Sell This Stock Now

As an income and dividend stock investor, I love real estate investment trusts (REITs). A REIT is a type of company that owns real estate in some form and then leases that real estate. It could be apartments, hospitals or urgent care facilities, office space, or even farmland.

The idea is to have rental income that is larger than debt payments. If a REIT can do this, then it is making money. 

Now, REITs enjoy a very special corporate structure that makes them very attractive to investors. They are considered an investment partnership with their shareholders. And so they pay out pretty much all (+90%) of their profits as dividends.

This special structure also means that the REIT itself doesn’t pay income taxes. So investors (or partners) typically get very nice dividend payments that haven’t suffered a big 20–30% tax bite. It is not at all uncommon to find solid, well-managed REITs that pay 5%, 6%… sometimes 7% or 8% in annual dividends. In fact, right now, one of my favorite REITs is paying nearly 10% in annual dividends.

Unfortunately, a bigger dividend isn’t always better. Usually, when a company’s dividend approaches double digits, it’s a warning sign that the dividend payment may not be sustainable. Companies that pay dividends do not want to cut the payment, because that’s a sign of trouble. Even when business is weakening, companies try to keep their dividend steady. They may even take on debt in order to maintain the payment. 

That’s why income investors pay attention to a special metric called the “payout ratio.” The payout ratio simply tells you what percentage of income a company is paying as a dividend. If that ratio is around 40–50%, it means the company is paying half its net income as dividends. 

Companies like Cisco (NASDAQ: CSCO) and Starbucks (NASDAQ: SBUX) have payout ratios in the mid-40s. And this is generally considered healthy. The payout ratio starts to signal trouble when it approaches 100%. If a company is paying out virtually all of its profits as dividends, well, there’s not much room for error. One earning slip, and the company may have to dip into cash to make the payment. Or take on debt.

Analyzing REITs

Of course, it’s a bit different for REITs, since they are required to have a payout ratio near 100%. This means investors can do themselves a big favor by really understanding the business model of a REIT.

Because REITs derive their revenue from long-term leases, they are usually pretty predictable. So if you can determine that a particular REIT has a business model that supports solid growth, you can find an investment that steadily grows revenue and dividend payments.

That’s exactly the case with the REIT I mentioned earlier that pays a 10% dividend. At first glance, the 10% dividend may look like an indication that the dividend is not sustainable. My research tells me the opposite: that it is not only sustainable, but it is likely to rise…

You see, this REIT is a recently formed company, spun off of a larger company. And the parent company has a long-term lease. It should have no problem maintaining the current payout. And I say the payout is due to grow. That’s because right now, this REIT has only one customer: the parent company.

That may sound like a problem, but remember, this is a new company. It has only recently entered the market to sign up new customers. And because its business is in the sweet spot of the REIT universe right now (think network infrastructure), I think it will have no problem attracting new customers. 

I recommended this stock to my Wealth Advisory readers back in February. Yeah, we got lucky and bought it near the bottom of that January–February correction around $16. It’s hitting $25 now, and I think it’s headed at least $10 higher…

But that’s not the main reason I’m writing to you about REITs today. Over the weekend, I was doing some digging in the REIT sector. I found a couple REITs that look like complete disasters ready to happen, and I want to make sure you are not affected.

Fire in the Hole!

Have you ever heard of Apollo Global Management (NYSE: APO)? I kinda hope not, because if you have, it probably means this vulture capitalist firm has cost you money. 

What makes a company a vulture capitalist firm? Well, they prey on weak companies and make them weaker, all the while making themselves richer. Usually a vulture capitalist firm will buy a majority stake in a company with debt. The vulture capitalist will not put up very much of its own cash, usually less than 10%. Then it transfers all the debt to the company balance sheet. And then it starts paying out huge dividends to shareholders, of which it is the majority. 

Often, the company itself will take on even more debt to pay these dividends.

Like in the case of Claire’s Stores, a jewelry chain that Apollo acquired in 2007. Sales per square foot at the chain have stayed roughly the same. But the company has been losing money ever since Apollo acquired it:

Click Chart to Enlarge

Why have profits been so bad? Probably because of the payments on the $2.3 billion in debt that Apollo put on the company. Claire’s is teetering on the brink and probably won’t survive. 

Apollo did basically the same thing with an aluminum producer called Noranda Aluminum, also acquired in 2007. Apollo loaded the company with debt and started paying huge dividends. Noranda was once a solid company that paid union wages. But don’t worry — you won’t find much about it now. It declared bankruptcy in February of 2016. 

That’s how it goes with companies owned and operated by Apollo.

Watch Out for These…

I came across Apollo when I was screening for REITs. My screener turned up Apollo Residential Mortgage REIT (NYSE: AMTG), which pays a 14% dividend. Apollo Residential has reported net losses for operating income for the last three years. Yet it pays a $1.92 a share dividend. 

How can it pay that dividend? It seems it is doing so with debt and stock sales.

But you may not need to worry about Apollo Residential Mortgage for long. It is being acquired by Apollo Commercial Real Estate Finance (NYSE: ARI). 

ARI pays an 11% dividend. The payout ratio is 142%, which means it, too, is paying out more than it makes. Again, that dividend is very likely unsustainable. Apollo will keep taking on debt to pay it until it can’t find any lenders anymore. That’s when the trouble will start. 

You should be careful with any of these Apollo companies. Plus, you should also know that Apollo owns ADT (NYSE: ADT) home security company. It is also trying to buy out Concordia (NASDAQ: CXRX). 

I wouldn’t touch either of these companies, either — or any other that Apollo is involved with. Just thought you should know.

Until next time,

Until next time,

Briton Ryle

@BritonRyle on Twitter

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.