Trusting the wrong person can cost you a lot of money.
Millions of unfortunate investors found that out the hard way last year when the cryptocurrency exchange FTX collapsed.
When crypto prices cratered and investors tried to get back what little they had left in FTX, they found out that even that had been stolen. As a result, FTX is now being described as one of the largest Ponzi schemes ever.
To brush up on the technical definition, a Ponzi scheme is a case of fraud in which money from new investors is used to pay off older investors who were promised investment returns that are too good to be true. Meanwhile, the con man running the scheme steals investors’ money for themselves.
It works as long as new investors keep pouring money in.
One of my readers responded to last Friday’s Intelligent Income Daily and asked me if real estate investment trusts (REITs) are a Ponzi scheme. After all, REITs pay large dividends that yield more than regular companies.
And they frequently issue new shares. Some even have “ATM” programs that allow them to continuously issue shares at market prices.
Are REITs using new investors’ money to pay oversized dividends to their old investors like a Ponzi scheme?
Here at the Intelligent Income Daily, my team and I are focused on finding the safest income investments on the market. We frequently recommend REITs and I am currently writing the book REITs for Dummies, so it’s safe to say we don’t think they are Ponzi schemes.
But you shouldn’t just take our word for it. It’s important to understand for yourself how these investments work so you can sleep well at night and not wonder if you’ll wake up to find your money gone in the blink of an eye.
So today, I’ll explain why REITs are not Ponzi schemes and show you how the issuance of new shares is an important tool to help REITs keep growing.
Money Flow Explained
A classic Ponzi scheme pays investors back with their own money without actually making any real investments and promises returns that are too good to be true.
That’s not the case with REITs, which actually invest in real estate and collect rent. While their dividends tend to be higher than average, they are not outlandish like the 50%+ promised in Ponzi schemes. Instead, REITs often yield between 3-8%, similar to high-yield corporate bonds.
But what about all those shares they keep issuing? Isn’t that a red flag?
Not necessarily. You see, REITs have a unique structure that legally forces them to pay out 90% of their taxable income in dividends.
That means that there’s very little money left over to reinvest. So if REITs want to grow their portfolio, they have to either raise more money or sell some of the real estate they own to recycle the capital into better opportunities.
The key here is that share issuance is for growth, not to keep paying dividends to investors with their own money – that’s already covered by the rental income they receive from their properties.
Let me give you an example.
Last year, Realty Income (O) made one of its biggest deals ever by agreeing to buy the Encore Boston Harbor Resort and Casino for $1.7 billion. The initial capitalization rate was 5.9% – that means that the property would generate about $100M (5.9% of $1.7 billion) in operating income.
Realty Income’s capital structure is approximately two-thirds equity, one-third debt. Between the dividend yield for newly issued shares and the interest rates for new debt, the company’s weighted average cost of capital last year was approximately 4.2%.
Clearly, the 5.9% return on investment more than covered the 4.2% cost of issuing new shares and adding new debt to finance the deal. And the 1.7% spread of excess cash flow could be used to increase dividends for all shareholders or to pay for new deals.
This shows how issuing shares to buy new properties results in increasing, incremental benefits for all Realty Income shareholders over time. But there are also some secondary effects of growing a REIT’s portfolio:
- Increasing the diversification reinforces the safety of the income stream in case one of its properties loses a tenant.
- Larger REITs have the opportunity to do more and potentially bigger deals.
- As REITs grow larger and improve in quality, their credit rating tends to improve and they get access to lower-cost debt.
As you can see, this virtuous cycle actually improves safety and potential returns for investors.
Now, I’m not recommending buying Realty Income shares today. It is a fantastic company, but not within range of a good bargain deal at this time.
But Realty Income is the perfect example to show how REITs can issue shares in order to pursue opportunities that benefit all shareholders, and why they are not Ponzi schemes.
Happy SWAN (sleep well at night) investing,
Brad Thomas
Editor, Intelligent Income Daily
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Source: Wide Moat Research