Why are dividends different from property income like rent?

Question

My question should be more like: why dividends are inseparable from the appreciation of a stock's price?

The common explanation is something like:

Stock A pays a $10 (10%) dividend and a share is worth $100. Stock B pays no dividend and is also worth $100/share. If they both grow by 10% at the end of the year, you would have the same return on the both of them. This is because A's prices goes up to $110 and after paying a $10 dividend, A's share price goes down to $100. B's price grows to $110. 100+10=110

Makes sense. But not to me. I don't know why but I can't wrap my head around why the dividend takes money away from the share price. I thought the share price was the price for the piece of the company, and not the money is pays out. Is that not true?

To me, I see a dividend as the same thing as income from renting out a property. If you own a $100k house (assume no mortgage) and you rent it out for $1k/month, your yearly income from the house is $12k (12%). If the price of the house goes up 10%, then you still have the $12k but also $110k house so your total net worth is $122k. But if you (for the sake of argument) just owned the house so that it appreciates in value and did not rent it out, you would be $12k short at a 10% growth. This is because rental income is separate from the value of the house, obviously.

Why are dividends not the same? Why do dividends take money out of share price and not considered income from the company the same way rent is income from property?

As an aside, I understand that stocks that pay dividends are not automatically better than stocks that don't. That isn't my claim. Dividends are irrelevant in determining whether a stock is a solid investment (that is not to say they are irrelevant to your returns, see this calculator).

Answer 1

I will give a counterpoint to Bob Baerker's answer.

When your tenant pays you your rent, it does not decrease the value of your house.

It doesn't decrease the value of the house as a physical asset, but it does decrease the value of the house as a financial asset. When you have a tenant, your house is encumbered by a rental agreement (either lease or month-to-month).

Let's say a buyer is required to assume the rental agreement (keep the tenant on the same terms until they can otherwise be renegotiated). Suppose the tenant pays $1,000 rent for August on August 1.

Just before the tenant pays, let's say the buyer is willing to pay $X for the house. That deal includes the buyer receiving the tenant's August rent payment (because the rental agreement has been assigned to the buyer) and continuing to grant the tenant use of the house for the month of August.

On the other hand, if you sell just after the tenant pays you the rent, then the buyer has the same obligation to grant the tenant use of the house for the month of August, but the buyer does not receive that $1,000. It follows that the buyer is willing to pay $(X - 1,000) for the house.

So, a house and a stock are more similar than they may seem. The economic value of a company includes not only its physical assets but also its claims (loans and deposits, accounts payable and receivable). Likewise, the economic value of a house includes claims like rental agreements, liens, etc.

Whenever there is a contractual discrete cash flow whose recipient is determined by who owns property on a particular date, the market value of that property will drop immediately after that date as a new owner will no longer be entitled to that payment.

The value will exhibit a characteristic sawtooth pattern versus time. Even if the physical attributes are stable, economic value builds up gradually as claims (hopefully) accumulate from profitable use of assets, then jumps down when cash is extracted. In between rent payments, the house value has an extra increasing trend because the tenant is using up the month they've paid for, and the owner's remaining obligation to the tenant is declining.

It would be difficult to demonstrate this empirically with real estate since the property value is not precisely quoted daily and value of one month's rent is likely lost in the noise of illiquidity, but the principle is valid.

Answer 2

Just to give an alternative analogy to the other answers:

Think of a company as being like your bank account. If the bank account has $100 and it earns 10% interest per year:

A) If you decide to keep the interest in the account, then at the end of the year the account has $100 + $10 = $110. This is analogous to a company earning profits of $10 and retaining those profits.

B) If you decide to withdraw the interest in the account, then at the end of the year the account has $100 but you have $10 in cash = $110. This is analogous to a company earning profits and paying them out as dividends. The bank account / company is worth $100 instead of $110 because it now no longer has the extra $10.

If you own a $100k house (assume no mortgage) and you rent it out for $1k/month, your yearly income from the house is $12k (12%). If the price of the house goes up 10%, then you still have the $12k but also $110k house so your total net worth is $122k. But if you (for the sake of argument) just owned the house so that it appreciates in value and did not rent it out, you would be $12k short at a 10% growth. This is because rental income is separate from the value of the house, obviously.

