mREIT Preferreds - Great Taste And Less Filling

 |  Includes: AGNC, CLNY, MFA, NCT, NLY, NRF, RAS
by: Rubicon Associates

Some people might remember the SABMiller advertising campaign which featured George Steinbrenner, Billy Martin, Mickey Spillane and Bubba Smaith arguing over whether Miller Light tastes great or is less filling. On Seeking Alpha, the same sort of debate rages over equity REITs (eREITs) and mortgage REITs (mREITs) - where either type of REIT can fit either side of the debate. While many will debate which REIT type is the best investment, perhaps we can address an alternative - mREIT preferred stocks.

Many in the "eREIT camp" contend that mREIT dividends, and the business model generally, has too much risk (rising rates, flattening curve, leverage...) or too much volatility (dividend increases and decreases). Maybe they are right, maybe they are not - risk is defined by the investor. What I have noticed is some investors shying away from mREITs due to real or perceived risk. They want the yield, but the risk does not fit their risk/portfolio profile.

One way "around" this issue is to invest in mREIT preferred stocsk. The preferred stock of the mREITs does not have the yield of the common (as it is higher up in the capital structure and fixed) or the "volatility" of the common stock dividends. Perhaps we have found something that tastes great and is less filling - the compromise many investors have been looking for that might better address their risk needs as well as their return needs (all this without Billy Martin getting fired).

Let's take a look at the possible ingredients in an mREIT Lite investment:

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Now a look at the issuers (all price data from Quotemedia):

MFA Financial (MFA) is engaged in the business of investing, on a leveraged basis, in residential Agency mortgage-backed securities (MBS) and Non-Agency MBS. Its business objective is to generate net income for distribution to its stockholders resulting from the difference between the interest and other income it earn on its investments and the interest expense it pays on the borrowings, which it uses to finance its leveraged investments and its operating costs.

Its operating policies require that at least 50% of its investment portfolio consist of ARM-MBS, which are either Agency MBS or rated in two rating categories by at least one of rating agency, such as Moody's Investors Services, Inc., Standard & Poor's Corporation (S&P) or Fitch, Inc. The remainder of its assets may consist of direct or indirect investments in other types of MBS and residential mortgage loans; other mortgage and real estate-related debt and equity, and other yield instruments.

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I wrote an article on the MFA 8% notes when they were announced which has the details of the deal, but there is a change of control feature as well as a merger, consolidation, sale of assets covenant.

On the Series A preferreds, if dividends on any outstanding Series A Preferred Stock, or any series MFA may issue on a parity with the Series A Preferred Stock as to payment of dividends, have not been paid for six or more quarterly periods (whether or not consecutive), holders of the Series A Preferred Stock, voting as a class with the holders of any other classes or series of their equity securities ranking on parity with the Series A Preferred Stock which are entitled to similar voting rights, will be entitled to elect two additional directors to the board of directors to serve until all unpaid dividends have been paid or declared and set apart for payment

There are no change of control provisions for the Series A preferred stock.

As I stated in my earlier article, the swap from the series A to the 8.00% notes is a no brainer as you extend call protection and move up in the capital structure at the cost of 24bps on a current yield basis.

Colony Financial Inc (CLNY) is a real estate investment and finance company that primarily acquires, originates and manages a diversified portfolio of real estate-related debt instruments. CLNY focuses primarily on acquiring, originating and managing commercial mortgage loans, which may be performing, sub-performing or non-performing loans (including loan-to-own strategies), and other commercial real estate-related debt investments.

The REIT has also acquired and may continue to acquire other real estate and real estate-related assets. Their objective is to provide attractive risk-adjusted returns to investors through a diversified portfolio of commercial mortgage loans and debt-related and other investments. The total return profile of our investments is composed of both current yield, which is distributed through regular-way dividends, and capital appreciation potential, which is distributed through regular-way and/or special dividends. Colony has a market capitalization of $548 million.

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The preferred have a change of control feature that lets the investor convert their preferred holding into common shares.

If one is considering an investment in CLNY for income, this is a no-brainer. Higher in the capital structure and pick up yield - all day.

American Capital Agency Corp (AGNC) earns income primarily from investing on a leveraged basis in agency mortgage-backed securities. These investments consist of residential mortgage pass-through securities and collateralized mortgage obligations for which the principal and interest payments are guaranteed by government sponsored entities such as Fannie Mae and Freddie Mac or by a U.S. Government agency such as Ginnie Mae. The company may also invest in agency debenture securities issued by Freddie Mac, Fannie Mae or the Federal Home Loan Bank.

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The preferred have a change of control feature that lets the investor convert their preferred holding into common shares.

