With the stock market having gone into a bit of a tailspin last year, finding a high dividend yield investment has become far easier. Traditionally, elevated levels of shareholder payouts are a sign of unsustainability. But that isn’t always the case. And when looking at the real estate sector today, lucrative income opportunities seem to be all around.
Generally speaking, one of the most popular ways to build a passive income with property is through buy-to-let. And an investor capable of identifying prime undervalued residential real estate can make a fortune.
However, this approach comes with quite a few headaches, especially if dealing with unreliable tenants. Not to mention the hassle of repaying a mortgage in a rising interest rate environment. And to top it off, the British government seems to be making life harder by steadily increasing taxes.
Fortunately, there is an alternative. Buying shares in a real estate investment trust (REIT) virtually achieves the same result. Some 90% of net rental earnings are returned to shareholders via dividends resulting in a high yield. And individual investors can even tap into the opportunities within the industrial property segment, such as warehousing. What’s more, investing through a Stocks and Shares ISA means all this dividend income is tax-free.
High-yield real estate investments
With interest rates on the rise, the valuation of properties has been steadily falling in the last 12 months. And that’s added quite a bit of pressure to the share prices of most real estate stocks.
But this price retraction has helped elevate the average dividend yield to tasty levels. And two warehouse operators that seem to be thriving are Londonmetric Property (LSE:LMP) and Warehouse REIT (LSE:WHR).
Both UK stocks are down by around 35% compared to a year ago. Yet their yields stand tall at 5.4% and 6.1% respectively. So the next question is, is this payout sustainable? Yes. Or at least, that’s the impression their cash flows give.
Remember, REIT dividends are paid out of free cash flow generated from rental income. Both businesses cater to established enterprises rather than consumers. And the deeper pockets of their customers paired with longer multi-year contracts provide greater income reliability compared to the residential real estate sector.
That’s why despite both shares dropping by double digits, the rental cash flow that funds dividends have actually been growing. So much so, that in November 2022, both businesses actually increased shareholder payouts, driving the dividend yield even higher.
Taking a step back
The recent tumble in real estate prices is undoubtedly creating lucrative opportunities for patient long-term investors. However, like any investment, it’s not risk-free.
Economic forecasts predict that the UK is likely heading into a recession. And if it turns out to be quite severe, the risk of customers defaulting on their rental payments goes up. After all, recessions don’t exactly provide an ideal selling environment for businesses.
Needless to say, this could compromise REIT investors’ rental income. And, consequently, today’s lofty yields could get slashed. Nevertheless, the impressive track records of both Londonmetric Property and Warehouse REIT make me cautiously optimistic. And while their stock prices may endure further volatility, the long-term passive income potential makes it a risk worth taking, in my opinion.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
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Zaven Boyrazian has positions in Warehouse REIT Plc. The Motley Fool UK has recommended LondonMetric Property Plc and Warehouse REIT Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
Motley Fool UK 2023