Darn, Those Pesky Dividends Keep Coming
Co-produced with Treading Softly
Have you ever watched Scooby-Doo? It’s a story of these pesky kids, always meddling around, and their menacing dog. They ruin excellently contrived plots by brilliant minds aimed at their own personal gain.
Well, from the villain’s perspective, anyway. Whenever they are caught, the villains in the show always exclaim “And I would’ve gotten away with it too, if it weren’t for those meddling kids!”
The market can be contrived to be the villain of many retirees’ stories. It tries to upend the calm, stable lifestyle you’ve created. It dips, drops, or enters into a bear market and causes your valuable holdings to become less valuable. Its sidekick the Sequence of Returns risk helps compound the problem, making timing harder for when to sell and meet RMDs (Required Minimum Distributions).
Ironically, many retirees feel it wise to keep a massive pile of cash on hand to avoid having to be forced into selling. They often don’t realize that by not buying, their returns are stunted by choice.
It goes back to the saying “You miss 100% of the shots you don’t take.” as said by hockey’s “Great One” Wayne Gretzky. If you take yourself out of the game, you never can win at it. If you keep your money on the “sidelines”, you might as well have never bothered investing it in the first place. It is a reality of investing that most of your money will not be invested at the absolute bottom. Almost all of your stock market buys will trade at a lower price at some point in the future than the price you paid. Yet at the same time, the market goes up a lot more than it goes down. It goes up more frequently, and it goes up higher amounts. Over days, weeks, and months the market can go down a lot. Over years, and decades, it is on a steady trend up. Those who stick with the market over the long haul will be rewarded.
So how do I plan to mess up the plans of the cold, harsh market? By warming myself next to the blazing, bright and warm fires of dividends. My dividends keep on coming in. It allows me to not sell anything – gotcha market! – while actually buying more if I want to.
While others are being forced to sell because they need cash, I always have dividends coming in, and I earmark a portion of them specifically for reinvesting. I am always a buyer. Even if I go into a falling market with no cash on hand, within a week more companies will be depositing more dividends into my account. A cut goes to me, the rest goes to buy more assets to increase the number of dividends I will get next quarter.
So at the end of the day, when we unmask all the reasons for the market’s dips and drops using hindsight, it will look at us and exclaim, “And I would’ve gotten away with it too if it weren’t for those pesky dividends!”
Let’s dive in on two excellent places to get strong dividends that will foil the market’s attempt to disrupt our retirement!
Pick #1: ARI – Yield 11.1%
When interest rates are rising, you want to have exposure to floating rate mortgages. One attractive option for investors is commercial mortgage REITs, which provide short-term floating rate loans that are secured by real estate. These REITs benefit from rising rates directly, the higher rates are, the higher their revenue. They also benefit indirectly from real estate inflation. The loans are secured by commercial real estate, and as real estate prices go up the risk of defaults declines as distressed borrowers usually prefer to sell if they can do so at a gain. From time to time, commercial mREITs will end up foreclosing on a property, and a strong real estate market will help them regain most, if not all, of their principal back.
So when you have a combination of a strong real estate market, high inflation, and rising rates, it points to fantastic opportunities for commercial mREITs.
One specific example is Apollo Commercial Real Estate Finance, Inc. (ARI). It invests in mortgages that are secured by commercial properties across the globe, primarily in the U.S. and the UK.
ARI is trading at a 15% discount to its recently reported book value ($15.01). This was after an earnings report that beat expectations and covered its dividend in a quarter that management had guided as likely being the weakest of the year.
Since the average term of mortgages is only 3 years and prepayments happen frequently, REITs like ARI are always busy refilling their pipeline. In Q1, ARI had $1.3 billion in funded originations, outweighing $726 million in repayments. (Source: Q1 2022 Financial Results)
It is notable that ARI’s new originations are more conservative while maintaining the same yield. Last year, ARI originated $3.2 billion in mortgages, with an average yield of 5.6% and a loan-to-value of 62%. In Q1, they did $1.8 billion, at the same 5.6% yield and a loan-to-value of only 50%!
ARI has been moving away from subordinate mortgages and focusing more on first mortgages, which have a much lower risk of loss when a borrower defaults. Subordinate mortgages now make up only 9% of ARI’s portfolio.
With ARI trading at a 19% discount to book value, there is ample cushion to insulate shareholders from the risk of defaults. It’s a reality of investing that occasionally a borrower will fail to pay.
ARI directly benefits from rising rates, and rates are rising in both the U.S. and the UK.
ARI is covering its dividend in the current environment. As rates rise in the U.S. and the UK, that dividend coverage will improve. We won’t see a dividend raise in 2022, but with the yield approaching 12%, we’re happy with comfortably covered along with growth potential for 2023/2024 if interest rates rise more.
While the market is selling off everything, we are happy to grab some of this double-digit yield!
Pick #2: EPR – Yield 6.6%
EPR Properties (EPR) is a REIT that invests in “experiential properties.” The types of places people go to do things. Movie theaters, ski resorts, water parks, Top Golf, a casino, and even museums. If you decide to do your due diligence and visit a few EPR properties, you will have fun!
One way to describe 2020 is “anti-fun.” The experiential properties that EPR invested in weren’t so great in the era of “social distancing” and isolation at home. EPR’s tenants were hit hard. It would be difficult for Stephen King to write a more horrible scenario for EPR.
Yet, EPR’s management stepped up to the plate. EPR made it through COVID without increasing its net debt, it actually reduced the total share count by buying back shares during the March 2020 crash, and the lease modifications it made with theater tenants provided relief on the fixed portion but also gave EPR more variable rent, so it could capitalize as the industry recovered.
The recovery is underway, and by year-end, EPR expects to be approximately 10% below pre-pandemic FFOAA (Funds From Operations as adjusted, EPRs preferred version of AFFO) on a run-rate basis. At $4.39-4.55, EPR’s dividend payout ratio will be 70-75%. This is more conservative than EPR’s pre-COVID payout ratio, which was around 80%. This suggests that there is room for more dividend raises as EPR gets more confident about the future outlook.
One of the main reasons that FFOAA is lower than 2019 is that prior to COVID, they had sold off much of their education portfolio. Those funds were never deployed as EPR hunkered down through the COVID storm.
EPR continues to have a substantial amount of liquidity, with over $300 million in cash and no balance on their $1 billion revolving lines of credit. EPR has maintained guidance for $500-$700 million in acquisitions for 2022 which can be funded with current liquidity without having to raise more equity.
Deploying this capital is the final step to recovery, and will bring EPRs earnings back in line with pre-COVID levels. Investors today can look forward to the capital upside and dividend growth.
We put a fair value for EPR today around $60-$65 (13-14x forward FFOAA). EPR is a strong buy at current prices, investors can expect 20-30% potential price upside, a +6.5% yield today, and annual dividend growth.
ARI and EPR offer something few other high-yield firms have to offer. They offer experience, skill, and strong balance sheets. EPR’s management showed a willingness to act intelligently through the COVID pandemic to keep their company in good standing financially, and we can be long-term beneficiaries of that.
ARI is tied to a world-class asset management firm, Apollo Global Management, Inc. (APO), and is superbly set up to strongly benefit from rising rates, which we expect to see looking forward.
Overall, your retirement shouldn’t be heavily impacted by the whims of the market. The Sequence of Return risk shouldn’t be looming over your every choice, waiting to pummel you for making a single inopportune purchase. Instead, your retirement should be carried along, lifted up by strong dividends which allow you to enjoy the fruits of your labor, not the stress of decision-making.
So get your income portfolio kicking out those pesky dividends that just won’t stop and go live your best life!