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I bought this 6.4% dividend-yielding stock to grow my passive income

a couple embrace in front of their new home

Growing a passive income portfolio has several benefits, including valuation support in times of economic slowdown, income stability and the opportunity to reinvest dividends.

When a dividend-paying company sees its shares (and valuation) trend lower while maintaining its dividend, thereby increasing the yield, the market is anticipating a dividend cut at some point in the future. 

This is precisely what is happening with Barratt Developments (LSE:BDEV). However, I believe the dividend is unlikely to be paused — and if it is cut in the future, I do not believe it is likely to go below 4% (it’s currently 6.4%).

Why is the market pricing in a dividend cut?

Homebuilder profits are directly tied to home prices, production volume and building costs such as labour and raw materials that determine profitability. Home prices are driven by:

  1. Demand – mortgage rates (currently at 4.38%), average incomes and population growth.
  2. Supply – volume of new homes being built. 

Mortgage rates are likely to be much higher in 2023 than in 2021 or 2020, which is expected to cause a correction in UK house prices because a decrease is required to maintain payment affordability for home buyers.

Lower house prices will result in lower future profits for homebuilders like Barratt Developments, but this entirely depends on the rate of decrease in average house prices.

Despite negative sentiment towards homebuilders, the UK is still suffering from an undersupply of new homes as the target of building 300k (as per the Conversative party manifesto) new homes is far from being met.

Net new dwellings in 2021 was below pre-pandemic levels — according to the Department for Levelling Up, Housing and Communities — at around 220k. 2022/23 figures are expected to be higher, but they do not appear to be on target to reach 300k by the middle 2020s according to industry specialists.

Therefore, I would argue house prices will see some level of price support in a correction, unlike in the 2008 financial crisis. Furthermore, analyst estimates suggest a growing dividend over the coming years with annual distributions of 39p (FY22), 45p (FY23) and 51p (FY25).

Even if these estimates are reduced by 40% as a result of margin pressure and lower house prices, the dividend yield would still be relatively attractive at over 4% (18p+) given Barratt Developments’ investment-grade balance sheet and long-term potential.

Balance sheet built for recession 

As of 31/12/2021, Barratt Developments had over £1.33bn in cash and cash equivalents, meaning the £300m paid in dividends last year could easily be maintained. Barratt Developments comfortably covers its LT debt of £208m, thereby significantly reducing bankruptcy risk.

One area of weakness on the balance sheet is inventory, which is marked at £4.9bn. In a housing correction the value of this inventory could easily be marked down, resulting in additional losses or a more severe dividend cut.

Conclusion

Overall, I believe the market has already significantly de-risked Barratt Developments’ market capitalisation, making today’s valuation of £4.6bn attractive enough to open a small position.

I agree the current economic situation is likely to negatively impact UK house prices over the coming quarters, which is likely to result in earnings revisions and lower price targets.

Therefore I have only opened a small position, with the idea of averaging down as negative news and recession data mounts over the coming 12 months.

The post I bought this 6.4% dividend-yielding stock to grow my passive income appeared first on The Motley Fool UK.

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George Theodosi has a position in Barratt Developments. The Motley Fool UK has no position in any of the shares mentioned. 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.