Investment income is a key portion of total return, and I fully understand the impetus for investors to seek high-income securities. An 8% yielding portfolio can finance a greater standard of living than a 5% yielding portfolio so increasing one’s dividend yield can feel like getting a raise.
This article will discuss 3 high-yield opportunities that are well-supported by high-quality assets, but to understand why these opportunities are special, I want to start by looking at the other side of the coin which is the minefield that is a large portion of the high-yield space. The following categories are particularly ripe with landmines.
- Private equity and private REIT investments will frequently offer unsustainably high yields to entice investment.
- Stocks will often IPO with really high yields to encourage full enrollment of the IPO issuance.
- ETFs with juicy yields often utilize high leverage to attain such a yield which can cause even modest volatility to result in permanent destruction of capital.
So how can one find high yields without running into these landmines?
Well, it comes down to understanding one financial fact: Dividend policy does not affect shareholder value. It is a simple policy decision.
The value comes from the cashflows produced by the company while dividend policy just determines what portion of those cashflows are paid out as dividends and what portion are retained for growth.
Dividends are great and capital retained for growth is great. Neither is necessarily better than the other. What matters is the underlying cashflows. With this in mind, allow me to contrast an opportunistic income investment with a landmine that on the surface looks quite similar.
- The landmine – private equity paying unsustainably high yield out of the gate.
- The opportunistic income play – CTO Realty Growth, Inc. (CTO).
I used to analyze private REITs and was just baffled by how many of them offered 8%+ yields right out the gate but then when looking deeper into their business models they would be investing in 7%-8% cap rate properties. So an investor would invest let’s say $10,000 in the private REIT, management would get roughly 4%-6% of that as compensation then the investor would get back roughly 2% as the first quarterly dividend payment before the capital was even invested in the real estate.
So, the company was effectively investing 92%-94% of the investors’ capital in 7%-8% cap rate properties and somehow was expected to generate an 8% yield?
That is clearly not sustainable. A few of the private REITs of this model got extremely lucky by happening to be in property sectors where rents skyrocketed in the next few years such that they were able to dig out of the hole. Many, however, eventually ended up having to slash their dividends and then listed their stocks on public exchanges at a fraction of the price per share at which capital was raised.
CTO is ostensibly a similar investment. It is also a REIT and yields 7.5%. So what makes it a better source of income?
The key differentiator is a high-income company versus a company with an aggressive payout ratio.
CTO’s properties are actually quite similar to those of many of the private REITs. The difference is that the CTO is trading far below asset value such that in buying a CTO one gets more property for each dollar invested. This means the underlying property-generated cashflows are much higher relative to each dollar invested.
In 2025 CTO is slated to earn AFFO of $2.07 which is a 10.24% AFFO yield against market price. The higher underlying earnings allow CTO to pay out $1.52 annually in dividends (7.5% yield) while still retaining 55 cents per share of earnings for growth.
A comfortably covered dividend and retained earnings make the CTO’s dividend likely sustainable in the long term with potential for growth.
Risk as a means of producing high-yield
In the private REIT example above one obviously cannot generate an 8% yield by investing 94% of an investor’s capital in 7%-8% cap rate properties. However, there are 2 ways that such entities can juice cashflows such that the dividend is fully covered.
- These are very high-risk investments.
- Leverage.
If the private REIT were to invest in junky properties with bad tenants it is quite easy to find cap rates as high as 12%. With this higher level of cash flow they can sustainably cover the 8% dividend yield promised to investors….. until something goes wrong.
Leverage works similarly. Many ETFs will position to pay out very high yields to investors which they can assemble by buying normal yielding stocks and then levering up. The assets might be reasonably good and the spread over cost of debt is positive, so with enough leverage, they can amplify the yield on reasonably good assets to get to 10% dividends.
The challenge here is that leverage has an adverse interaction with volatility. Even if the underlying holdings of the ETF are entirely fine fundamentally, a market correction of say 20% would be amplified by the ETF’s leverage forcing them to sell at bottom of market prices.
So even if a dividend is fully covered by cashflows, high risk assets or levered investment vehicles can make the dividend unreliable.
In contrast, we can look at Easterly Government Properties, Inc. (DEA) which has a 9% dividend yield.
We wrote a full thesis on DEA on Portfolio Income Solutions, so I won’t cover all the fundamentals in this piece other than what is specifically relevant to dividend sustainability.
DEA’s cashflows come from properties long term leased to the U.S. Government which makes the dividend quite sustainable. These assets are not high yield assets. Cap rates are typically in the high 6s to low 8s which is quite normal for this interest rate environment.
These are quality assets and DEA only uses a modest amount of leverage. As an investment vehicle, DEA is designed to have a dividend yield of about 4% or 5%. The only reason the dividend yield is 9% is because the stock is trading steeply discounted to asset value.
A discounted market price is the best source of high yield. Unlike risky assets or leverage, a discounted market price actually reduces risk.
In general, investment vehicles designed to be high yield will be high risk and potentially landmines. We much prefer discounted valuation as the source of high yield.
Bonus dividend opportunity – Farmland Partners Inc. (FPI)
In 2024, Farmland Partners Inc. (FPI) will pay a total dividend of $1.39 consisting of 4 quarterly $0.06 dividends and a special $1.15 dividend to be paid to shareholders of record on December 23rd. Against its current price of $12.66, that is a full year dividend of 10.97%.
I understand that special dividends are not recurring in nature, so one may not count FPI as an 11% yielding stock, but note that one can still catch the majority of this dividend with even a brief holding period. So think of it more as getting an 11% dividend in the forward year, but getting paid a majority of that 11% in the first month.
FPI uses special dividends because its earnings come at unpredictable time periods. This particular dividend is funded by the profits of a major land sale.
Note that selling assets is not generally considered a sustainable source of income, but this dividend was not funded by the principle of asset sales. It was funded by the profits, meaning the sale price was in excess of what FPI paid for the land.
Farmland Partners executed a similar although smaller special dividend in December 2023 as well. It is their process by which they convert appreciation of land value into shareholder returns.
FPI is not typically a dividend stock, but for those who get in before the ex-dividend date, it can be.
Wrapping it up
In a high-yield investment landscape riddled with landmines, we see 3 sources of responsible high-yield well-funded by company profits:
- CTO – 7.5% and growing.
- DEA – 9% funded by extremely reliable assets.
- FPI 11% (one time only).
