Can't Take The Heat? REIT Preferred Shares Look Sweet

by: Brad Thomas

About a month ago I wrote a Seeking Alpha article, 4 Intelligent REITs I Adore, But Can't Buy Right Now, in which I explained my admiration for some of the "best in class" blue-chip REITs.

As the title of my article suggests, I adore the four REITs I'm writing about and I might even go as far as saying that I really love the quadruplets. Heck, I even wrote about one of them, Realty Income (NYSE:O), in a recent article (O, I Love You Just The Way You Are). I stand behind these words. I really do love Realty Income; however, it's not the time to buy today. When examining the fundamentals of Realty Income we discover a truly amazing REIT with a history of consistent FFO growth.

But as I went on to write, the mere attraction to a fully-valued stock does not mean that it's the right time to "pull the trigger" and oftentimes being patient is the difference between a good deal and a great one.

Remember, psychology has an awful lot to do with how we make decisions. It is critical that investors learn to bifurcate the psychological side (Mr. Market) from the computational side. Also, remember that a company's present price is based on a mix of unpredictable factors, many of which pertain more to emotion and mass psychology.

But wait! Remember that "intelligent investors" have another way to own a slice of the great American REIT pie that could be just as appetizing, with much less volatility risk.

Own a Smaller Piece of the Capital Pie: Preferred Shares

Last year I wrote a Seeking Alpha article on REIT Preferred Shares and explained that...

most investors view preferred stock as bond alternatives because the preferred stock is a low-risk investment proposition that offers a higher yield than bonds. Not only do REIT preferred dividend yields generally exceed the dividend yield on the common stock, they are fixed and do not fluctuate with REIT earnings.

The advantages to owning REIT preferred stocks include (1) wider yield spreads compared with common stocks (2) less volatility compared with common stocks (3) safe dividends (supported by stable REIT cash flows), and (4) more competitive yields due to a compressed cap rate environment (i.e. modest growth rates for common shares due to compressed yield).

Now keep in mind that preferred shares are considered to be distant cousins for common owners and the differentiation between the two alternatives are summed up as follows: (1) preferred shares have no claim on any growth and therefore there's no upside relative to increases in value (2) virtually all of the return comes from yield (so there is no direct benefit from economic growth), (3) there is no maturity date offering protection from secular increases in interest rates (however, the company can redeem the stock in five years after issuance should interest rates fall).

One of the primary reasons that I like preferred shares is because unlike bond holders, preferred owners aren't creditors of the company and thus have no standing in the creditor pecking order. Conversely, they do not share in a REIT's growth in dividends, cash flow or NAV accretion, even though they are considered "equities." This makes the income highly attractive, albeit at the cost of upside in dividends and capital appreciation. As I explained in a previous article:

Moreover, preferred stockholders receive their dividend before common stock investors receive any payment. In practical terms, this means that if a REIT finds it challenging to continue to pay interest on its bonds and dividends for its shareholders, the amount of money that is available to meet financial obligations is paid first to bondholders, then preferred stockholders and finally common stockholders.

As we learned this week with Digital Realty (NYSE:DLR), "preferred stock investors are exposed to some reinvestment risk since REITs can redeem preferred stock". Most REIT preferred stocks are callable in whole or in part by the issuer five years after issue and anytime thereafter and in the case of Digital, the company announced it was converting their convertible preferred shares into common equity.

Can't Take the Heat? These Preferred Shares Look Sweet

The increase in demand for preferred REIT stock is so strong that companies have been able to issue shares at all time lows. REIT sponsors realize that they may never be able to issue preferred shares this cheap again. This bodes well for investors as the menu for complimentary fixed-income alternatives (especially when common stock dividends are low) help round out a diversified real estate portfolio.

Remember that the primary objective for preferred shares is income and therefore the intelligent investor should remain focused on the fact that they are equivalent to a bond (for income); however, they yield more than bonds (but with a similar risk profile). Perhaps a better way to describe preferred stocks is that they could be something like a "bond replacement" strategy.

I often recommend that investors implement a blended strategy of buying both REIT common stock and preferred stock. This way investors can take advantage of any dividend growth and stock appreciation from common stock, while enjoying higher dividend yields from preferred stock. The preferreds could add more of a complimentary "bond-like" component to the fixed-income portion of your portfolio.

One word of caution: I would not recommend an all out replacement of REIT common stocks for REIT preferred shares. Over any reasonable time period, total returns for common REIT shares will most definitely outperform the preferred REIT cousins.

Note: Generally REITs issue around 10 percent in preferred stock as this is an attractive alternative to traditional debt, and the decision to issue this type of stock is viewed as a form of permanent debt for their companies. The yields on recent issuances have compressed the yield spread and preferred rates now range from 5.0 to 7.0 percent - still more appealing than today's low yielding bond instruments.

Here is a snapshot of REITs that have issued preferred shares since January 2012 (source: SNL Financial):

Click to enlarge

For More Information: Michael Terry posted a terrific Seeking Alpha article on REIT Preferred Stocks last year. Terry no longer writes for Seeking Alpha (wish he did) but you can find the blog HERE.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.