When an investor wants to prepare their portfolio for retirement, they often start thinking about income more and growth less. The level of risk they can withstand in their portfolio is often materially lower than when they working. Investors may typically think of ability to bear risk as a factor that declines at a set rate over time, but that interpretation is far too simplistic. Prior to announcing their retirement, there may be materially more flexibility in deciding when an investor wants to stop working or how quickly they want to reduce their hours. If they encourage their employer to find a full time replacement, their ability to return to work and earn the same salary may be materially compromised.
Because the ability to earn income can be materially reduced, recovering from an unsuccessful investment can be substantially harder. This is one of the human factors that can play into a fairly sudden change in the ability to handle risk. Knowing that this point is coming for those with retirement on the horizon, I believe it is wise to start structuring the portfolio years in advance. For investors with a substantial amount of their assets in taxable accounts, that may often mean getting a personal financial advisor or another professional trained in tax law to assist with the planning stage. The importance of this step will vary depending on the individual investor's knowledge base, cash needs, and portfolio structure.
What Can Investors Do?
I would suggest that investors watch for quality offerings that go on sale. That is obviously much easier said than done, so the focus of this article will be on the process. We need to define potential investments and how those investments should be analyzed.
Economic theory usually suggests that volatility and risk are synonyms. That makes sense in theory, but it breaks down in practice. The real challenge comes when an investor or analyst is tasked with defining volatility. Should we simply measure the change in dividend adjusted close for each day or each week? If the market were entirely efficient, a premise I strongly doubt, then the dividend adjusted close for each day would work. Since this theory expects everything to be perfectly efficient, then the risk could even be assessed by the minute.
The Problem with Measurements
When liquidity is strong, measuring volatility using closing values makes sense. When liquidity is weak, a better method is needed. For instance, investors measuring the volatility in preferred shares of a REIT may see the ending share price change by $.50 in a day. If the investment averages around $25, then we are talking about a change of about 2% in a day. This would lead investors to overestimate the volatility in some cases. If the average share price for each month lands between $24.50 and $26.50 for over a year, should investors really worry about a move of 2% that is still within the normal ranges?
While the examples above are given in a vacuum, rather than applied to the preferred shares of a single REIT, there are some easy examples. Preferred shares for Realty Income Corporation (NYSE:O) and National Retail Properties (NYSE:NNN) have had exceptionally steady prices if we measure using the average price for each month and adjusting for dividend payments. Daily values will fluctuate, but the preferred shares tend to trade in a fairly tight range. Due to shares often trading at premiums to call value, the call risk limits their ability to appreciate.
When a large REIT is issuing preferred shares with a $25 liquidation value, I would expect them to receive over $24 per share in proceeds after underwriting expenses. The argument for those REITs to call their preferred shares and issue new ones can be based on how quickly they would "earn back" the underwriting expenses through paying a smaller dividend. Remember that management's fiduciary duty is to the common shareholder. It is their duty to look for ways to achieve lower cost financing.
The last offering of preferred shares for Realty Income indicated that the underwriting discount would cost them $.7875 per preferred share. The result would be $24.2125 in net proceeds. The cost of the discount was effectively 3.25%.
Due to call risk, investors should assess the reason for share prices remaining stable.
If we simply look at the preferred shares for equity REITs, then I think there are a few techniques investors can use to get a rough idea. Remember that this is a simple first step; it is not the last step.
The first step can be glancing at the dividend yield, FFO (funds from operations) yield, or AFFO (adjusted funds from operation) yield. Lower yields generally indicate REITs that the market perceives favorably and the perception is demonstrated in the higher multiple (high multiples = low yields). O and NNN are great examples of trading at higher multiples and both have preferred shares. I've spent quite a bit of time looking through both REITs and believe higher multiples (relative to peers) are justified. I'm concerned about price risk since they are trading at such high multiples, but I would expect their multiples to remain higher than most peers.
