The Crystal Ball into REIT Health

By Britton Costa, Director, U.S. REITs, Fitch Ratings : Find out how the relationship between dividends and operating cash flows can be a crystal ball for assessing a REIT’s health and priorities.
Britton Costa

The relationship between dividends (a REIT requirement) and operating cash flows can be a crystal ball for assessing a REIT’s health and priorities. Fitch Ratings is typically indifferent to payout ratios so long as they are not at either end of the payout percentage spectrum.

To evaluate the relationship, Fitch compares dividends to adjusted funds from operations, which measures recurring free cash flow from operations after maintenance capital expenditures, leasing costs and tenant improvements. A payout ratio above 100 percent indicates a REIT is not retaining cash flow for future liquidity needs and is accessing other sources to pay dividends. High payout ratios are an unsound corporate finance practice and may not be consistent with an investment-grade rating. Conversely, low payout ratios supplement liquidity so long as they meet shareholders’ expectations and do not diminish the equity market’s interest in the REIT’s common equity.

In instances of high payout ratios, Fitch considers the cause (e.g. weak property-level fundamentals or identifiable one-time expenditures for large leases) and the materiality of the dividend subsidy and evaluates it in the context of the overall credit profile and strategy. While the REIT structure requires a careful balancing of investor constituencies, Fitch views a reluctance to cut dividends as speaking to management’s investor priorities.

By and large, the sector has shown prudence. Median payout ratios improved to 78 percent in the second quarter of 2014 from a peak of 87 percent in 2010 when 7 REITs had ratios above 100 percent. The improvement has been driven by both increasing operating cash flows and the dividend cuts enacted in 2009 and 2010 (13 percent – 98 percent, median 39 percent).

However, there have been instances when payout ratios have affected ratings. Earlier this year, Fitch downgraded Liberty Property Trust and Mack-Cali one notch each due in part to persistent shortfalls in dividend coverage.  Conversely, Simon Property Group retains upwards of $1.3 billion per year given its policies (payout ratios of 59 percent in 2013 and 66 percent in the second quarter of 2014), which is sufficient to fund the equity components of its acquisitions and developments.