KBWY: Continued Risk For Dividend Cuts And Share Price Decline (NASDAQ:KBWY)

Investment Thesis

Invesco KBW Premium Yield Equity REIT ETF (NASDAQ:KBWY) is a strong sell due to the unsustainability of its high dividend yield and the quality of the REIT holdings contained within the fund. These negative factors have historically resulted in a considerable decline in share price and will continue to pressure the fund lower. Alternatively, I favor Vanguard’s VNQ fund due to its more sustainable dividend yield, higher quality REIT holdings, and relatively low expense ratio.

KBWY Overview and Compared ETFs

KBWY is a passive exchange-traded fund that seeks to track the KBW Nasdaq Premium Yield Equity REIT Index. This index uses a modified dividend yield-weighted strategy and therefore favors REITs with the highest dividend yield. With its inception in 2010, the fund has 31 holdings and $191M in AUM. KBWY consists of predominantly small-cap REITs at 92.6% weight, along with some mid-cap holdings (7.4% weight).

For comparison purposes, other funds examined are Global X SuperDividend REIT ETF (SRET), Invesco Active U.S. Real Estate Fund ETF (PSR), and Vanguard Real Estate Index Fund ETF Shares (VNQ). SRET has similar negative characteristics to KBWY in that it seeks to capture the highest dividend yield REITs without necessarily considering other qualities such as payout ratio and growth. PSR was selected as it is an actively managed ETF to show its performance in comparison to the other passive funds. Finally, VNQ is the most diversified fund that passively captures a mix of REIT holdings with the objective of achieving income and some growth.

Fund Comparison: Performance, Expense Ratio, and Dividend Yield

KBWY’s average annual return over the past five years has been -2.44% along with a total price return of -43.9%. The fund saw a major drawdown at the onset of the COVID pandemic, but unlike other sectors of the U.S. market, the fund never quite recovered. SRET, which also seeks the highest dividend REITs, has seen an even worse performance with an average 5-year return of -7.78%. In contrast, PSR and VNQ have performed better with 5-year average returns of 3.23% and 2.88% respectively.

KBWY’s dividend yield is the most attractive quality for the fund. With a yield of 8.87%, KBWY offers the highest dividends of REIT ETFs compared. However, as we dig deeper, we see a negative growth rate for its dividend at a -5.59% CAGR over the past five years. Additionally, as I will cover later, there are reasons to suspect that KBWY’s dividend is unsustainable. KBWY also has a relatively low expense ratio of 0.35%. However, VNQ is even cheaper at 0.13%.

Expense Ratio, AUM, and Dividend Yield Comparison

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Source: Seeking Alpha, 18 Jun 24

KBWY Holdings and Key Outlook Factors

Because KBWY focuses on REITs with high dividends, the fund’s top holdings consist of Global Net Lease, Inc. (GNL) with a whopping 15% dividend, and Gladstone Commercial Corporation (GOOD) with an 8.52% dividend. However, as I will discuss later, there are reasons to question the sustainability of many of KBWY’s top dividend producers. Both GNL and GOOD are diversified REITs, but KBWY also includes other REIT types such as Healthcare Realty Trust Incorporated (HR).

Top 10 Holdings for KBWY and Compared REIT ETFs

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Source: Multiple, compiled by author on 18 Jun 24

Looking forward, there are multiple reasons why KBWY is postured to perform poorly. The first is that while its top REITs have high dividend yields, they also have very high payout ratios. The second concern is that KBWY’s REITs also have poor growth characteristics. Both these factors are discussed below as well as the overall REIT market outlook.

Dividend Sustainability and Payout Ratios

The first concerning factor for KBWY is that its top holdings have high payout ratios, indicating concerns about dividend sustainability. REITs do typically have a substantial dividend yield, as they are required to pay out 90% or greater of their taxable income back to shareholders. However, if its payout ratio, or the portion of dividends relative to the company’s net income, is too high, it could result in low growth and potential dividend cuts. As listed in the table below, some of KBWY’s top holdings have a payout ratio even greater than 100%, raising the likelihood that its dividends will be cut.

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Source: Multiple, compiled by author on 18 Jun 24

In contrast to KBWY, other funds have lower average payout ratios. For example, Invesco’s PSR fund has seen a weighted average payout ratio of about 71% for its top 10 holdings, notably lower than KBWY. As stated, a lower payout ratio typically is directly linked to greater sustainability. Interestingly, KBWY has seen a negative 5-year dividend CAGR of -5.59% while PSR’s dividend yield has been growing with a 5-year dividend CAGR of 7.73%.

