Non-Agency Mortgage REITs: Part 8 - Preferred Stock

by: Philip Mause

This series of articles deals with REITs that invest entirely or at least significantly in mortgages or mortgage-backed securities that do not have sponsorship by one of the federal agencies. Thus, the companies discussed in this series are inevitably exposed to default risk because there is always a possibility that there will be defaults on the mortgages they directly or indirectly own as assets.

Many of the companies in this sector have issued preferred stock and I will try to list the securities of which I am aware without necessarily representing that I have compiled a complete list. Investors may find some of these securities to be attractive components of a yield oriented portfolio. I am not an expert on preferred stocks, but I am familiar with the companies in this sector and I can add a note of caution because the companies in this sector tend to be exposed to default risk and can be very sensitive to the economic cycle so that the owner of preferred stock is exposed to some risk of dividend interruption and even loss of principal in the event of bankruptcy.

The financial statements for stocks in this sector do not always provide complete information (coupon, maturity date if any, terms governing dividend arrears, etc.), and in some cases, I have not been able to provide as much information as I would like.

The table below lists preferred stocks by symbol and provides Thursday's closing price and the dividend yield on the $25 par price. It appears that iStar Financial (SFI), RAIT Financial (NYSE:RAS), Invesco Mortgage (NYSE:IVR), MFA Financial (NYSE:MFA), NorthStar Realty (NRF), Colony Financial (CLNY), Newcastle Investment (NCT), Resource Capital (NYSE:RSO), and Gramercy Capital (GKK) are the only companies in this sector with preferred stock, but as noted above, I cannot swear that I haven't missed one. More information about each company can be found in the first 7 articles in this series. As noted, the dividend yield in the chart is based on a par price of $25; if the stock is trading below $25, the effective yield is higher. The price information is derived from Yahoo Finance; other information is derived from the most recent financial statement of the relevant company as filed with the SEC.

Price Yield at $25
SFI-PD $24.28 8.0%
SFI-PE $23.95 7.875%
SFI-PF $23.64 7.8%
SFI-PG $23.22 7.65%
RAS-PA $23.71 7.75%
RAS-PC $25.26 8.875%
IVR-PA $25.15 7.75%
MFA-PA $26.04 8.5%
NRF-PA $25.36 8.75%
NRF-PB $24.64 8.25%
NRF-PC $25.32 8.875%
CLNY-PA $26.43 8.5%
NCT-PB $25.65 9.75%
NCT-PC $25.25 8.05%
NCT-PD $25.31 8.375%
RSO-PA $25.42 8.5%
RSO-PB $24.80 8.25%
SFI-PI $23.22 7.5%
RAS-PB $24.64 8.375%
GKK-PA $32.41 8.125%

A few points. GKK-PA has omitted dividends starting in the fourth quarter of 2008 and now has dividend arrears of at least $8.63 per share. This explains why the stock is trading well above par - investors anticipate getting the arrears back at some point. Investors should note that, as far as I have been able to determine, the considerable amount of arrears is "dead money"; that is, no additional dividends or interest is paid or accrued on the $8.63 per share of arrears. Although the stock's coupon of $2.03125 per annum provides a yield of 8.125% on a price of $25 per share, it provides a much lower effective yield on the current price of $32.41 per share.

GKK has to catch up on its preferred dividends before it can start paying common stock dividends so there is a strong incentive for GKK to settle up at some point. On the other hand, GKK does not have to pay interest on the "dead money" and does not have to describe the dividends which accrue each quarter as a "cost" or "liability" for balance sheet and income statement purposes. There has recently been a detailed analysis of GKK-PA which readers should look at. I am not crazy about it at this price, but if it dips a bit, I might be a buyer.

In buying any of these securities above par, an investor should be aware of the redemption or call dates because they can be called away or redeemed at par under certain terms. Investors should also be aware of dividend dates because a quarterly dividend is generally worth about 50 cents and it can make a big difference whether or not you buy early enough to capture a given dividend.

My general policy has been to buy preferred stocks only when they are available at significant discounts to par. Thus, I would not be a buyer of any of these with the possible exception of RSO-PB which I find attractive because of: 1. the high coupon, 2. the discount to par, and 3. my generally positive view of RSO.

In this sector, an investor is always exposed to a certain amount of "blindside" risk (or as Donald Rumsfeld would put it "unknown unknowns"). My strategy with common equity in this sector has been to research carefully, buy several that look seriously underpriced and then hope that my big winners outweigh my big losers. In the world of preferred stocks trading at or near par, there are no big winners but I am afraid that in this sector there is always the potential for big losers. My strategy would be to bookmark this article and return to it on market dips to determine if big discounts open up on any of these. Many of these preferreds got hammered in the 2008-09 Panic, and if you could climb into a time machine and buy them at those prices, you would do very well. Take a look at this chart for AFC, a publicly traded debt security which was originally the debt of Allied Capital (which no longer exists) but became a debt obligation of Ares Captial (NASDAQ:ARCC) when ARCC took over Allied Capital a few years ago - I bought in the big dip in the summer of 2011 and made a bundle quickly. AFC is essentially low or no risk in terms of default because of the low leverage on the ARCC balance sheet, but it briefly declined in a big way in 2011 because it is relatively lightly traded and the market was in extreme "risk off" mode. If you can do something like that with some of these preferred stocks, you can make out very nicely.

Because I believe that there is always a possibility of a big loss in this sector, I generally prefer the common stocks of these companies unless I can buy the preferred stocks well below par. On the other hand, with "yield hunger" pervading the market, some of these preferred stocks may fit nicely into a broadly diversified yield oriented portfolio.

Disclosure: I am long GKK, RSO, IVR, NRF, RAS, ARCC. 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.