Preferred equity in the private markets is used by owners/borrowers to boost returns by getting additional leverage over and above the mortgage debt. The preferred equity in private markets could be at up to 80-85% loan to value (LTV), and yield could be at 10-15%. On the other hand, equity REIT (excludes mortgage REITs) preferreds are usually at a low leverage (up to 60% of capitalization), but also yield lower at 5-7%, which could be interesting for slightly risk-averse investors.
I have been following the REIT preferreds since summer 2013 and believe that these provide interesting investment opportunities from time to time and I intend to share my experience on this forum. At the end of the day, REIT preferreds will not make an investor rich overnight, but they could be a good placeholder in the fixed income portfolio, especially given the still prevailing low interest rate environment.
Organization of this article
In order to cover this topic, I intend to write a three-part series about REIT preferreds:
Part 1: Covers an introduction to REIT preferreds and I talk about one of the preferred stock series of Public Storage (PSA; PSA-E). PSA is one of the most prolific issuers of preferred stocks, so I thought it would be good to start here.
Part 2: I will talk about preferreds of Ashford Hospitality Prime (AHP; AHP-B) and Investors Real Estate Trust (IRET; IRET-B). These are two names that are trading at the widest levels in the universe (7%+), but are still at low leverage levels, making them attractive.
Part 3: I will cover preferreds of Pebblebrook Hotel Trust (PEB; PEB-D) and Sunstone Hotel Investors (SHO; SHO-F). These two have a very interesting nuance in their structure, which makes them highly attractive from a credit point of view, but they are trading above their face value, exposing an investor to call risk. Nevertheless, they should be on the watch list for now.
In this three-part series, my goal is to take a look at the names mentioned and highlight the leverage and credit risk. Unlike the article I published recently on Brixmor (NYSE:BRX), where I went into a detailed cash flow model, the approach I take here is rather simplistic, which is to: (1) look at the basis ($/sf or $/unit or $/key etc.) of the preferred, implied cap rate at that basis and finally leverage at the preferred level to determine the creditworthiness of the preferred stock, and then (2) use current yield and expected yield to call at the current price level to make an investment decision to buy (or sell).
Brief Introduction to REIT Preferred Stocks
REIT preferred are securities that fall between the debt and common equity of a REIT. A simplistic capital structure will look something like below:
For REITs, generally speaking, preferreds are issued at a face value of $25, pay a fixed dividend and do not have a maturity date. However, REIT preferreds usually come with a 5-year optional redemption provision whereby the issuer can call back the preferreds at the face value of $25. Whether or not a particular issue will be called or not depends on the prevailing interest rates and company credit risk perception at the time of redemption. So, for e.g., if a preferred was issued at a face value of $25 and at a coupon of 7%, and by its redemption date, the issuer can issue a preferred at a 5.5% coupon, it is very likely that the issue will be called.
There are two main types of REIT preferreds: cumulative perpetual and non-cumulative perpetual. The main difference is that in a cumulative perpetual REIT preferred, the dividends on the preferred are senior to the dividends of the common equity, i.e., the common equity cannot get its dividend unless the preferred holders have been paid all their accrued dividend. Most of the REITs pay quarterly dividends, but there are a few that also pay monthly dividends.
Some preferreds are convertible preferreds, which means that they can be converted to common stock in a certain ratio. If purchased at the right price, in addition to good income return, these can also offer an investor solid growth potential as they will mimic the underlying stock price. (More on this in Part 2.)
For tax purposes, the preferred dividends are not treated as qualified dividends. Preferred REIT investors also do not get any voting rights, but have certain provisions where if the dividends have not been paid for a certain number of quarters, then preferred holders get voting rights.
A comprehensive list of outstanding REIT preferreds can be found at this link. You will see in the link that different companies issue REIT preferreds from time to time and may have one or more series outstanding. As you can see from the list, Public Storage is one of the most prolific issuers of REIT preferreds.
Some Trading Background
Below is a chart showing the 30-year treasury rate from 12/15/15 (a day before Fed raised rates for the first time in a while) until now. During this time period, the Federal Reserve has raised the Fed Funds rate (short-term rates) 4 times (1% in total), yet long-term rates have gone down slightly from 3.0% to 2.9%. (I hope to talk about commercial real estate prices and interest rates in a separate article.)
I have been following and investing in REIT preferreds since summer of 2013 and have observed that every time there is chatter about raising rates by the Federal Reserve, the preferreds sell off and start trading at a discount to the face value but then recover soon and trade back to PAR value as rate fears subside. These whipsaws in pricing are perfect entry points for REIT preferreds. Unfortunately, the latest round of opportunity in REIT preferreds was in November 2016, and most of the REIT preferreds have since recovered and are now trading at PAR or a premium to face value.
Nevertheless, I intend to talk about a few in this three-part series, which I think are still interesting, the first one being Series E of PSA.
