A 7% yield can make an income stock look like an easy decision. Put $10,000 to work, collect about $700 a year, and keep your shares. That sounds particularly appealing when groceries seem determined to become a luxury purchase.
Yet the yield only tells you what the current payment represents relative to the share price. It doesn’t tell you whether the business can afford it. In fact, a falling stock price can make the yield look better just as the outlook gets worse. Before buying, I’d check the payout ratio.
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Follow the cash
The payout ratio measures how much of a company’s earnings or cash generation goes toward its dividend. For many businesses, comparing dividends with free cash flow is useful. For a real estate investment trust (REIT), I’d examine adjusted funds from operations (AFFO), which adjusts accounting earnings to better reflect recurring rental cash generation.
Say a REIT generates $1 per unit in AFFO and distributes $0.80. Its payout ratio is 80%, leaving a cushion. Pay out $1.05 instead, and something else must fund the difference. Neither number tells the whole story, but that’s a useful starting point for dividend investing.
A monthly payer worth checking
Automotive Properties REIT (TSX: APR.UN) offers a good example. It owns dealership and service properties in Canada and the United States. Rather than selling vehicles, it collects rent from the businesses occupying those properties.
Most leases are triple-net, meaning tenants cover costs such as property taxes, insurance, and maintenance. The weighted average remaining lease term was approximately 8.1 years at June 30. Those arrangements provide some visibility, although a long lease is only valuable when the tenant can keep paying. Following its August increase, the monthly distribution is $0.07 per unit. That’s $0.84 annualized, producing a yield of approximately 7% at writing.
APR REIT reported a second-quarter AFFO payout ratio of 78.3%, down from 80.7% a year earlier. Diluted AFFO per unit increased to $0.263 from $0.249. That’s encouraging because cash generation improved per unit, not just because the property portfolio got bigger.
Considerations
There’s one important catch. That reported ratio predates the distribution increase. Comparing three months of the new payment with second-quarter diluted AFFO gives an illustrative payout ratio of roughly 80%. It isn’t a forecast, but it suggests the increase hasn’t used up the entire cushion.
At today’s rate, here’s what approximately $10,000 could generate before tax and trading fees. The payments are distributions, despite the standard dividend headings below.
| COMPANY | RECENT PRICE | NUMBER OF SHARES | ANNUAL DIVIDEND | ANNUAL TOTAL PAYOUT | FREQUENCY | TOTAL INVESTMENT |
|---|---|---|---|---|---|---|
| APR.UN | $11.86 | 843 | $0.8388 | $707.11 | Monthly | $9,997.98 |
What’s more, debt represented 47.5% of gross book value at quarter-end. Higher refinancing costs could squeeze future coverage, while weaker dealership finances could affect rent collection. Contractual rent increases provide a potential offset, but they don’t eliminate those risks.
At writing, the price is roughly 11.3 times second-quarter diluted AFFO annualized. That looks worth investigating and investors comparing monthly dividend stocks should keep that in mind.
Bottom line
I’d consider APR REIT for a diversified income portfolio because its payout has room beneath cash generation. The 7.1% yield gets my attention. The coverage earns the closer look. But before buying any high-yield investment, make sure the business can afford the income you’re already planning to spend.
