course, the new acquisitions they make in the future have less-pleasant cap rates of 5%, like recent acquisitions by WPT Industrial… then they’d be paying something between 5-7% for capital that brings them only 5% annual cash flow, which means they’re really fighting uphill. That’s the challenge of REITs whose dividend yields are high in comparison with the cap rates of the buildings they want to buy — if investors demand a high yield but competition for properties means each property has a lower income yield to the company, they have to really count on improving operations in some way to make the business have a chance at sustainable growth… that means adding by construction instead of just acquisition, or improving their facilities to raise rents, or cutting costs considerably, or just getting substantially higher rents as leases expire and new leases are brought on. (Or, for those lucky REITs who are not already pretty levered up, it means putting more debt on the balance sheet so they don’t have to use high-dividend-paying shares to raise money, but most REITs are in a position where they are already at close the maximum comfort level for debt and, on average, tend to raise capital in roughly equal parts from equity and debt to grow.)
All of those things are possible, for sure, but with lots of capacity being built in the light industrial space you’d probably want to really understand the specific strengths of Summit and its properties before committing to an investment. The ad notes that the company is getting 10-15% rent increases when leases roll over, which sounds reasonably decent, and is likely the reason they’ve been able to increase the dividend recently, but those are probably leases from five or ten years ago that are rolling over — the annual increases in rent on their existing leases average 1.6%, and those leases have a weighted average term remaining of something over five years… so there’s not a huge rent increase rolling through imminently, growth probably primarily has to come from cash flow from new buildings that’s higher than the cost of the capital that they acquire to pay for those buildings, and that’s tough because they’re small enough that it’s probably hard to squeeze out a lot more efficiency from their overhead… though, in theory at least, the overhead costs of the corporation should become smaller as the portfolio of properties grows (one person can oversee ten properties as easily as eight, to oversimplify).
A concern about “too high” dividends is sometimes the ironic aspect of REIT investing, and it’s a general concern to keep an eye out for if you want to try to be conservative in your investing: If a REIT pays an unusually high yield, much higher than the cap rates of the buildings that are being sold in their sector, that makes the business harder to run because they have to effectively promise that yield to new investors to sell new equity. And they can’t grow without raising fresh capital, since REITs don’t retain any earnings to finance growth and they don’t generally amortize their debt (meaning they don’t pay back principal on their mortgages, they just pay interest and roll them over), so they either have to do really well operationally or use debt wisely (or luckily) to reduce their cost of capital, otherwise it’s really hard to improve the bottom line on a per-share basis.
REITs can easily grow right now, with debt easy to come by and investors happy to lap up equity that pays out any dividend at all… but that’s overall growth, which makes the company bigger, it’s not necessarily per-share growth that makes each share of the company more valuable — for per-share growth you need each acquisition to make more money than the cost of the debt and equity capital you used to make the acquisition, and many REITs can do that if they’re disciplined and well-managed… but in a very competitive market, it’s hard to do that with any great margin that provides surprising profit increases (or margin for error), or that provides the potential to increase dividends by much more than the low-single-digits growth rate that should be the baseline expectation for any income stock.
Or, of course, if things go a bit south our intrepid high-yielding REIT might have to cut the dividend to reduce their cost of operating, which will then drive the stock price lower in most cases, making it again harder to raise capital on good terms, and harder to grow… and if you can’t grow, management doesn’t get a bonus and there’s no hope for efficiency improvements and you’re sunk.
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This all works better when interest rates are low, because that means they can “average down” their cost of capital by both selling high-dividend equity and borrowing at lower rates, but it also makes them more interest-rate sensitive (meaning that the business gets dramatically less attractive if their cost of borrowing rises).
It can be a vicious circle sometimesso whenever you’re looking at a REIT that pays a dividend yield that looks unusually high it’s worth thinking through how their capital structure works, and what it costs them to raise money to grow, and what is important to you about the company as an investor — are you just concerned about the dividend stability? Do you require dividend growth? Share price growth? What makes the value enticing enough to risk your capital?
I don’t know that Summit Industrial will be under stress at any point in the future because of the relatively high cost of their dividend — it’s just the first concern that popped to mind when I looked through a couple of their press releases, and I like to provide the somewhat skeptical view to try to balance the optimism inherent in newsletter teaser ads.
Being small means they’re relatively less insulated from regular ol’ real estate problems, like a property they can’t lease or a customer that goes bankrupt, but being small and paying an unusually high yield is also, of course, attractive to individual investors… it gives you room to imagine substantial capital gains as well as nice income checks (if investors decided that Summit should trade at a 5% yield instead of 7.3%, that would drive the stock price up by 40% or more, all else being equal), and the possibility that you could be buying a great company before it becomes huge.
Those possibilities are real, but so are the risks — buying a REIT that’s discounted because investors are worried about it is one of the few ways to get really strong returns from REITs in a relatively short period of time, because the biggest change in REIT stock prices generally tends to come not from actual per-share fundamental improvement, which tends to be rather gradual for most REITs, but from investor re-rating of the company’s potential or risk.
In order for most REIT stocks to surge higher you need to have either the potential for dramatic dividend growth driven by strong per-share growth in revenue and earnings or FFO (which is what largely drove the shares of data center REITs dramatically higher over the past few years, for example, their real per-share growth was fantastic because of cheap capacity growth that required little new capital, combined with large rent increases)… or you need to have investors adjust their expectations, reduce the risk assessment, and decide that the stock you bought with a 7% yield should really trade with a 4% yield (which, of course, assuming a steady dividend per share, means that the people who bought when it had a 7% yield see their shares go up roughly 50% in value).
There’s little chance of dramatic dividend increases with Summit or the other industrial REITs, in my opinion, they just don’t have the per-share cash flow growth power to support huge double-digit sustained dividend increases. From what I can tell, they’re only earning a little more than their cost of capital on new acquisitions, and don’t seem to have properties that are in-demand enough to generate rent increases that are much above inflation, so the cautious investor should probably go in assuming that the dividend will represent the lion’s share of their returns over the next few years… and the optimistic investor will hope that the company becomes more palatable to investors, and that interest rates don’t surge higher, and that this will bring a bump up in the share price as investors continue to seek safe dividend yields and are willing to accept lower yields than the stock currently provides (or, of course, that I’m wrong and there’s something unique enough about the company’s properties to force much higher rents in the near future… or higher asset values if they sell properties for capital gains).
Summit and WPT are in some ways quite attractive in comparison with their larger, stronger US counterparts because they trade at much higher yields, so there is that potential that they could see continued share price strength if that gap between their 7% and 5% yields and the 3% currently on offer from Prologis (PLD) or Duke Realty (DRE) shrinks a bit, but that’s a possibility if investor perceptions shift — it’s not at all a guarantee, and there are real reasons why these (much) smaller Canadian operators are probably genuinely riskier than their huge US competitors.
So I’m watching these guys, both WPT and Summit, and will probably take a closer look in after I’ve slept on them for a spell, but I’d want to really understand what the unique value of their properties might be, or where the possibility comes from for per-share improvement in fundamentals, before I toss my money into the ring. You don’t necessarily need a lot of growth to justify investing in a 5% or 7% yield these days, but it helps.
And with that, dear readers, I’ll send it back to you for your cogitation and thinkolation… it’s your money at stake, so do you find the yields from these Canadian warehouse/industrial REITs appealing? See promise or peril in their financial statements? Let us know with a comment below.