Ann: Dividend/Distribution - SCG, page-13

"....my concern is that the reduction in dividend reflects not only covid conditions on rent paid but also new and potential new future rentals at a lower level than current contract rentals."

@noomxx,

I think you are right about the direction of the dividends, but possibly for some wrong reasons.

I've watched these REITs for several years and they way the distribution yield on many of them has been synthesised at unsustainably high levels, predicated on a payout ratio based on the the somewhat arcane Funds From Operations (FFO) metric, adopted by the National Association of Real Estate Investment Trusts.

If we look at the period of SCG's listing to FY2019 (FY2020 was heavily Covid impacted, so let's ignore that period for this exercise), the company recorded cumulative FFO/share of 120cps.

This adequately covered cumulative DPS of 109cps over that period.

So the DPS payout ratio on FFO has been 90%.

All good, seemingly, at first glance.


However, I'm an old-fashioned cash flow investor and, as such, am always wary of esoteric, custom-designed measures of financial performance, such as FFO.

(Effectively, FFO excludes capital expenditure and purchase of PP&E, so I consider FFO to be inadequate a measure in isolation because, as a business owner, what interests me most is the amount of Free Cash Flow that falls to the bottom of the financial statements.)

So if I look at the historical relationship between SCG's FCF and dividends, on a per share basis it looks as follows:




As can be seen, the dividend has been meaningfully underfunded, in terms of organic capital generation.

If you add up the numbers, you will see that cumulative FCF over that period was just 55cps.

So SCG has essentially paid out in dividends and amount double the FCF it has generated.

So how has this 54cps dividend funding shortfall been financed?

You might have guessed it... with increasing borrowings, which have gone from $11bn (Net Debt) @ 31 Dec 2015 to $13.6bn @ 31 Dec 2019.

[Do the numbers: that $2.6bn increase in Net Debt equates to the bulk of the missing 50cps; the remainder comes from asset sales.]

So that's the dynamic which has been at work for the past 5 years (incidentally, SCG is not alone in this, several REITs have been doing the same thing.)

Of course, the question is how sustainable is this trend of increasing borrowings to maintain the dividend?

The answer is that it isn't.

The reason it has been able to occur is because it has been "supported" by increasing property valuations, thanks in great part to the secular fall in interest rates over the past decade which, as you know, has fed into lower cap rates.

But there is a limit to which that magic valuation rubber band can stretch.

And that limit would have been reached at some point soon, with the result being the requirement to re-base the dividend a lot lower than it had been.

Covid merely brought forward that inevitability, in my view.


So I think you are correct in being wary about maintaining significant holdings in REIT's.

For there is a bit of a value-trap air about them, I sense, and I believe that lockdowns are masking the real underlying flaws in the investment thesis.

.