Tenant quality is important when it comes to real estate investment trusts (REITs). Easterly Government Properties (DEA -0.36%) has a lock on some of the highest-quality tenants around -- the U.S. government and government agencies. And yet the stock has sold off over the past year, pushing the dividend yield to a historic high of 7.5%. What's going on?
Business basics
Easterly owns a portfolio of 86 properties, covering 8.7 million square feet spread across the United States. Office assets make up around 62% of the portfolio, outpatient properties 20%, lab space 6%, and courthouses 4%, with a fairly sizable "other" category rounding things out to 100%. The average remaining lease term is a pleasing 10.3 years, and occupancy is solid at 98.8%.
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As noted, almost all of the property in the portfolio is leased to either the U.S. government or a U.S. government agency. These are some of the highest-quality tenants that a REIT could hope for. That said, management doesn't buy properties willy-nilly -- it is specifically looking for well-located, young buildings with direct tenants that are growing.
From a foundational view of things, the REIT's business model seems fairly attractive. And yet the stock has sold off by about 30% over the past year, pushing the yield sharply higher. It is likely that investors are worried that Easterly won't be able to sustain its dividend.
Follow the money
From a top-level view, such concerns seem overblown. In 2022 Easterly generated funds from operations (FFO) of $1.27 per share. The dividends paid during the year added up to $1.06 per share. That results in an FFO payout ratio of around 83%. That's not at all unreasonable for a REIT, which has to pay out at least 90% of taxable earnings.
However, when you dig a little further, you'll see that Easterly also offered up another figure called cash available for distribution (CAD). Essentially, taking into account other expenses that are necessary, this is the amount left over that could be paid out as dividends. According to the company, CAD in 2022 totaled $108.5 million. If you go the annual report and look at the cash flow statement, you'll see that the company paid out total dividends of $109.2 million last year.
That comparison makes the dividend look a lot less secure. Now consider the guidance that Easterly provided for 2023, in which it is projecting FFO between $1.11 and $1.14 per share. That represents a year-over-year drop of as much as 12.5% and would push the FFO payout ratio up to 95% at the low end of guidance. There's a lot less room for adversity in that payout ratio than its 83% in 2022. And while the company didn't provide formal guidance for CAD, the FFO drop it is projecting would clearly make covering the dividend more difficult, not easier.
Not as strong as it seems
It would be hard to suggest that shares of Easterly Government Properties would be a massive risk for investors. Given its business model, that just isn't likely to be the case. However, the historically high yield is a warning that Wall Street has concerns about the safety of the dividend. And indeed, a dividend cut isn't as far-fetched as it might seem when you consider the FFO guidance and the CAD numbers for 2022. In the end, dividend investors looking to live off of the dividends their portfolios generate should probably tread with caution here.