This analogy is incorrect. With the company that doesn't pay dividends, it is still earning the profits of $10, just choosing not to pay them out to shareholders. In your example where you don't rent out the house, you are failing to make any profits at all. These are not comparable scenarios. The correct analogy is that you rent out the house for $12k, but instead of receiving that money as income, you re-invest it into the house (e.g. by improving or enlarging it). If we assume that $12k of improvements results in $12k of extra value on the house, your house is now worth $122k as expected. This is what happens with the non-dividend paying company: the $10 that it fails to pay in dividends is retained in the company and increases its value by "improving" it (by increasing it's cash balance).

Answer 3

What's the difference between dividends and rent?

When a dividend is paid, that cash is removed from the company, decreasing the company's value. For that reason, stock exchanges decrease share price by the amount of the dividend on the ex-dividend date.

When your tenant pays you your rent, it does not decrease the value of your house.

Suppose that share price was not reduced by the amount of the dividend on the ex-dividend date. For ease of discussion, let's pretend that per your example, it's a $10 dividend paid once a year. Everyone would buy your $100 stock at the close the day before the dividend and in the morning, the stock would be $100 before trading opened and the company would owe you $10, to be paid on the Payable Date. Now what's wrong with that picture?

I think that dividends being taxed as income (if received in a non sheltered account) has led to a massive misconception by the public that dividends are income. They're not. They are merely cash flow from the value of your equity positions and in and of itself, a dividend provides zero total return. Only share price appreciation provides total return. Note that this refers to what is happening to share price and in your brokerage account on the ex-div date not the corporate side (dividends come from earnings).

Another Catch 22 issue is the relevance of dividends to one's return. The powers that be often state the S&P 500 has returned X% over some number of years with Y% coming from dividends. Let's pretend that it's 7% (total return) and 2% (average yield). In reality, it all came from share price appreciation.

As previously mentioned, dividends provide zero total return. However, when reinvested, they alter the calculation because now you have additional shares compounding the return when share price appreciates. While it is possible to break these apart by using adjusted share prices, it's a royal headache to do so. An easier way is to just use a DRIP calculator and compare the total return of reinvesting versus not reinvesting. Here's one such calculator. Just understand that all of the gain comes from share price appreciation. If share price drops (actual drop due to selling, not ex-dividend reduction) then there will be negative compounding.

Answer 4

The house example can be appropriately modified, without concerning the actual sale of the property (which is a good example, also), to match the stock market.

The rent the tenant pays is the source of income for the house, not for the owner of the house, in this example. The house is the company, remember! Just like a company that sells widgets would sell $10k worth of widgets, and that would cause its value to appreciate by $10k, the house sells tenancy, and so appreciates in value by the rent paid for it. That's separate from appreciating in value due to the market, or due to capital improvements, or any other reason the value might increase: it's simply an increase from income. So the house is worth $100k, plus the accumulation of rents it has taken in but not yet paid out.

In your example, you immediately take that "dividend" of rent from the house - which is not directly possible with a public company, but only because of SEC regulations. But you could just as easily have taken that money and built an addition, right? Just like any public (or private) company, which has income, can make a similar choice:

• Dividend that income back to the owner(s) - value of company reduces by dividend $
• Make capital improvements - value of company changes based on perceived value of those improvements (could go up, down, or stay neutral)
• Keep cash in reserve - value of company stays neutral

If you did keep the house in a company (as some people do!), then you would have exactly the same math to do - that company's value would decrease each time you took a payout (dividend).

Answer 5

Because a stock and a house are inherently different things. To compare them more meaningfully, consider them in a more equivalent way. The stock is ownership of (part of) a business. That business includes employees (who provide labor) and assets, and generates some amount of profit (or loss). The house is just a house; you need to put it your own time and effort (and money) to maintain it, find tenants, collect rent, pay taxes, etc. You could consider that whole enterprise (the house plus all your associated work) as a company.

