Pressure to offer rent deferrals during COVID-19 lockdowns could put dividends paid by real estate investment trusts (REITs) at risk. However, it is becoming increasingly evident that some property sectors may be better able to weather the crisis, according to Guy Barnard, Tim Gibson and Greg Kuhl from the Global Property Equities Team.
- With REITs required to pay the majority of earnings to shareholders in the form of dividends, concerns have grown about dividend cuts, especially as tenants seek rent deferrals during the COVID-19 crisis.
- Companies are beginning to offer some insight into how large the revenue hit could be. There are signs that some industries, such as industrial/logistics, may likely be able to weather the crisis better than others.
- In general, REITs have entered the current downturn with stronger balance sheets, having learned the lessons of the Global Financial Crisis. Many REITs have lower leverage than in 2008 and, crucially, well-laddered debt maturities with minimal near-term refinancing risk.
Questions about the sustainability of dividends abound as companies across many equity sectors face unprecedented disruptions to cash flow and look for ways to preserve liquidity amid the ongoing crisis.
For real estate investment trusts (REITs), which are generally required to pay out the majority of earnings to shareholders in the form of dividends, concerns around a potential reduction in dividends is even more acute. The good news is that most REITs receive contractual rental income, which should provide greater clarity of earnings. Along those lines, there are questions that can be used to help identify which REITs could be most at risk of a dividend cut:
- What is the current dividend payout ratio, earnings variability and leverage ratio of the REIT? A low reading from all three provides a larger buffer against a potential dividend cut if REIT cash flows were to temporarily fall.
- How much pricing power did the REIT have over its tenants before COVID-19? Companies that enjoyed favourable supply/demand dynamics before the crisis are the most likely to weather the storm, as well as be able to collect any deferred rents when things begin to normalise.
Several REITs have started to detail just how much rent may have to be deferred in the near term, with clear differences across property sectors. For example, Prologis, a global industrial/logistics landlord, announced that cash rents received for April were in line with 2019 levels and that a minimal amount of rent deferral arrangements are expected. Similarly, industrial/logistics owners GLP J-REIT, based in Japan, and VGP Group, based in Europe, have recently issued similar positive updates. Meanwhile, Equity Residential, a US residential landlord, announced that cash rent receipts totaled 93% during the first week of April – little changed from the same period a year ago. 1
In contrast, news from the retail sector has been more grim. Hammerson, a UK-based retail landlord, reported that it had received only 37% of cash payments for UK rent billed for the second quarter. Even worse, CBL Properties, a US mall landlord, reported that the majority of its portfolio is closed and that it expects a “significant near-term deterioration in revenue.” The revenue hit was not quantified, but the company has taken steps to furlough the majority of its employees and materially reduce compensation for those who remain.2
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Balance of supply/demand is key
As you can see, the picture could not be more different between property sectors. Of the examples above, only Hammerson and CBL have reduced their dividends at the time of writing (21 April 2020). REIT dividends tend to get cut when cash flows fall and there is little cash on hand to make up for the shortfall. Cash flows typically fall when rents/occupancy decline but can also fall in the short term if tenants stop paying rent.
In our view, contract law will generally prevail, and even where tenants enter into rent-deferral agreements, the rent will ultimately be repaid, as per the lease, unless the tenant reorganises itself through bankruptcy. This belief, however, comes with an important caveat as landlords in weaker property sectors may face a choice: hold firm on rents and push tenants toward failure or effectively bail out tenants by foregoing and/or permanently reducing rents.
This is where the balance of supply/demand becomes paramount. REITs in positions of strength are more likely to be able to successfully play 'hard ball' and take their chances on re-leasing coveted space if a tenant defaults, while REITs operating in more troubled sectors are aware that if they lose their existing tenants, there likely will not be many candidates to backfill.
In our view, REITs that do not need to grant many rent deferrals or that are confident in the near term about repayment of any deferrals granted are probably the least likely to reduce their dividends. We also believe REITs should help vulnerable tenants where feasible. A good example of this is Deutsche Wohnen, a German residential landlord that has established a €30 million relief fund to provide non-bureaucratic financial assistance to its tenants.
Looking beyond the yield
In most cases, in exchange for the benefit of paying no corporate income tax, REITs are legally required to pay out nearly all taxable income to shareholders through dividends. While we believe dividends are very important, we think the focus should be on secure, rather than high, dividend yields. In our experience, yields typically tend to reach unsustainably high levels just before REITs cut dividends (high single or low double-digits, as a rule). We would also remind investors that income makes up only one component of total return and that durable, long-term cash flow growth underpinned by secular demand drivers can often more than make up for a lower current yield.
It is important to highlight that REITs, as a group, entered the current downturn with stronger balance sheets, having learned lessons from the Global Financial Crisis3. Unlike 2008, today, most REITs have lower levels of overall leverage4 and, crucially, well-laddered debt maturities with minimal near-term refinancing risk.
Separating the winners and losers
We believe that some businesses, like retail, were weak before the arrival of COVID-19, and the virus has further highlighted and accelerated this vulnerability. In many ways, it has had the opposite impact for sectors like industrial/logistics. To-date the sector has appeared to not only continue to weather the storm rather well, and is more likely to offer a more sustainable dividend, but also appears to have the opportunity to grow their cash flows and dividends into the future. While almost no type of business is being spared from the ongoing downturn, the industrial/logistics sector is an example of the separation of winners from the losers, making a thoughtful and active approach to portfolio construction as important as ever.
1,2 Source: various company earnings reports as at April 2020.
3,4 Source: Citi Research, as at 7 April 2020.