The Motley Fool

Forget buy-to-let! I think these 6% dividend stocks could deliver much greater returns

Investing in buy-to-let often involves a lot of hard work and risk. After meeting the cost of property maintenance, agency fees and mortgage interest, rental yields are often low. And an extended void period between two tenants can completely wipe out any gains for the year.

In my view, it makes more sense to invest in listed companies with exposure to the property market. Today, I’m looking at two small-cap dividend stocks that fit this description.

Build-to-rent could be big

AIM-listed Telford Homes (LSE: TEF) believes purpose-built rental housing will be “a significant part of the London market” in the future. The company expects this trend could extend to other parts of the UK as well.

If chief executive Jon Di-Stefano is right, his company is well positioned. Telford has shifted its focus towards built-to-rent housing over the last three years. The firm is now in the process of delivering more than 1,750 homes in London.

Group sales rose by 31% to £129.6m during the first half of the year, while pre-tax profit was 16.1% higher at £10.1m. This highlights a fall in profit margins, which is to be expected — bulk-buying landlords are able to secure cheaper prices than individual buyers.

The company says that because build-to-rent projects are often pre-funded by the eventual owners, lower margins are acceptable. I can accept this — the group’s return on capital employed was an impressive 20% over the 12 months to 30 September, unchanged from the 2017/18 financial year.

What could go wrong?

My only concern with today’s half-year figures is that Telford’s business still seems to be sucking up a lot of cash. Net debt rose from £103.1m to £122.7m over the six months to 30 September. That represents 52% of net assets.

Although this level of borrowing should be manageable, I can’t think of another house-builder with such a high level of gearing.

Telford shares look cheap, trading at 1x net asset value and on a forecast price/earnings ratio of 5.5. The forecast dividend yield of 6.3% is well covered by earnings. But the group’s falling margins and rising debt don’t appeal to me, given the uncertain outlook for the UK economy.

Telford could be a profitable buy. But for me the risks are too high.

Here’s one I would buy

In contrast, US company Somero Enterprises (LSE: SOM) has made good use of a long boom in commercial property to build up its financial strength.

This firm — which makes equipment used to produce perfectly flat concrete floors for warehouses and factories — went into the financial crisis with too much debt. It’s since repaired its balance sheet and now maintains a net cash balance of at least $15m to ensure the business is safe during the next downturn.

This conservative approach hasn’t stopped the company delivering impressive levels of growth and shareholder returns. Revenue is expected to reach $90m this year, double the level reported in 2013. Return on capital employed in 2017 was a stunning 52%.

Looking ahead, Somero trades on 10.8 times 2018 forecast earnings, with a dividend yield of 5.8%. Although the business is exposed to the risk of a slowdown in its core US market, I think this firm looks good value at current levels. I rate the shares as a buy.

Under-The-Radar Investment

There are a number of small-cap stocks that could be worth buying right now, and our investing analysts have written a FREE guide called "1 Top Small-Cap Stock From The Motley Fool".

The company in question may have flown under your investment radar until now, but could help you to build a great income from your investments and retire early, pay off the mortgage, or simply enjoy a more abundant lifestyle. Click here to find out all about it — it's completely free to do so.

Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Somero Enterprises, Inc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.