REIT Selections and Quality

The second major red flag stems from KBWY’s selection of holdings. Due to its prioritization of REITs that offer high dividends, the fund does not focus on either growth or REIT-type diversification. For a REIT, an important factor is its adjusted funds from operations, or AFFO, which is the cash available for distribution. GNL, KBWY’s #1 holding, has seen a 5-year AFFO CAGR of -7.98%. KBWY’s #2 holding, GOOD, has also seen negative AFFO growth with a -4.02% CAGR over the past 5 years. In contrast, American Tower Corporation (AMT), a top holding in PSR and VNQ has seen a 5-year AFFO CAGR of 4.32%. Prologis, Inc. (PLD), another top holding for PSR and VNQ, also has seen solid growth with a 5-year AFFO CAGR of 7.96%. A fund that has inconsistent or negative AFFO is a red flag.

The other drawback is KWBY’s selection methodology leading to sub-optimal REIT diversification. While VNQ, for example, includes a wide mix of retail REITs (13.3% weight), telecom tower REITs (11.9% weight), and industrial REITs (11.50% weight), KBWY merely includes the highest dividend producers regardless of their REIT-type. Therefore, while AFFO growth over the past five years is rearward-looking, high payout ratios and lack of REIT-type diversification for KBWY are likely to perpetuate this low growth looking forward.

REIT Outlook and Interest Rates

Although KBWY demonstrates multiple red flags and peer funds have not performed well recently, there are reasons to be optimistic about REITs looking forward. This is particularly true given that most economists predict the U.S. Federal Reserve to make an interest rate cut later this year. Such cuts have historically been a strong positive factor for REITs. In the four quarters after fed tightening, REITs have trended towards outperformance, compared to equities and private real estate.

In addition to an interest rate cut later this year, four more cuts are expected in 2025 with another four in 2026. This would lower the federal rate down to almost 3%. While it seems unlikely to me that REIT ETFs will suddenly outperform the S&P 500 by multiple percentage points as indicated in the figure above, it is realistic that PSR and VNQ will see stronger than normal performance as interest rates are lowered. This performance is due to the AFFO growth of their individual holdings. However, due to KBWY’s REIT selection strategy, its negative growth, and its high payout ratio, I do not expect the fund to see a turnaround in performance even as interest rates are lowered.

Current Valuation

Consistent with 5-year performance metrics, KBWY and compared REITs have all had a challenging past year. Only PSR and VNQ have managed a positive price return. However, I attribute this poor performance due to the elevated interest rate environment we have been seeing. VNQ’s long-term performance since its 2004 inception has been 7.21%. Additionally, PSR’s return since 2008 has averaged over 12%. Both funds have strongly outperformed KBWY. Therefore, I see VNQ and PSR’s recent performance as a temporary dip versus a long-term trend.

Examining price-to-earnings and price-to-book ratios for KBWY and peer funds, KBWY and SRET are more favorably valued. However, I see this as a direct result of their poor AFFO growth and share price. While PSR and VNQ both have relatively high P/E ratios, I consider them more favorable buying opportunities due to their stronger fundamentals discussed earlier.

Valuation Metrics for KBWY and Peer Competitors

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Source: Compiled by Author from Multiple Sources, 18 Jun 24

Risks to Investors

REITs have been thought of as an asset class that offers diversification from other stocks and bonds. While this can be substantiated by their beta values and standard deviations, REITs are not without risks. Typically, interest rates are the primary risk factor as REITs as sensitive to interest rate changes. However, this risk is mitigated by the likelihood of an interest rate reduction later this year. The second major risk factor is the risk of real estate values declining. While residential real estate is unlikely to significantly drop due to current demand, commercial real estate faces greater risks. Vacancies and hybrid work schedules have driven office vacancies to almost 17% last year. Such vacancies and reduced demand result in commercial real estate values declining. REIT funds, such as VNQ and PSR, mitigate this risk factor by diversifying with data centers, industrial, self-storage, and even timber REITs.

Concluding Summary

While KBWY offers an alluringly high dividend yield, it has multiple red flags. Its high dividend payout ratio on average along with negative AFFO growth will likely lead to further share price decline and potentially dividend cuts. Although REITs may perform well in periods of lowering interest rates, as historical data indicates, KBWY warrants a sell rating. Alternatively, I prefer VNQ or possibly PSR which have more sustainable payout ratios and REIT holdings that are experiencing growth characteristics.