As odd as it seems, the Wall Street Reform Act, signed into law in July 2010, is likely to make high quality preferred stocks* (see footnote) issued by Real Estate Investment Trusts (REITs) very popular throughout 2012. Odd since the Act has nothing to do with REITs.
Trust Preferred Stocks (TRUPS), issued by our Big Banks for the purpose of boosting a key metric of their regulatory reserves ("Tier 1 Capital"), are no longer going to be able to be counted as such beginning on January 1, 2013. Consequently, such TRUPS, which are very popular with preferred stock investors, are highly likely to be retired ("called") as their call dates arrive.
As the relevant provisions of the Wall Street Reform Act reduce the supply of bank-issued TRUPS throughout the year, high quality preferred stocks from REITs will offer an attractive alternative to many risk-averse investors seeking to preserve their dividend income.
REITs were invented in 1960 in order to provide individual investors with access to the long-term income potential of revenue-generating properties without having to actually own the property itself. The REIT model has been so successful that it has been adopted by a multitude of countries around the world. REITs are required to distribute at least 90% of their taxable profits to shareholders. The IRS extracts its taxes from the shareholders rather than from the company (hence avoiding the "double taxation" treatment of non-REIT dividends).
Two Ways To Invest In REITs
Individual investors can buy into a REIT by either purchasing shares of the company's common stock or preferred stock. Either way, the company is allowed to count their dividend payments to both types of investors toward the 90% payout requirement.
There are currently 51 high quality preferred stocks available from 15 REITs.
This chart provides a comparison of these 15 companies' common versus preferred stock dividend yields (December 16, 2011 prices).
Notice that most of the points on this chart fall below the Equal Yield line meaning that the dividend income generated by high quality preferred stocks is well beyond that offered by the same company's common stock shares (with two exceptions).
For example, Vornado Realty (NYSE:VNO) currently offers a 3.80% dividend yield on its common stock while the average annual dividend yield being paid by VNO's high quality preferred stock shares is 6.72%. Conversely, the common stock of Hospitality Properties (NYSE:HPT) is currently offering a yield of 8.40% compared to the 7.05% average of its high quality preferred stock yield.
Beyond protecting their dividend income though, there are several other reasons that those holding Big Bank TRUPS shares are likely to look toward high quality REIT-issued preferreds throughout 2012.
Converging Legal Requirements
Two legal requirements put those holding high quality REIT-issued preferred stocks in what is arguably a very enviable position.
First, remember that preferred stock investors take less investment risk than those holding shares of the same company's common stock since all preferred stock shareholders must be paid in full before those holding common stock shares receive a dime. There's no getting around it; dividend distributions will go first to those holding preferred stock shares. The above chart depicts an interesting case where the lower risk security (the preferred) provides a higher return than the higher risk security (the common).
Second, the 90% payout requirement that is unique to REITs adds another layer of risk protection since the company cannot decide to hold onto their profits for some other use. They are required by law to provide that cash to shareholders, starting with those holding shares of the REIT's preferred stock.
So not only is the profit payout required by law but as a preferred stockholder you have first claim to that cash.
Available For Less Than Par
Preferred stock investors can add another layer of principal protection by purchasing preferred stock shares below the security's "par" price ($25 per share in most cases) since shareholders will receive the par amount in the event that the issuing company chooses to retire (call) the shares downstream. Purchasing your shares below the par price positions you for a downstream capital gain in the event of a call.
The number of high quality, REIT-issued preferred stocks available below par changes every day as market prices fluctuate, but at the moment there are a couple dozen such issues to pick from.
Because of the diverse nature of revenue-generating real estate, investors have a wide variety of choices when considering an investment in REITs.
With high quality REIT preferreds one can choose from companies focused on differing segments such as apartments and port logistic centers, grocery stores and office buildings or warehouses and data centers to name a few. This degree of diversification is a benefit that Big Bank TRUPS investors do not currently enjoy.
And the 15 REITs that are offering the 51 high quality preferred stocks that are available today are generally decades old, multi-billion dollar companies.
Stable Rates, Stable Prices
The Federal Reserve introduced our current low-to-no interest rate environment in December 2009. Rates have been stable for the last two years. Further, in August 2011 the Federal Reserve made the unprecedented announcement of future monetary policy when they committed to leaving the current low-to-no interest rate environment intact for at least another two years. The Fed reiterated that commitment after their December 13 meeting as well.
Due to the Fed's stable rate policy, the market prices and dividend yields of high quality preferred stocks have been very stable as well. While it is not possible to know with certainty what the future holds, high quality REIT-issued preferred stocks have offered investors an average annual dividend yield of about 7% for the last two years and, if the Fed has their way, are likely to continue to do so for at least another two years.
As we approach the January 1, 2013 implementation date of the relevant provisions of the Wall Street Reform Act, Big Bank TRUPS are highly likely to be retired by their issuing banks.
As a consequence, throughout 2012 a large pool of TRUPS shareholders will enter the marketplace with cash in hand seeking to purchase replacements. High quality, REIT-issued preferred stocks are likely to become very popular with risk-averse preferred stock investors as the year unfolds.
* High quality preferred stocks are those that meet the ten risk-lowering selection criteria from chapter 7 of my book, Preferred Stock Investing. For example, high quality preferred stocks (a) offer "cumulative" dividends (if the issuing company skips a dividend payment to you they still owe you the money; their obligation to you accumulates), (b) are rated as investment grade and (c) are issued by a company that has a perfect track record of never having suspended a preferred stock dividend. For more about how to select, buy and sell the highest quality preferred stock read my October 24, 2011 Seeking Alpha article titled "Preferred Stock Investing: A Simple Guide To 7% Yield."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.