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As we know, common equity is linked very closely to the issuing company. Distributions, intrinsic value and even market value are in flux with the company's performance. With preferred equity, however, the bond to the issuer is much weaker. Intrinsic value is no longer a variable and instead held constant at the set liquidation preference and calendar. Distributions are also held at the initial coupon and even supported during hard times through the process of accrual. In fact, the issuing company only has relevance to the sustainability of distributions.

The constraints provided by the structure of a preferred simplify the decision making process. Only the risk associated with the sustainability of distributions and the percentage of yield differentiate preferreds. With this, we can make two statements which govern the preferred selection process.

1) All preferreds with an equal level of risk can be considered fungible.

2) Among fungible preferreds, the highest yielding is superior

Using this process, it becomes necessary to establish a criterion with which to compare the risk levels of different preferreds. The primary basis of comparison is normalized cash flow sufficiency. Of course, many factors go into analyzing the stability and strength of future cash flows, but that lies outside the scope of this article. For our purposes, we can simply say that risk levels can be categorized into strata based on sufficiency and stability of cash flows.

The big risk-big reward

Regardless of the strength of current cash flows, the highly levered business model of m-REITs makes them inherently riskier. To maintain the desirability of their preferreds these companies have to issue some impressively high coupons.

Company

Preferred ticker

Annual Dividend $

Recent Price $

Current Yield %

Newcastle Investment Corp. (NYSE:NCT)

NCT-B

2.4375

25.35

9.62%

Northstar Realty Financial Corp. (NYSE:NRF)

NRF-B

2.06252

23.36

8.83%

NRF-A

2.18752

25

8.75%

American Capital Agency (NASDAQ:AGNC)

AGNCP

2.224

25.59

8.69%

Anworth Mortgage Asset Corp. (NYSE:ANH)

ANH-A

2.156248

25.9

8.33%

The medium

In the midrange of yield we see the large and stable REITs. The business practices are still susceptible to industry fundamentals and the economy, but the massive size of these companies adds that extra bit of security.

Company

Preferred ticker

Annual Dividend $

Recent Price $

Current Yield %

Kimco Realty Corp.

KIM-F

1.6625

25.25

6.59%

National Retail Properties

NNN-D

1.656248

26.28

6.30%

Public Storage

PSA-O

1.718752

27.35

6.28%

Simon Property Group

SPG-J

4.18752

68.2

6.14%

The low range of yield approaches bonds where the returns are small but as close to guaranteed as is possible in the financial world.

With such a strong correlation between risk and reward, how does an investor glean superior yield without taking on extra downside. There are 3 primary sources of opportunity: Misconceptions, purchase timing, and pareto superiority.

Misconceptions

Quite a number of preferreds are deemed by the investment public to be far less reliable than they actually are. Many of these are considered risky due to the highly cyclical nature of the company's earnings. However, unlike with common stock, cyclicality of earnings has less bearing on risk for preferred dividends due to the accrual process. To illustrate this point, let us look at the extremely cyclical hotel sector. During the downturn, FelCor Lodging Trust (NYSE:FCH) and Strategic Hotels (NYSE:BEE) were forced to suspend dividends on their preferreds. Now that industry fundamentals are coming back into cycle, all the accrued dividends were successfully paid off and both remain stably current on payments.

The misattribution of cyclicality as risk leaves many of the hotel REIT preferreds trading at far higher yields than they rightfully should.

Company

Preferred ticker

Annual Dividend $

Recent Price $

Current Yield %

Supertel Hospitality (NASDAQ:SPPR)

SPPRO

2.5

25.36

9.86%

SPPRP

0.800004

9.5

8.42%

Summit Hotel Properties (NYSE:INN)

INN-A

2.3125

26.15

8.84%

Hospitality Properties Trust (NYSE:HPT)

HPT-B

2.218752

25.19

8.81%

Strategic Hotels

BEE-A

2.125

25.28

8.41%

Purchase Timing

As discussed above, the intrinsic value of preferreds is constant, but the market price still fluctuates to an amazing degree. The most notable price fluctuation was from the crash of 08 where preferreds could consistently be bought at yields in excess of 20%. The current value buys are not this extreme, but are still quite solid.

Company

Preferred ticker

Annual Dividend $

Recent Price $

Current Yield %

FelCor Lodging Trust

FCH-A

1.95

23.5

8.30%

NorthstarRealty Financial

NRF-B

2.06252

23.36

8.83%

While I do view the m-REIT preferreds as unpredictable, the steep discount to par on NRF-B mitigates a good portion of the risk.

Pareto Superiority

So far, we have been referring to different preferreds as having approximately equal risk, but with those from the same issuer, the level of risk is identical. This opens up the potential for a pareto optimization in which a stock is traded for one that is equal or better in every possible way. Consider these two preferreds:

Company

Preferred ticker

Annual Dividend $

Recent Price $

Current Yield %

Hersha Hospitality (NYSE:HT)

HT-B

2.0

$26.20

7.63%

HT-A

2.0

$25.10

7.97%

The only complication that makes the transfer from HT-B to HT-A not a true pareto upgrade is the fact that HT-A is currently redeemable. I consider this to be rather irrelevant as the redemption value plus the accumulated dividend outweighs the cost of purchase. Anyone who transferred over would save $1.10 per share and get a higher yield.

There are excellent sources of yield out there; it is just a matter of finding those that defy the risk-reward tradeoff.

Disclosure: 2nd Market Capital and its affiliated accounts are long FCH-A, NRF-B, HT-B, SSPRO, SPPRP, and BEE-A. This article is for informational purposes only. It is not a recommendation to buy or sell any security, and is strictly the opinion of the writer.

Source: Fungible Risk Strata Of REIT Preferreds Afford Optimization