This Stock’s High Yield Is Less Risky Than It First Appears

If you’re searching for high yields, you’re bound to look into real estate investment trusts…

Historically, they’ve offered some of the most attractive yields in the market.

But as we learned in our “prudent yield hog” series a month ago, it’s naïve to just chase high-yielding stocks without doing a little bit of additional work. (Catch up here and here.)

For example, astute investors might hesitate after taking a first glance at Getty Realty (GTY) and its 5.2% yield… They might think the real estate investment trust (“REIT”) is simply offering a “junk” or “sucker” yield.

That’s why it pays to take a closer look. When you do, you’ll see a much better picture…

Getty’s portfolio includes more than 1,000 properties. And I bet you patronize some of its tenants on a regular basis… These operations include car-care centers (Valvoline), convenience stores (7-Eleven), car washes (Zips Car Wash), and more.

Getty leases its properties through “commercial net lease.” In short, that means its tenants pay more than just base rent… They also pay a piece of the taxes, insurance, repairs, capital improvements, and more.

REITs like Getty are “pass-through entities”… They don’t pay taxes. But in exchange for those tax breaks, they must pay out all their profits to shareholders in dividends. They can’t reinvest any portion of their profits to fund future growth.

By contrast, non-REITs must pay corporate income taxes. But their boards of directors can hold some – or even all – of their profits to reinvest for future growth.

So dividends paid to non-REIT shareholders are taxed twice (once to the corporation and then again to shareholders). To soften the double-taxation burden, income from these “qualified dividends” is taxed at lower rates.

REIT dividends aren’t taxed twice. As a result, Uncle Sam taxes these “non-qualified dividends” at higher “ordinary income” rates.

After-tax yields are supposedly balanced by REITs having higher nominal (pretax) yields.

In reality, the actual tax rates of shareholders vary based on individual circumstances. That’s why you should always consult with your accountant or tax adviser for REITs.

Here’s a clear benefit of REITs for certain investors…

If you’re using a tax-deferred account like an individual retirement account, you keep all the income. Any money in these accounts will be taxed when you withdraw funds. But in the meantime, you can earn additional income through reinvesting shares of REITs.

It’s not exactly a “free lunch”… Let’s call it a cheap, tasty snack.

REITs’ yields are also high because they can’t use their profits to fund growth. But that doesn’t mean REITs don’t grow…

At Getty, for example, its “funds from operations” – the source of REIT dividends – and the dividend itself are growing at an annual rate of about 6%.

Acquisition opportunities abound for convenience-oriented properties. Getty acquires new properties by borrowing money or issuing additional shares of stock.

REIT managers know investors hate dilution, though… So they’re especially careful about making sure new operating profits of any acquisitions exceed new capital costs – usually from day one.

Let’s wrap up by considering dividend-payment risk…

Because REITs must pay out all profits as dividends, they can’t retain any cash for rainy days. If profits fall in a bad year, REITs are quicker to trim dividends. For quality REITs, cuts like that tend to be modest and temporary… It’s part of the ebbs and flows of the business.

Plus, Getty holds a distinct advantage over other REITs…

Its convenience-oriented business is stable. Economic downturns and e-commerce aren’t meaningful threats. Everyone will still need to buy basic goods like milk and bread… And they’ll all need to fill up their cars’ gas tanks no matter what happens in the economy.

That’s a big reason why it has been able to raise its dividend every year since 2012.

Inflation is less worrisome here than for many companies, too… Getty’s leases – like many in commercial real estate – call for rents to rise with rising prices and tenant revenues.

Although our Power Gauge system rates the stock as “neutral” today, that’s OK… Capital gains aren’t critical to income seekers. With a stock like Getty, we’re focusing on stability… We want a bigger part of the returns to come from steady cash payments.

In the end, Getty is a great example of a “prudent yield hog” selection.

Good investing,

Marc Gerstein

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