The disparity between American Capital Agency Corp's equity and preferred is significant. AGNC, being one of the arguably better run mREITs, makes the trade difficult. AGNC preferreds, however, would make a nice addition to a preferred portfolio.

Annaly Capital Management (NLY) manages a portfolio of primarily agency mortgage-backed securities. Annaly's principal business objective is to generate net income for distribution to investors from its mortgage-backed securities and from dividends it receives from its subsidiaries. Annaly has a market capitalization of $15 billion and is the bug kahuna in the space.

The Annaly preferreds are currently callable, but as I stated in a previous article, Annaly Capital - Check out the Preferreds, I do not believe that they will be calling the issue as it is not economical at this time.

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As one of the older mREIT preferreds, Annaly's preferreds are not convertible in the event of a change of control.

Determining if Annaly's preferreds have value relative to the common is difficult. As I stated in my earlier article, looking at the historical volatility in Annaly's price and/or dividend, an investor that wants exposure to the mREIT sector, or Annaly specifically, might do well in the preferred. Another way to look at this is that Annaly preferreds could play a role in a preferred portfolio due to the yield and diversification benefits.

Newcastle Investment Corp. (NCT) is a real estate related investment and finance company. Newcastle invests in, and actively manages a portfolio of, real estate securities, loans and other real estate related assets. The Company conducts its business through four primary segments: investments financed with non-recourse collateralized debt obligations (CDOs), investments financed with other non-recourse debt, investments financed with recourse debt, including Federal National Mortgage Association (OTCQB:FNMA)/ Federal Home Loan Mortgage Corporation (FHLMC) securities and unlevered investments.

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As these series of preferred stock are older, there is no conversion into equity in the event of a change of control. There is, however, an optional redemption if the shares are no longer listed on the exchange and the company is no longer subject to reporting requirements.

If one is considering NCT preferreds, the obvious choice, in my opinion, is the Series B. Technically, there shouldn't be this price difference and yet there is.

NorthStar Realty Finance Corp. (NRF) is a real estate finance company, which focuses primarily on originating, investing in and managing commercial real estate debt, commercial real estate securities and net lease properties. The Company has invested in the areas of commercial real estate that enabled it to leverage its real estate investment, utilize its capital markets knowledge, and capitalize on its ability to employ financing structures. NRF Capital Markets, LLC Capital Markets, is the Company's wholly owned subsidiary wholesale broker-dealer.

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Northstar preferreds have change of control language in the prospectus, but with a bit of a twist. If there is a change of control and the securities are no longer listed or quoted, the company has the option to redeem the shares.

If dividends on the Series A and/or B Preferred Stock are in arrears for six quarterly dividend periods (whether or not consecutive), the holders of the Series A and/or B will have the right to elect one member to serve on the company's Board of Directors until such dividend arrearage is eliminated.

Looking at the yield give of approximately 1% versus the common equity, the preferreds are very compelling. Of the two series, I believe that the Series B have more value.

RAIT Financial Trust (RAS) is a self-managed and self-advised real estate investment trust (REIT). RAIT is a vertically integrated commercial real estate company with a commercial real estate focused platform capable of originating primarily commercial real estate loans, commercial mortgage-backed securities (CMBS) eligible loans, acquiring commercial real estate properties and investing in, managing, servicing and advising on commercial real estate-related assets. It offers a set of debt financing options to the commercial real estate industry along with asset and property management services. The Company also owns and manages a portfolio of commercial real estate properties and manages real estate-related assets for third parties.

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Whenever dividends on the preferred shares are in arrears for six or more quarterly periods (whether or not consecutive), the holders of these shares (voting together as a single class with all other shares of any class or series of shares ranking on a parity with the Series A preferred shares which are entitled to similar voting rights, if any) will be entitled to vote for the election of two additional trustees to serve on our board of trustees until all dividends in arrears on outstanding Series A preferred shares have been paid or declared and set apart for payment.

If the shares cease to be listed or quoted on an exchange, the issuer has the option to redeem the shares in whole, but not in part.

All I can say here is that you get paid over 200bps to move up in the capital structure. All day. Of the three series, I think RAS-B have the most value.

Bottom line: Within the ranks of mREIT preferreds, there are some easy choices and some not so easy choices with regards to the yields available versus the equities. For those concerned about the "volatility" of mREITs, many of these preferred stocks make sense.

In some cases (RAS, NRF and CLNY), it is a yield no brainer as to which I would invest in. I do, however, believe that mREIT preferreds have a role in any income/REIT portfolio regardless of the comparison to their equities. In short, it is possible to taste great and be less filling.

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Disclosure: Long REM