Fitch: Stock Dividends Imperfect Liquidity Solution for US REITs
Investors have recently asked Fitch whether the ability to pay stock dividends changes our views on REIT credit ratings. Applying this ruling across the sector would serve as a liquidity enhancement to support ratings on the downside as similar IRS policies did during 2008-2010, corresponding with the global financial crisis. However, it is unlikely to result in positive rating momentum unless REITs commit to and act on paying meaningful stock dividends as part of their ongoing liquidity management strategy through cycles.
Paying stock dividends could have a positive but likely temporary effect on an issuer's liquidity profile. The inability to retain meaningful amounts of operating cash flow to satisfy maturing debt obligations and organically manage leverage levels is a key restraint to REIT credit profiles, historically making the sector reliant on consistent access to the debt and equity capital markets.
Limited visibility on the timing and composition of the next commercial real estate downturn challenges predicting how REIT managements would approach this option. At this point, there is little to go on other than comments addressing hypothetical downturn scenarios made by company managements during a period of generally strong property fundamentals and capital markets access. Nevertheless, Fitch makes the following observations, some of which could inform REITs' views towards taxable stock distributions when the next downturn ensues.
Stock dividends are a form of equity issuance, although potentially less costly than an underwritten follow-on offering or at-the-market issuance with greater certainty of execution. REIT shares typically trade at wide discounts to net asset value (NAV) during market declines, making stock dividends dilutive and only moderately more appealing than issuing new stock below NAV. Fitch believes companies are likely to view alternative sources of capital more favorably than stock dividends during a normalized period in the cycle. Examples include revolver borrowings and secured property-level mortgages, which could result in weaker credit profiles.
Fitch also expects companies to weigh the benefits of paying a taxable stock dividend against potential reputational damage to investor confidence and trust in their financial policies. Cash dividends have historically comprised a meaningful portion of REIT total returns, underscoring their importance to REIT investors. A stock dividend would likely create a non-cash yet taxable event for many investors, requiring them to either pay taxes with other cash on hand, or sell all, or some, of the shares they receive through the distribution. The latter could be executed below the price that determined the distribution ratio in a rapidly declining market, as well as lead to additional selling pressure on the shares. The higher share count could also increase the likelihood that the REIT reduces its per share cash dividend in future quarters, depending on its taxable net income and dividend payout cushion relative to adjusted funds from operations.
Moreover, companies arguably would need foresight and the courage of their convictions to eliminate cash distributions far enough in advance to retain capital to meet upcoming financial obligations. Negative market perception related to the dividend policy change could also make future equity issuances more costly.
At this point, Fitch does not expect the ability to pay stock dividends to result in positive rating actions within our rated REIT portfolio, but the added cash retention flexibility could potentially result in greater rating stability during periods of stress if issuers take advantage of this option. We plan to review this concept with issuers to determine whether the option results in financial policy modifications.