Sunstone Hotel Investors (SHO) operates as a REIT that engages in the acquisition, renovation, ownership and sale of luxury hotels in the US. The company is a serial issuer of common stock, diluting existing shareholders on a massive scale. However, this is of benefit to holders of the company's preferred stock, the Series D Cumulative Redeemable Preferred (SHO-D, may differ depending on your broker). In this article, we'll take a look at SHO-D to see if it is a good fit for your income portfolio.
To begin, we'll define what SHO-D is. SHO-D is a traditional preferred stock, meaning it has no stated maturity date and no debt issue backing it. In addition, it makes regular quarterly distributions to holders. Those distributions are set at an annualized rate of $2 per share and since shares were issued at $25, the coupon yield of this preferred is 8%. However, since shares are currently trading for a small premium to that price, $25.15 as of this writing, the current yield is a bit lower at 7.95%. That is still a very strong yield and given SHO's ability to pay on its obligations, I'd say it's a reasonably safe yield as well.
This issue is cumulative, meaning that if SHO were to miss dividend payments on SHO-D it is obligated to make them up. This means that, barring bankruptcy, distributions from SHO-D are virtually guaranteed to occur. In addition, the common stock dilution I mentioned earlier is actually a positive for holders of the preferred. While common shareholders have been diluted many times over, all of that additional capital flowing into the business means SHO is better able to grow and service its obligations than it otherwise would be. Thus, while I don't want to own the common due to constant, massive dilution, as a preferred shareholder, you can actually benefit from that practice as it makes SHO-D safer than it otherwise would be.
Unfortunately, SHO-D isn't eligible for the preferential dividend tax treatment because it was issued by a REIT. Even traditional preferred securities like SHO-D are ineligible for the favorable dividend tax treatment when issued by a REIT and as such, holders in a taxable account will potentially be subject to a materially lower after-tax yield than they would be on an issue that is eligible for the favorable treatment. That is something you'd need to fully understand the implications of before owning SHO-D in a taxable account. Of course, if you own it in a retirement account, it doesn't matter and if you want to own SHO-D, I'd suggest that would be the best route to go to avoid the unnecessary taxation.
Beginning in April of 2016 SHO has the option to call SHO-D at the full issue price of $25. This means that, if SHO chose to exercise this option at some point in the future, holders who purchase now would be subject to a miniscule capital loss on their positions. Given that interest rates look to be higher in 2016 I don't really see that as much of a risk and in particular, SHO loves diluting common shareholders to raise capital so I don't think a call is a credible threat. However, I could be wrong and SHO may decide to call SHO-D; it is something to keep in mind if you are going to own it. Regardless, you will be able to own SHO-D for at least two more years with no threat of a call.
SHO-D is going to be subject to the same interest rate risk as any other income security and as such, as interest rates move up and down you'll likely be subject to capital gains and losses accordingly. This is something any income investor must make peace with and SHO-D is no exception to that rule. On the plus side, given what I've laid out here, I don't think repayment risk is even remotely possible with SHO. The company simply issues new common stock whenever it needs capital and as such, its ability to repay its obligations is terrific.
If you can move past the taxation issue, I think SHO-D offers investors a very safe 8% yield. I fully understand SHO is seen as a riskier company to own than many but given that it raises capital constantly through common shareholder dilution, I think the preferred is one of the safest out there in the hotel space. In addition, SHO is a very successful company in terms of operating results so when you add those factors together, SHO-D is a great choice for an 8% yield. While you can certainly find higher yields in the preferred space, SHO's capital-raising exploits make this one safer than most, in my view.
Additional disclosure: I may get long SHO-D at any time.