The market downdraft has created a buying opportunity in the REIT preferred sector. Apartment Investment & Management Co. (AIV) has several series of relatively high yielding preferred stocks (AIV-T, AIV-U, AIV-V) outstanding which are trading at a discount to par value. Each series is $25 par value and offers a yield of over 8%. The rationale for the trade is that the preferred dividend is secure and there is a huge equity cushion beneath this slice of the capital structure to mitigate the risk of default. Prior to the recent correction, these stocks were trading at a premium to par value. Now they are in the low $24 range.
The decline is an opportunity for investors to receive a high yield and the prospect of a capital gain if the pfds are redeemed.
American Investment, or AIMCO, just reported results with improving operating metrics. Generally, the apartment sector has shown resilience. The housing debacle has left many with no choice but to rent and multifamily starts have not kept pace with demand. Overall effective rents have increased and vacancy has declined. Improving operating results will translate into improved credit metrics. The current EBITDA coverage ratio of interest and preferred dividend is 1.72x. There are about $650 million par value of preferred securities outstanding with a corresponding annual dividend obligation of about $50 million. The preferred dividend is miniscule compared to annual revenues in excess of $1 billion. In addition, AIMCO pays about $50 million in common dividends per year. Clearly the business produces sufficient cash flow to support the preferred dividends for the foreseeable future.
From a balance sheet perspective, preferred shareholders are more than adequately protected. AIMCO has $7.1 billion of assets on a book value basis. Those properties are financed by $4.9 billion of non-recourse debt. Having non-recourse debt is a great benefit to preferred holders. If an individual asset defaults, the company can walk away without have to make up any shortfall between the market value of the property and the amount of the debt. At $650 million, preferreds are less than 10% of the capital structure. Beneath the preferred stock is common stock with $1.55 billion dollars of book equity. That implies that the book value of the assets would need to decline 20% to impact the liquidation value of the preferred. Clearly, a decline in the asset value will affect the market to market value of the preferred stocks. Accounting values understate the protection afforded preferred stockholders. The market capitalization of the company is about $3.2 billion, which implies that there is a 40% cushion beneath the preferreds.
The three issues are currently callable which limits the potential upside. However, with the stocks trading at a discount to par value, the yields to call are close to 10%. The company recently announced a partial call of the Series V. I would look for the company to continue to retire these relatively high cost issues. The latest offering of Series Z pfd was priced at a 7.21% yield. Further, the company has access to inexpensive non-recourse debt at the property level. As one apartment REIT executive told me about residential finance conditions, a bank would rather lend a large sum to a credit-rated borrower with a cash flowing multifamily property than to lend small amounts to a lot of individual borrowers on single family homes with no cash flow and whose ability to repay is solely dependent on employment. The mortgage market remains liquid, so AIMCO should be able to refinance any upcoming property level borrowings.
I think that at a discount to par value, AIMCO preferreds are a tremendous buy for income investors. The spreads in terms of yield to call over short term rates are 10 points and the spread of long rates is almost 6 points. It is appropriate to look at both since callable preferreds exhibit negative convexity, that is the duration or interest rate sensitivity increases as interest rates rise. Therefore the price declines in a rising rate environment will be greater than comparable non-callable securities of the same term.
If you are concerned about the company defaulting or a continued price decline, you can hedge by shorting some shares of common stock. The company is rated BB- so the implied default probability is probably less than 5% over five years. To me that would imply shorting common stock equal in value to 5% of the investment to hedge the default risk.
Preferred stocks are somewhat illiquid with large bid ask spreads, so it pays to be patient and put in below market bids.