Income investors need to be aware that not all income stocks are equal. Unfortunately, the coronavirus crisis has forced income investors to re-think the way they invest. Not all income stocks are created equal, so it is imperative to build an income portfolio with discretion.
A perfect example is H&R REIT (TSX:HR.UN). Last week, H&R announced a massive 50% dividend cut; previously, the REIT was yielding over 16%! While this move was certainly prudent by management, this scenario demonstrates a few things income investors must be cautious of.
Income stocks: Be cautious with +10% yields
First, overtly high-yielding income stocks (10% or more) can be dangerous. A high yield often means the markets foresee significant future business disruptions. From time to time, the market can be wrong, but more times than not, it is right.
Second, high-yielding stocks generally mean the investment thesis has changed. H&R’s portfolio of office and retail properties were already challenged prior to the COVID-19 hit. The crisis will seriously challenge any hope of a turnaround.
H&R has significant office exposure to Alberta, and there are major concerns around its most expensive property: the Bow. H&R is also heavily (33%) exposed to retail. Retail is a massively challenged sector, right now. We have already seen a wave of retail bankruptcies, and this is only the beginning of some more ugly times.
Third, high-yielding stocks, like H&R, generally signal growth is detracting or stalled. In order to attract capital, it needs a substantial yield to compensate for higher business risks.
As a consequence, income investors can actually put their principle capital at risk, just for the sake of a higher monthly distribution. This is what has happened with H&R. Despite a still elevated 8% yield, I wouldn’t touch this stock.
Income investors: Buy long-term growth themes
I would rather own a business that has the capacity to grow my investment capital — not just pay out income. I want income stocks that have long-term growth themes supporting their investment thesis. So, look out for best-in-class income stocks that are actually growing their cash flows, even in tough times.
That brings me to my buy suggestion: Summit Industrial Income REIT (TSX:SMU.UN). It has 154 light industrial properties located primarily across Ontario (52.6%), Alberta (28.7%), and Quebec (18.5%). Summit focuses particularly on mid-size (about 60,000 square feet) warehouses and logistics properties. This is an attractive dividend-paying stock for the long run.
First, this income stock has strong exposure to growing markets like Quebec and Ontario. These regions have seen strong population and economic growth for a number of years. Demand is very high, vacancy is at all-time lows, and the opportunity for rental growth is significant.
Its Alberta exposure is somewhat a concern. Yet most of Summit’s Albertan properties are leased to international/national tenants, and it only has 5% overall portfolio exposure to oil and gas.
Second, the REIT will survive the COVID-19 crisis. Management believes that less than 2% of its 2020 rents are really at risk. The REIT has strong portfolio occupancy of 98.9% and has collected 87% of May’s expected rents. Summit’s properties are mostly distribution/warehouse space, so it could actually benefit over time from the recent acceleration towards e-commerce.
Last, Summit has a good balance sheet and growth fundamentals. It has a solid history of accreting cash flows through organic growth, developments, and acquisitions. In Q1, it achieved an impressive average 14% rental growth rate on lease renewals. Summit has $200 million of excess liquidity, which it can hold to preserve its balance sheet, or it can begin to deploy it as 2020 stabilizes.
The bottom line
Summit pays a well-covered 5.72% distribution. The stock is trading cheaply today at 85% of its price to NAV. The REIT is structurally set up for long-term growth, despite, perhaps, some temporary COVID-19 setbacks. It has the right type of properties in the right locations, and I think this income stock will go up for a long time to come.
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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Robin Brown has no position in any of the stocks mentioned. The Motley Fool recommends SUMMIT INDUSTRIAL INCOME REIT.