On November 2, the US Fed gave investors some relief by maintaining its interest rate at 5.25%–5.5%. And the latest October inflation figure of 3.2% hints that the Fed may hit pause on its rate hike for good. This aggressive interest rate hike has been bothering Canadians and Americans with debt. As the hierarchy goes, creditors get a preference over shareholders in payments. Thus, many companies with high leverage cut their dividends as their interest expense doubled in a year. When a company slashes dividends, its stock price falls.
Which stocks are at risk of dividend cuts?
This year alone, Algonquin Power & Utilities, two small commercial REITs, and Northwest Healthcare REIT slashed dividends. The real estate sector is at the cusp of a property bubble burst as mortgages are stressing the finances of several Canadians and businesses. This has put some real estate stocks on the radar of dividend cuts.
SmartCentres REIT
SmartCentres REIT (TSX:SRT.UN) is a popular retail REIT because of its Walmart lease and Walmart-anchored stores. The rental income from grocery retail has helped it survive the pandemic without distribution cuts. But this time, its third-quarter earnings are showing warning signs. Its distribution payout is 96.1% of adjusted funds from operations (AFFO) at a 98.5% occupancy. Although the payout ratio has improved from 101.6% last year (with a 98.1% occupancy rate), it is still pretty high.
The REIT doesn’t have the flexibility to handle any more fluctuations in cash flow. A company cannot sustain such high payout ratios for a longer term. And the way interest rate decisions are progressing, a small rate cut of 0.25% or 0.5% in 2024 won’t be enough to relieve the stress off SmartCentres’ AFFO.
Although the REIT has not stated any intention to cut distributions, the probability is high. The stock price has dipped 16% year to date, which has inflated its distribution yield to 7.93%. Such a high yield is unsustainable at a 96% payout ratio.
Dividends of Timbercreek Financial
While grocery retail is resilient, office REITs are vulnerable to economic situations. Timbercreek Financial (TSX: TF) is a lender to commercial REITs that generate income by renting space to businesses. Commercial REITs have been struggling with occupancy rates as many companies are cutting costs by vacating or reducing leased areas.
Timbercreek is feeling the struggles of commercial REITs as its loan portfolio turnover fell 6% in the third quarter, hinting that REITs have slowed their repayments. More loans are moving to stages two and three, which signals payment delays and defaults. Timbercreek is handling each loan on a case-by-case basis, looking to find a workable resolution.
So far, the situation is under control. Its distribution payout is at 85.6%, which is slightly higher but manageable. It ended the third quarter with a loan portfolio of $1.1 billion with a 9.9% weighted average interest rate. Most commercial REITs have paused new developments and are struggling to pay existing mortgages. A recession could trigger large-scale default, a risk every lender is facing.
Until now, lenders enjoyed high-interest income. But this cyclicality has reached its peak. It’s now time for a dip. Even if Timbercreek withstands a credit crisis, its dividend will likely take a hit. Thus, its 10.6% dividend yield comes with a high risk of a dividend cut.
Final thoughts
If a recession hits, the above two stocks are likely to make significant distribution cuts as they are struggling to hold onto their distribution in the current environment.
Instead of getting lured by high yields at risk of a cut, consider dividend aristocrats with a payout ratio at or below 80%. BCE or Enbridge are good alternatives. And if you are looking for monthly payouts, CT REIT is a less volatile option.
