REITs must pay out at least 90% of profits in the form of dividends to investors. Thus, 90% is the REIT dividend payout ratio.
REITs can help you grow your net worth much like dividend stocks. Both pay out dividends, but the way REITs payout works differently than the way stocks payout. In this article, we’ll look at the dividend payout ratio for REITs and how it is determined.
What Are REITs?
REITs themselves are not stocks. A real estate managed trust is a company that manages properties that create cash flow. These properties can be residential or commercial.
There are different types of REITs, including equity REITs and mortgage REITs. Equity REITs directly manage income-producing real estate properties, while mortgage REITs generate income by owning mortgages on properties.
In order to raise capital, REITs can issue shares, much like a company would issue stock. Issuing shares, also known as equity, is not as cheap a way to raise capital as debt, but many REITs issue shares anyway.
Shares can be traded publicly or privately. If they are traded publicly, you will find them listed on stock exchanges.
What is the 90% Rule?
The 90% rule was put into place by the IRS and requires REITs to pay at least 90% of income to shareholders. 90% sounds like a rather high ratio, but one thing to keep in mind is that dividend payout ratio is calculated using earnings per share. That is different from dividend yield, which is calculated using price per share.
The result of this is that the dividend payout ratio could be a more accurate reflection of the REIT’s performance because price per share can be influenced by speculative investors.
Dividend Payout Ratio
Understanding the dividend payout ratio requires you to understand a few basic formulas. While the formulas are fairly simple, there are multiple formulas that ultimately affect the dividend payout ratio.
For instance, dividend payout ratio is calculated as:
Annual dividends per share
Earnings per share
But how do we calculate earnings per share? Now you can see why we must understand multiple formulas. Annual dividends per share is simply the total dollar amount paid out per share, but to determine the earnings per share, we must calculate:
Net income – Preferred Dividends
Common shares outstanding
Preferred dividends are dividends paid out to shares of preferred stock, while common shares outstanding simply refers to how many shares of common stock are currently outstanding.
Net income is a whole calculation of its own. In the interest of not making this a “formula-ception,” we won’t go into that here.
Dividend Payout Ratio for REITs
It’s important to note that depreciation and amortization on properties can reduce net income. These are items that will inevitably be part of a REIT’s balance sheet.
And because net income is in the numerator of the earnings per share formula, earnings per share are reduced as net income decreases. Thus, the reduction in net income means that REITs will have a higher dividend payout ratio.
At 90%, the dividend payout ratio seems high for REITs. After all, this quite literally means that 90% of the company’s profits would have to be returned directly to investors.
Despite this, deprecation and amortization don’t actually cost the REIT anything. So even though your REIT dividend payout ratio may be close to 100%, there’s a fairly good chance you aren’t actually being paid out such a high percentage of their earnings as a whole.
It’s possible that at times, you may see a REIT with a dividend payout ratio higher than 100%. While that sounds nice, it may not be sustainable because it might mean the business isn’t reinvesting enough of its earnings back into the business.
That being said, that isn’t always the case. In fact, there are several very dependable REITs that have incredibly high dividend payout ratios:
|REIT||Dividend Payout Ratio|
|Realty Income Corp||123.28%|
Despite having payout ratios that seem extremely high, all of these are dependable REITs that should be around indefinitely. Therefore, any of them would be a good place to invest your money and grow your net worth.
How Important is Dividend Payout Ratio?
Dividend payout ratio can be useful and offer better insight into a REIT’s performance than other measures, such as dividend yield. That’s because payout ratio is how much the company is earning rather than on the share price.
But, still, certain balance sheet items, such as depreciation and amortization, can reduce net income despite having little to no impact on a REIT’s cash flow. And yet, that reduction in net income increases the dividend payout ratio.
As a result, this item should be just one thing we take into consideration when evaluating a REIT. Instead, we should consider the whole picture when deciding where to invest our money.
Luckily, certain REITs (such as those mentioned above) regularly show strong performance. These REITs have a positive outlook that is sure to help you grow your net worth for years to come.