Real estate investment trusts (REITs) have quite a reputation for generous dividend policies. The structure of these special businesses makes them immune to corporation tax. But that requires them to pay out 90% of their net profits to shareholders.
With that in mind, it’s no surprise that so many of these stocks typically pay a chunky yield. But in 2024, this impact is only amplified, thanks to a combination of factors from investor sentiment to interest rates.
In June, Gore Street Energy Storage Fund (LSE:GSF), NextEnergy Solar Fund (LSE:NESF), and Residential Secure Income (LSE:RESI) are in the top 15 UK REITs with the most generous dividend yields offering 11.7%, 11.6%, and 10.1% payouts. Does that make them the best passive income investments right now? And what should investors be on the lookout for?
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The debt problem
As previously mentioned, the REIT business structure requires the lion’s share of profits to be redistributed through dividends. Consequently, the level of retained earnings for these businesses is minimal, at best.
Over the last decade, this hasn’t been much of a problem. After all, debt was cheap with interest rates sitting close to 0%. Today, the economic landscape is quite different. The Bank of England has raised rates to 5.25%, turning previously affordable debt into a ticking time bomb.
To make matters worse, the fair market value of a REIT’s assets, whether it be solar panels or residential properties, is also adversely affected by the cost of capital. All three highlighted companies have suffered a massive blow to their reported net income due to the revaluation of assets.
These losses only exist on paper (since they don’t affect cash flow). However, it also means that if a firm is forced to sell some of its assets to raise money, the transaction is going to be less than favourable, likely resulting in the destruction of firm value and shareholder wealth.
That’s why most REITs, including Gore Street, NextEnergy, and Residential Secure, are all trading at a significant discount to their net asset value. And these depressed stock valuations are a big contributor to their generous yields.
Bargains hiding in plain sight?
Despite leverage being a valid concern, the latest inflation figures suggest that an interest rate cut is coming soon. And apart from easing the pressure of existing and new debt burdens, the recovery of asset market values could quickly send REIT share prices flying.
If that’s the case, investors could be looking at an extraordinary opportunity to lock in a sustainable double-digit yield. After all, NextEnergy Solar has actually just hiked its dividend, while Gore Street’s improved cash flow is improving dividend coverage and affordability as it maintains its existing payout.
However, it’s not all sunshine and roses. Residential Secure Income has recently had to cut its payout as underlying earnings continue to suffer in the unfavourable operating environment.
As with any income investment, chasing high yields requires careful investigation. This is especially true for REITs, given their heavy dependence on external financing through debt. And while interest rate cuts are expected to improve prospects this year, all it takes is a rebound of inflation for those expectations to be thrown out of the window.
Currently, out of these three businesses, NextEnergy Solar has most of my attention. Given its superior performance and resilience, I believe the company merits a closer look for a potential investment despite the risks that come with it.
