Stocks with high dividend yields can be alluring. That's because they enable investors to make more income on each dollar invested. For example, $10,000 invested into a stock with a 10% dividend yield would produce $1,000 of annual dividend income. For comparison, $10,000 invested in the S&P 500, which yields 1.6%, would only produce $160 of annual dividend income.
Unfortunately, an ultra-high-yield dividend is often a warning sign that the market doesn't believe the company can sustain its payout. That is the case for office REITsBrandywine Realty Trust(NYSE: BDN) and Office Income Properties(NASDAQ: OPI), which have double-digit dividend yields.
The first of many cuts
Office REITs have been under tremendous pressure since the pandemic. Many employees now work from home, either 100% remotely or in a hybrid setting. That means companies don't need as much office space as they once did. That's putting downward pressure on occupancy levels and rental rates. On top of that, rising interest rates to combat inflation will cause REITs to pay more in interest this year, either because of floating rate exposure or an upcoming maturity.
Because of these dual headwinds, we've already seen one dividend casualty in the office REIT sector. SL Green Realty(NYSE: SLG) cut its monthly dividend payment by 12.9%. That broke a streak of 11 straight years of dividend increases from Manhattan's largest office landlord. SL Green opted to cut its dividend payment to better align it with its projected funds available for distribution in the coming year. That will improve its liquidity as it reduces debt to mitigate the impact of surging interest rates on its floating-rate debt. That reduction pushed SL Green's dividend yield down to 8%.
More cuts could be coming to office REITs
Several other office REIT dividends are at risk of a reduction in 2023. The two the market sees most likely to cut their payouts are Brandywine Realty and Office Income Properties, given their current yields of 11.9% and 15.2%, respectively.
Brandywine Realty recently declared its fourth-quarter dividend payment of $0.19 per share, flat with its third-quarter level. However, the market has concerns about its ability to maintain that level, given its high payout ratio, capital needs, and balance sheet.
For 2022, Brandywine anticipates its payout ratio will be between 84% and 95% of its cash available for distribution. Because of that high level, it's funding the bulk of its $70 million of investment and capital spending through its available cash and its line of credit. As a result, it expects to end this year with only $311 million of liquidity.
Meanwhile, higher interest rates are starting to impact the company. It only fixed about 72% of its debt, exposing it to higher rates on its floating debt. In addition, it's getting a lot more expensive to refinance. For example, the company recently raised $350 million to redeem debt that matures next February. The legacy debt has a 3.95% interest rate, while the new borrowings have a rate of 7.55%. With its interest expenses rising and an already high payout ratio, Brandywine's big-time dividend seems likely to be reduced next year.
With an even higher yield, the market is even more certain that Office Income Properties' dividend is heading lower. That view comes even though the office REIT's payout seems to be on solid ground at first glance. It had a reasonable dividend payout ratio of 67% over the past year, has an investment-grade credit rating, primarily fixed rate debt (94.4%), and over $600 million of liquidity.
However, a significant portion of Office Income Properties' leases will expire over the next few years (14% in 2023 and 14.4% in 2024). That means its occupancy level could fall, affecting its rental income. The REIT also has a sizable amount of debt maturing over the next two years ($208 million in 2023, which is 9% of its total, and $350 million in 2024). With interest rates rising, its interest expenses will likely increase as this debt matures, and it needs to refinance at higher rates (its current weighted average interest rate is 3.9%). These issues could force the REIT to reduce its dividend to retain more cash for capital improvements and debt reduction.
Not the best stocks for steady passive income
Office REITs are facing growing headwinds from lackluster leasing demand and higher interest rates, which could put more pressure on their cash flows and balance sheets. And more office REIT dividends could be on the chopping block in 2023, including the big-time payouts of Brandywine Realty and Office Income Properties. Given that likelihood, income-focused investors should steer clear of these office REITs.
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Matthew DiLallo has positions in SL Green Realty. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