If we assume stock A and stock B are both companies whose business is "being a landlord", and they each own one (approximately identical) house, then (a very simplified, not-exactly-realistic, version of) the scenario in your question looks like this:

• Company A owns a $100,000 house (and nothing else) and has no debts/expenses. There are 100 shares of the company, so each share is worth $1000. The tenants pay $1,000 in rent, which is immediately paid to each shareholder as a $10 dividend. The company still owns exactly $100,000 in assets (the house; ignoring depreciation, maintenance, etc.), so each of the 100 shares is still worth $1000.
• Company B owns a $100,000 house (and nothing else) and has no debts/expenses. There are 100 shares of the company, so each share is worth $1000. The tenants pay $1,000 in rent, which the company keeps. The company now owns $101,000 in assets ($100,000 house, $1,000 cash), so each of the 100 shares is now worth $1010.

If I buy a share of company A, I get a piece of ownership of a business that owns a $100,000 house. If I buy a share of company B, I get a piece of ownership of a business that owns a $100,000 house and $1,000 in cash. That additional cash may be paid out as a dividend in the future (bringing Company B in line with Company A), or it may be used for further investment (e.g. buying a second house, improving the first house to increase rent, etc.).

Answer 6

A company's share price is essentially a combination of two things:

1. The value of all the company's assets (its book value), and
2. investors' estimate of the future prospects of the company (is this a "good investment?").

The assets include the cash in the company's bank accounts. When they pay out a dividend, they have less cash in the bank, so their book value drops. If nothing else has changed, it simply makes mathematical sense to decrease the share price accordingly.

In reality, things aren't quite that simple. For some investors, the prospect of receiving regular dividends is what makes a company more valuable than some other similar company. It's similar to the reason why some people buy bonds rather than stocks -- even though the overall returns may be less, the security of receiving payments on a regular basis is valuable in itself.

But at the moment that the company pays out its dividend, these effects can be ignored. It's still the case that the company's assets have been reduced, so no matter what you think about whether it's a good investment, it can't really be as valuable as it was when it had that cash in the bank.

Answer 7

I have once seen the question from another angle that should explain to you why the value decreases and why it has to decrease:

Imagine you've got stock that pays dividend. If dividend is paid once a year, why to buy such stock and keep in it your money for entire year if you could by 1 day before paying out dividend (actually the day it is decided you will get dividend if you hold the stock) and then the next day collect the dividend and sell the stock immediately just to repeat the process next year.

And the answer is - immediately after paying out dividend the stock price drops by approximately the dividend amount just to limit people from earning the money that way.

Going back to renting house example you have used - imagine you rent a house, you've got permanent tenant in it paying the rent and the rent is paid once a year. You can then sell the house along with tenant but it is clear that the value of such transaction will vary over they year. Once it is close to the rent being paid it is higher (approximately by the amount of the rent you will immediately get back) and will be lower when the rent will be paid in longer period. If you think this way it is very logical conclusion the price of such asset (not only being asset but a rented asset) must drop immediately after rent is paid.

Answer 8

Say that you own an LLC that owns a house worth $100k and rents it out for $12k/year like your example. That $12k is revenue for your LLC. Your LLC will have to pay property taxes and for other things like accounting, so let's say you have $7500 cash in the account at the end of the year. And let's say the housing market jumps so the house is now worth $110k.

You could pay yourself the $7500 which would be like a dividend. Now the LLC's only assets are the $110k house.

Another option would be to keep the money in the LLC. The LLC now has has assets of $117,500. You may be saving up to buy a second rental property. Or you could use that $7,500 on improvements to the property (landscaping, electric water heater, whatever) which would increase the value beyond the $110k.

That's what a company that doesn't pay dividends is like. You don't get that regular income, but the expectation is that the money will be used to make the company more valuable and increase the stock price.

Answer 9

I understand that your title and your question differ wildly. And other answers tackle that beautifully. However, because others are likely to come here based on the title, which currently is "Why are dividends different from property income like rent" and I would hate to see them disappear frustrated when I have the answer to that question as stated.

Dividends are taken from the available cash of a business. This cash has already been taxed by a corporate tax, so it is not taxed at the same rate as regular income. As a more personal finance related example, keeping in mind this varies from jurisdiction, so talk to your accountant to find the breakeven point, in my area if you're self employed and making 250k a year (500k if married) then you want to pay yourself a salary up to about that 250k and after that declare dividends. At that point, the personal tax becomes high enough that you are better off eating the corporate tax on the "profit" of the business and then eating again the tax on dividend - the two of them add up to less than the top tax rate.