Latest / Dividend Investing with Fexingo: Income Stocks, Yield, and Long-Term Cash Flow Portfolios / How Real Estate Investment Trust Dividends React to Rising Yields
Transcript
- Lucas: You look at Realty Income, ticker symbol O, down about 0.8 percent over the past five days. Not a disaster, but for a stock that a lot of dividend investors treat almost like a bond substitute, that move mirrors what's happening in the broader rate picture. Luna: And the 10-year Treasury yield is sitting at 4.45 percent as of May 28th, down just slightly from 4.48 percent the week before. So rates aren't spiking, but they're staying elevated. Lucas: Right. And that's the whole puzzle for REITs this year. When the risk-free rate offers 4.4 percent with virtually no volatility, the premium that REITs need to offer—the spread over Treasuries—gets compressed. Historically, REIT dividend yields have traded about 200 to 300 basis points above the 10-year. Right now, the average equity REIT yield is around 4.6 percent. That spread is roughly 15 basis points. Very thin. Luna: So you're taking on real estate risk, tenant risk, interest rate risk on their debt—and you're only getting maybe 15 extra basis points of yield versus a government bond. That doesn't sound like a great risk-reward trade-off. Lucas: It's not, on the surface. But the nuance is that not all REITs are created equal. A triple-net lease retail REIT like Realty Income—that's different from a cell tower REIT like American Tower, or an industrial REIT like Prologis. Their lease structures, their revenue growth profiles, and their sensitivity to rates are all different. Luna: Let's dig into that. What makes one REIT more resilient than another when rates stay high? Lucas: It really comes down to two things: lease duration and the ability to raise rents. Realty Income's average lease length is about 9 years, with built-in rent escalators—typically 1 to 2 percent annual increases. So their revenue stream is relatively predictable, but it doesn't grow much. That makes them more bond-like. When bond yields rise, their relative appeal drops. Luna: And then you have Prologis, which owns warehouses and logistics centers. Those leases are shorter—three to seven years—and they have more pricing power because e-commerce demand for space is still strong. So they can re-lease at higher rates more frequently. Lucas: Exactly. Prologis can pass through inflation more effectively. The same goes for data center REITs, where demand is surging because of AI and cloud computing. Those REITs have dividend growth potential that can outpace the 10-year over time. But the market is pricing them at a premium—lower initial yield, but higher expected growth. Luna: So for a dividend investor focused on current income, you might be tempted by the higher headline yields from retail or office REITs. But those yields could be a trap if the dividend is at risk. Lucas: And that's where the payout ratio becomes critical. For a REIT, the standard measure is funds from operations, or FFO, rather than earnings per share. A payout ratio above 80 percent of FFO starts to look tight if interest expenses rise. Realty Income's payout ratio is about 74 percent. American Tower is around 60 percent. Prologis is closer to 70 percent. None of them are flashing red, but if rates go up another 50 basis points and stay there, those ratios get squeezed. Luna: And higher rates also increase the cost of debt for REITs, since they tend to borrow a lot. Realty Income has about $20 billion in debt. If their average borrowing cost goes up by 50 basis points, that's an extra $100 million in interest expense annually, which directly hits FFO. Lucas: Right. And that's the thing—many REITs locked in low rates during 2020 and 2021, but those maturities are coming due. Over the next two years, a lot of debt will need to be refinanced at higher rates. That's going to pressure dividends unless they can grow revenue fast enough to offset it. Luna: And that's actually one of the reasons we're able to have these conversations without any corporate sponsorship—it's because listeners like you chip in a few dollars to keep the show ad-free. It's a small thing, but it genuinely makes a difference. Lucas: Yeah, it's true. If you've gotten value out of our discussions about dividends, REITs, or portfolio strategy, a couple of dollars a month at buy me a coffee dot com slash fexingo helps keep the lights on. No pressure, but it's appreciated. Luna: Absolutely. So back to the REIT landscape—what should a dividend investor do in this environment? Lucas: I think the key is to focus on REITs with strong dividend growth histories, even if the starting yield is lower. Look at American Tower. Their dividend has grown at a compound annual growth rate of about 20 percent over the past five years. The yield today is only around 3.2 percent, but if that growth continues, your yield on cost in five years could be well above current bond yields. Luna: So you're trading current income for future income. That makes sense if you have a long time horizon. Lucas: Exactly. And don't ignore the impact of share buybacks. Some REITs are using excess cash to buy back shares when they trade at a discount to net asset value. That boosts FFO per share and can support dividend growth without needing to raise rents faster. Luna: Are there any REIT sectors you'd avoid right now? Lucas: Office REITs are still under pressure. Vacancy rates in major cities are around 20 percent, and leasing demand is weak. Even well-managed office REITs are seeing dividend cuts. And mall REITs are facing similar headwinds, though the best-in-class ones like Simon Property are holding up better because they have higher-quality assets and more diversified revenue. Luna: So the takeaway is: don't just look at dividend yield. Look at the underlying business, the lease structure, the debt maturity schedule, and the dividend growth rate. Lucas: Right. And one more thing—keep an eye on the 10-year Treasury yield. If it drops back toward 4 percent, that spread widens again, and REITs could rally. But if it breaks above 5 percent, the pressure on valuations will intensify. For now, we're in a stalemate—rates are flat, and REITs are grinding sideways. But the next catalyst could be the June Fed meeting or the next inflation report. Luna: Good stuff. Thanks, Lucas. Lucas: Thanks, Luna. That's our show.