Resource Capital: 14% Dividend Yield Is Nice, But I’m Putting This One On Ice

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Resource Capital Corp. (NYSE:RSO) is a REIT that focuses on originating, underwriting, and investing in transitional commercial real estate loans, or bridge loans. While it is not categorized as an mREIT, it does have very similar characteristics. It provides financing primarily to borrowers in multi-family, office, retail, and hotel properties. It is externally managed by Resource Capital Manager Inc., a subsidiary of Resource America Inc., which manages over $17 billion in assets within comparable sectors as of 12/31/2013.

When Looking for Higher Yields, STOP! And Proceed with Caution

Where to find yield

The recent increase in rates has made it easier to find better yielding investments in what is still a historically low interest rate environment. Investors looking for yield in their portfolios have until recently found it very difficult to find any securities with yields that exceed the rate of inflation. For investors with a fixed income, the dearth of high yielding investments meant a loss of purchasing power over time.

Now that interest rates are higher and inflation has remained muted, opportunities are springing up in several different asset classes. But investors should be wary of investing in a security simply for the yield it offers. Some securities may be offering a high yield not because the dividend or coupon is growing, but rather, the price of the security has been dropping. (Yield=Dividend/Price) And if that’s the case, trouble may be lurking.

The common income producing sectors include: dividend paying stocks, real estate investment trusts (REITs), master limited partnerships (MLP’s), convertible bonds, high yield bonds, municipal bonds, preferred stock, and utility stocks. Each one of these sectors has different characteristics with its own set of drivers. For example, convertible bonds have components of both equities and fixed income; high yield bonds can not only be impacted by changes in interest rates but are also driven by default rates and the credit quality of the issuer; and REITs span a variety of sub-sectors that can be influenced by consumer spending, interest rates, ageing population, and others. (In a previous article, we wrote about REITs that are attractive in a rising rate environment)

Before an investor pulls the trigger on any one or several yield plays for their portfolio, they should make sure to do some homework on the fundamentals of both the sector and company. The following three factors can go a long way to preventing any headaches.

Sector/Industry Analysis – Make sure to understand the sector or industry the company is in and how the company actually makes money. If you can’t figure out what product or service the company offers and how they get paid for it, avoid it altogether. If you do understand it, does it make sense? Is it a product or service in demand in this environment or is it one of those products that is immune to the economic cycle? (diapers, groceries, to name a few) Once there is a certain level of comfort with the company, take a look at the financials.

Financial Stability – make sure the company will be around long enough to pay dividends. A current ratio above 1 is good and the higher the better. The interest coverage ratio indicates how well the company can cover its interest expenses on debt. And debt/equity should be low enough to provide enough comfort that the company is not too highly leveraged. Note: it is better to compare debt/equity relative to other companies in the same sector. Because of the nature of certain businesses, some companies may appear to have very high debt/equity compared to companies in other industries, when in fact, it is normal for the industry it operates in. For example, industrial companies may have much higher debt than the average technology company. Keep that in mind.

Earnings Potential – this measure often has to do with how well management is able to not only generate revenue but drive profitability through efficiencies, cost-cutting, or strategic maneuvering. Some common metrics to evaluate are revenue growth, operating margins, EBITDA (earnings before interest, taxes, depreciation, and amortization), and net margin. Most finance websites have these metrics easily available (i.e. Google, Yahoo, etc.). These metrics should also be evaluated relative to competitors in the same industry. For dividend paying stocks, another factor to consider is the amount of the dividend relative to earnings. A dividend that is too high relative to earnings may be in danger of being reduced. This is called the payout ratio. A low payout ratio may indicate the potential for an increase in the dividend. A high payout ratio could indicate a possible reduction.

Mutual Funds and ETF’s

For investors not comfortable investing directly in individual securities, there are a variety of mutual funds and exchange traded funds (ETF’s) that focus on yield. Some examples include: Vanguard REIT ETF (VNQ), Alerian MLP (AMLP), SPDR Barclays Convertible Securities ETF (CWB), and iShares Select Dividend ETF (DVY), to name a few. For additional ideas, check out Where to Find Great Yields.

Stop, Think, Yield

Before jumping into a bad investment looking for high yield, take a step back and think about whether it makes sense that the security you are considering is paying a high yield. If it doesn’t make sense, it’s probably too good to be true. Be patient. As interest rate rise, some of the income producing sectors may be adversely impacted in the short-run but the light at the end of the tunnel is that as rates rise, more high yielding opportunities should become available.