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Is City Office REIT, Inc. (NYSE:CIO) A Smart Pick For Income Investors?

Simply Wall St

Is City Office REIT, Inc. (NYSE:CIO) a good dividend stock? How can we tell? Dividend paying companies with growing earnings can be highly rewarding in the long term. Yet sometimes, investors buy a stock for its dividend and lose money because the share price falls by more than they earned in dividend payments.

With a five-year payment history and a 7.2% yield, many investors probably find City Office REIT intriguing. It sure looks interesting on these metrics - but there's always more to the story . Some simple analysis can offer a lot of insights when buying a company for its dividend, and we'll go through this below.

Explore this interactive chart for our latest analysis on City Office REIT!

NYSE:CIO Historical Dividend Yield, August 16th 2019

Payout ratios

Companies (usually) pay dividends out of their earnings. If a company is paying more than it earns, the dividend might have to be cut. Comparing dividend payments to a company's net profit after tax is a simple way of reality-checking whether a dividend is sustainable. While City Office REIT pays a dividend, it reported a loss over the last year. Paying out a majority of its earnings limits the amount that can be reinvested in the business. This may indicate a commitment to paying a dividend, or a dearth of investment opportunities.

The company paid out 89% of its free cash flow as dividends last year, which is adequate, but reduces the wriggle room in the event of a downturn.

City Office REIT is a REIT, which is an investment structure that often has different payout rules compared to other companies. It is not uncommon for REITs to pay out 100% of their earnings each year.

Is City Office REIT's Balance Sheet Risky?

As City Office REIT has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A rough way to check this is with these two simple ratios: a) net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and b) net interest cover. Net debt to EBITDA is a measure of a company's total debt. Net interest cover measures the ability to meet interest payments. Essentially we check that a) the company does not have too much debt, and b) that it can afford to pay the interest. With net debt of 8.60 times its EBITDA, City Office REIT could be described as a highly leveraged company. While some companies can handle this level of leverage, we'd be concerned about the dividend sustainability if there was any risk of an earnings downturn.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. With EBIT of less than 1 times its interest expense, City Office REIT's financial situation is potentially quite concerning. Readers should investigate whether it might be at risk of breaching the minimum requirements on its loans. Low interest cover and high debt can create problems right when the investor least needs them, and we're reluctant to rely on the dividend of companies with these traits.

Remember, you can always get a snapshot of City Office REIT's latest financial position, by checking our visualisation of its financial health.

Dividend Volatility

One of the major risks of relying on dividend income, is the potential for a company to struggle financially and cut its dividend. Not only is your income cut, but the value of your investment declines as well - nasty. City Office REIT has been paying a dividend for the past five years. Its most recent annual dividend was US$0.94 per share, effectively flat on its first payment five years ago.

It's good to see at least some dividend growth. Yet with a relatively short dividend paying history, we wouldn't want to depend on this dividend too heavily.

Dividend Growth Potential

Examining whether the dividend is affordable and stable is important. However, it's also important to assess if earnings per share (EPS) are growing. Over the long term, dividends need to grow at or above the rate of inflation, in order to maintain the recipient's purchasing power. It's good to see City Office REIT has been growing its earnings per share at 52% a year over the past 5 years. A majority of profits are being paid out as dividends, which raises the question of what happens to the current dividend if earnings decline. However, the rapid growth in earnings may indicate that is less of a risk.

We'd also point out that City Office REIT issued a meaningful number of new shares in the past year. Regularly issuing new shares can be detrimental - it's hard to grow dividends per share when new shares are regularly being created.

Conclusion

Dividend investors should always want to know if a) a company's dividends are affordable, b) if there is a track record of consistent payments, and c) if the dividend is capable of growing. First, we think City Office REIT is paying out an acceptable percentage of its cashflow and profit. Second, the company has not been able to generate earnings growth, and its history of dividend payments too short for us to thoroughly evaluate the dividend's consistency across an economic cycle. In sum, we find it hard to get excited about City Office REIT from a dividend perspective. It's not that we think it's a bad business; just that there are other companies that perform better on these criteria.

Earnings growth generally bodes well for the future value of company dividend payments. See if the 6 City Office REIT analysts we track are forecasting continued growth with our free report on analyst estimates for the company.

If you are a dividend investor, you might also want to look at our curated list of dividend stocks yielding above 3%.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.