While I don't believe the market is perfectly efficient, it also isn't entirely incompetent. If the yield on preferred shares looks exceptional, investors should put in some substantial due diligence to ensure they aren't making a mistake such as ignoring call risk or ignoring fundamental problems facing the REIT.
Further Positive Signs
If FFO and AFFO consistently cover the dividend and all three values have been steady or gradually rising over time, it is a good indication of management doing a solid job running the company. It is also important to look into the leverage of the company. You'll want to know more than the balance sheet leverage though. Since assets will generally be carried at historical cost minus accumulated depreciation, an older REIT that holds onto properties for decades could show a very weak book value of equity. The result would be an appearance of a highly leveraged REIT even if the fair value of the assets dramatically exceeded the liabilities. I believe it makes substantially more sense to consider the market capitalization of the common stock rather than the book value of equity.
In most areas of the market I would disregard technical analysis to a significant degree, but I see some value in analyzing preferred shares. Since preferred share prices are usually significantly more stable than common stock values, it would be wise to look at the price history as one step in assessing the preferred stock. If you see huge price swings, you'll need to commit to doing extra due diligence.
Triple Net Lease REITs
I've been following the triple net lease REITs and put together some tools to keep an eye on the preferred shares:
Realty Income Corporation
National Retail Properties
Lexington Realty Trust
Gladstone Commercial Corp
Monmouth Real Estate
Gramercy Property Trust
I also watch the preferred shares on mortgage REITs, but I want to keep the examples focused. The following table demonstrates several of the criteria on the preferred shares I found for each REIT. The call dates are simply the dates when shares can be called. This table is simply one tool in the analysis since there can be other substantial differences between the REITs and between the preferred securities.
I'm long on the shares of GOODO, which is the "O Series" for Gladstone Commercial Corp. I plan to do some articles on the REIT specifically and the preferred shares there because this was the best play I was able to find over the last few weeks. I don't see GOOD as being in the same league as stronger REITs like O and NNN, but I do think they are strong enough that I'm quite comfortable with the preferred shares when my purchase price is extremely close to par value and the yield is about 7.5%.
Call Options Are Not Call Risk
When I discuss the "call option" embedded in some of the EPR preferred stocks, I'm referring to the option to convert the preferred shares into common shares. This option provides positive value to the shareholder of the preferred stock.
Investors looking for significantly more appreciation potential could be looking at the shares for EPR since two of their preferred series is convertible into common shares. I believe it is the C and E series. Because these shares can be converted into common stock, the premium/discount values are substantially less viable since they relate to par value rather than the conversion rates.
Investors might think it is absurd for the E series to have an embedded call option and yet offer a stronger yield than the F series, but the E series has substantially more price risk so an investor that might need to sell their shares in the next several years is facing significantly more price risk. The E series is demonstrating that volatility because of the fluctuations in the value of the embedded call option. Since the conversion rate for the E series is less impressive than the C series, the option is effectively farther out of the money. That reduces the value of the option and results in the E series having higher yields than the C series to compensate for less value in the embedded call option.
Investors looking for steadier income in retirement and less volatility in total portfolio value may want to look at using preferred shares as part of their portfolio. When investors are looking at the volatility on their portfolio, they should consider that the weighted average price for a security for one month to the next might demonstrate dramatically less volatility than implied by a statistical analysis of the closing prices for each day.
Within the triple net lease sector I believe there are some preferred shares with favorable characteristics that create solid investment opportunities. My favorite option over the last several weeks was GOODO and I was finally able to get execution on that order. I like O and NNN, but the yield to call on their preferred shares is often too weak. EPR is another high quality triple net lease REIT, but some of their preferred shares contain embedded options. The options are valuable to the holder of the preferred shares, but they also create substantially more price volatility which can be a challenge for investors. Due to poor liquidity across many preferred shares, investors should only use limit orders and should avoid committing capital that they may need in the near future.
A Quick Challenge
If you think you know why I picked GOODO, I'd love to hear your theories. My average cost is $25.03 per share.
Disclosure: I am/we are long GOODO.
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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.