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When it comes to earning a second income through property, there’s a lot to like about real estate investment trusts (REITs). And Segro (LSE:SGRO) is a particularly interesting example.
The FTSE 100 firm owns and leases a portfolio of warehouses and light industrial properties. And it comes with a 4.5% dividend yield, which has the potential to be very attractive.
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What makes a good REIT?
There are two things I look for in a good REIT. The most obvious is strong demand – empty buildings create maintenance costs and don’t generate rent, which is something to avoid.
The second thing is less obvious, but a strong balance sheet is something I pay close attention to. This is important for any company, but especially so when it comes to REITs.
Unlike other firms, real estate investment trusts have to pay out the cash they generate in the form of dividends. This is partly what makes them attractive passive income investments.
The downside to this is it means they can’t use that cash to acquire new properties. So to do this, they typically have to sell equity in the business, or take on debt.
The basic ambition for most REITs is to raise capital at one rate and then buy properties they can lease at a higher rental yield. And the balance sheet is key to this.
A strong financial position means lower borrowing costs, which results in more opportunities and wider margins. That’s why I’m very focused on the financials when it comes to REITs.
How does Segro shape up?
According to Segro’s latest update, occupancy levels are stable at around 94% of the portfolio. That’s a positive sign in terms of demand for its properties, but there are some risks to consider.
It’s worth noting that strong demand for warehouses has encouraged more supply. While Segro thinks its properties are uniquely well-located, increased competition is a potential threat.
Equally, its largest customer is Amazon, which is both a strength and a weakness. I think the risk of a rent default is relatively low, but increasing prices over time won’t be easy.
The balance sheet, however, is where Segro really stands out. And a good way to illustrate this is by comparing it with LondonMetric Property – another FTSE 100 REIT that I think highly of.
Segro has a lower loan-to-value ratio (28%) than LondonMetric Property (33%). And this results in a lower average cost of debt (2.5% vs. 4%).
I think investors need be careful not to underestimate the significance of this. Lower borrowing costs should be a big advantage when it comes to future growth opportunities.
Dividends
Over the last 12 months, Segro has distributed 29.3p per share to investors as dividends. That means 3,412 shares could generate £1,000 per year in passive income.
That’s an investment of just over £22,000 at today’s prices, which is a lot. Furthermore, I certainly don’t think someone looking to start building a portfolio should focus all their attention on one stock.
As part of a diversified portfolio, however, I think Segro could be a good stock to consider. And reinvesting dividends could be a great way of adding more shares over time.
