By Ralph Block

Commercial real estate owners expect regular and substantial distributions from available real estate cash flows, along with very modest capital appreciation from increasing property values.

Stock owners, however, expect skinny dividend yields, with most of their returns coming from significant capital appreciation. What do REIT investors expect? How should REIT organizations respond?

REITs are a unique blend of real estate and equities. They are capital-intensive, and most of their value is embedded in the real estate they own. However, today’s REITs are active businesses—they own and manage commercial real estate as well as redevelop their properties, develop new projects and engage in various real estate-related businesses.

All these activities require capital, and one of the cheapest forms of capital is retained earnings. Furthermore, as space markets are cyclical, retaining earnings can protect the dividend against the inevitable downturn in operating income.

While capital markets have been accommodating in recent years, the real estate industry has sometimes suffered from capital starvation. Maintaining a conservative dividend policy will both provide the needed capital and ease pressure to cut the dividend during difficult times.

Keeping a dividend as low as legally possible isn’t always in REIT shareholders’ best interest. After all, REITs are as much about real estate as they are equities, and many institutions that invest in REITs do so as a proxy for real estate—a hallmark of which is a high level of cash distributions relative to income.

Perhaps most individual investors who own REITs directly or via mutual funds do so in the expectation of receiving a dividend yield significantly higher than is available from most other common stocks.

Dividend yields remain very important—which leads us to a conundrum. Due in substantial part to today’s low cap rates, REITs trade at relatively high multiples over funds from operations (FFO) and at historically low dividend yields.

Equity REITs’ average yield has been about 3.7 percent since the latter part of 2006, according to NAREIT. When held in taxable accounts, approximately two-thirds of these dividends are taxed at ordinary income tax rates, not the current 15 percent for “qualified” dividends.

If REITs were to retain every nickel permitted under current legislation, and if cash flows grow faster than dividend payments, then the average REIT dividend yield could decline even further. Still, despite some modest increases in recent years, the primary investment attribute of REITs would continue to be the relatively low correlation of REIT returns with the returns from other equities and bonds.

The relatively low correlation of REIT returns also tends to overshadow intertemporal changes in REIT volatility as share prices ebb and flow with changes in the economic outlook.

Accordingly, determining the “right” dividend policy is more complicated than a simple application of financial science. A REIT should recognize the sometimes-conflicting investment objectives of its shareholders, while remaining sensitive to the opportunity landscape.

Being tight-fisted with dividends is an easy call when high-yielding and low-risk acquisition or development opportunities abound, or when a REIT can repurchase shares at prices well below estimated NAV. However, at other times, dividend generosity july be the most effective use of free cash.

Accordingly, no “perfect” dividend program applies to all REITs, nor even to a single REIT at all times. While consistency is usually a virtue, an intelligent dividend policy should be flexible, responsive to shareholder objectives and focused carefully
upon prospective risk-adjusted returns on reinvested earnings. A well-crafted dividend strategy is a good indicator of a high-quality REIT organization.