The Toronto Stock Exchange has dividend aristocrats that offer an average dividend yield of 5–6%. The recent market dip has created an opportunity to lock in a higher dividend yield of over 6.5–7.5% from strong dividend stocks.
Is an ultra-high dividend yield a trap?
A 6–7% dividend yield is normal in a bear market as the dip in stock price inflates the yield. But what about a dividend yield of 8–11%? Can these stocks sustain these too-good-to-be-true ultra-high dividend yields in a rising inflation and interest rate environment?
- In January, Algonquin Power & Utilities’ stock with an over 10% dividend yield slashed its dividend by 40% as rising interest rates reduced its profits.
- In March, three US banks collapsed as accelerated rate hikes reduced the price of long-term bond yields, creating a liquidity crunch.
All this news makes you wonder whether a high dividend is a trap. There is a way to analyze such stocks and map out the risk.
Three TSX stocks with ultra-high dividend yields
- Slate Office REIT (TSX:SOT.UN) – 11.35%
- True North Commercial REIT – 8.74%
- Timbercreek Financial (TSX:TF) – 8.6%
The rising interest rate has reduced housing prices by 15.8% year over year. The decline has raised concerns that Canada’s real estate bubble could pop anytime. The high-interest rate made mortgages expensive and dried up the fiscal stimulus liquidity that caused the housing bubble. The rate hike significantly reduced the fair value of the invested properties, sending the BMO Equal Weight REITs Index ETF to fall by 22% from its March 2022 high.
The falling stock price of REITs throughout the rate hike cycle that began in March 2022, increased the distribution yield. What does it mean to investors? REITs distribute income from rent and any capital gain from the property sale to shareholders.
The falling property prices have affected their second source of income. But the first source of income, rent, is intact as it depends on the REITs’ occupancy rate. Thus, many retail REITs slashed distribution in 2020 as the pandemic reduced the occupancy rate. Will commercial REITs be the next to slash dividends as commercial activity weakens in a looming recession?
Are ultra-high dividend yields from commercial REITs safe?
Slate Office REIT stock price slipped 32.7% in the last 12 months amid a weak macro environment. The company refinanced $600 million of its maturing debt and reduced its floating rate exposure through interest rate swaps and caps. The management is looking for alternatives like acquisitions, divestments, and corporate transactions to enhance its occupancy.
In the first half of 2022, it acquired Ireland’s Yew Grove REIT, adding 23 properties leased by the government, technology, and life-science tenants. In the second half, Slate Office REIT sold a Toronto property with tenant and capital risk to buy a higher-yielding property in Chicago leased by Pfizer.
All these actions helped the REIT sail through a high-interest-rate environment. But its occupancy is falling, reducing its adjusted funds from operations (AFFO) and stressing its distribution payout, which has crossed 100% to 112%. Such a high ratio is not sustainable, creating a risk of a distribution cut. Similar is the case with True North Commercial REIT, which has a better occupancy ratio of 93% and an AFFO payout ratio of 110%.
While the two REITs are at risk of a distribution cut, their stock price is unlikely to see a drop as the market has already priced in the risk. However, the two REITs have an upside when the economy recovers after the property bubble pops. So hang tight and buy them in a bear market.
What about Timbercreek Financial?
The stock of Timbercreek Financial, a short-term lender to commercial real estate developers, fell 17% in 12 months. The lender benefitted from higher interest income, but rate hikes also increased the risk of default. One of its customer Groupe Selection filed for protection from creditors. However, Timercreek has a secured position.
The lender has been paying its dividends so far while maintaining a payout ratio of a comfortable 78.7%. The lender could sustain its dividend per share as the central bank slows interest rate hikes.