Public Storage 4.90% Series E Cumulative Preferred Shares (PSA-E)
Public Storage is the world’s largest owner and operator of self-storage facilities, serving over one million customers. Public Storage is a member of the S&P 500 and FT Global 500. Public Storage built its first self-storage facility in 1972. Today it operates thousands of unique and diverse company-owned locations in the United States and Europe, totaling more than 150 million net rentable square feet of real estate.
PSA is one the most prolific users of preferred securities as a financing tool (see below), and as of Q1-2017, it has about $4.37 billion of outstanding preferred securities at an average dividend rate of 5.51%. PSA seldom goes to the debt markets to issue notes or mortgages and has only two corporate bonds outstanding, both of which are trading at less than 1.5% yield to maturity. It should be noted that PSA preferreds are rated BBB+ by S&P and A3 by Moody's, which is highly unusual for an issuer. All preferred stock of a particular issuer share the same priority in a liquidation event or the capital structure.
Source: PSA Company Filing
Note that the above data is as of Q1-2017 and since then Series S has been called and a new Series F has been issued.
The second last preferred PSA issued was the Series E Cumulative Preferred (PSA-E) in October 2016 at a price of $25 and a coupon of 4.9%. In the past, they issued preferred at much higher dividend yields and redeemed the series that had higher coupon at the issue's respective optional redemption date.
As soon as PSA-E was issued, it went down from $25 to $20.5 in a span of two months and as a result, started trading at a current yield of approximately 6.0% and yield to call date of approximately 10%, which was highly attractive for a security with this type of a credit profile.
What is also interesting is that at the time of issuance of PSA-E (in Oct 2016), 30-yr Tsy was at 2.45% and PSA-E priced at $25 versus today (7/28/17) 30-yr TSY is at about 2.90% and PSA-E is at $24.53 or just 2% below issue price. What this also implies is that at the time of issuance, PSA-E was issued at a current yield of T + 2.45% (2.45% + 2.45% = 4.90%). Assuming a current yield of approximately 5.0% would imply that PSA-E is trading at approximately T + 2.10% (5% = 2.9% + 2.1%), implying that the increase in base rate was compensated by the decrease in spread.
Dissecting PSA-E Credit
As explained above, the approach I take here is to: (1) look at the basis ($/sf or $/unit or $/key etc.), implied cap rate at that basis and leverage to determine the creditworthiness of the preferred stock, and then (2) use current yield and expected yield at the current price level to make an investment decision to buy (or sell).
Below is a summary of the capital stack for PSA that I will use to discuss the credit.
Source: Company filings
Basis: As it can be seen from above, PSA has $396 million of debt (1% of capitalization), $4.37 billion of preferred stock (10.9%) and $35.23 billion of common equity (88.1%). At this level, the preferreds have a basis of $31/sf and an implied cap rate of 38.4% (!!!). Since a picture is worth a thousand words, see below a picture of the capital stack:
What does the above mean from a credit perspective? In a nutshell, it means that the debt and preferreds of PSA are highly secured. There can be a draconian event where the value of assets held by PSA can fall 88% (i.e., the common equity gets wiped out completely) and yet the preferred and debt will be fine. Another way to look at it is that the approximate annual interest expense on the debt and dividend payments on the preferreds add up to $248 million against a NOI of $1,830 million. So NOI can fall down 86%, but the dividend on the preferreds is still secured. Note that as mentioned above, PSA preferreds are also investment grade rated by Moody's and S&P.
To conclude on this, it is fair to say that the basis is very secured for the preferred stocks of PSA.
Yield: As of 7/28/17 closing, PSA-E was trading at $24.53. At this price, the current yield is about 5.0% and the yield to call (at the redemption date) is about 5.5%. So before I talk about the pros and cons of PSA-E, the natural question is why I picked PSA-E out of the other available series. The answer lies in the chart below. I picked the preferred that has the highest yield to call out of the given choices. For example, Series Y has a dividend of 6.375% and can be called on 3/17/19. At a current price of $27.47/share (110% of PAR), it has a current income yield of 5.8%, but if it is called at the redemption date in March 2019, the yield an investor is expected to make drops down to 0.6%. PSA recently redeemed Series S, which had a 5.9% dividend and issued Series F (not shown below) at a 5.15% coupon. Hard to say what interest rates will be in March 2019, but there is a very high probability that Series Y will be called if interest rates stay at the current levels.
Pros of PSA-E
First, PSA preferreds in general are at a highly secured basis ($31/sf; 38% cap rate!) and provides enormous margin of safety if there was an adverse development in the general capital markets. Second, while a 5-5.5% (current yield - yield to call, depending on how you look at it) for a very long-term security may or may not be a good enough yield for someone, I think one should look at it in the context of the credit, i.e., you are earning 5%-ish yield for a security at 12% LTV. Third, from a relative value perspective, a 5-5.5% yield on PSA-E is very attractive compared to some REIT unsecured bonds with a 40-year term. For example, take Kimco's (KIM) 40-year unsecured bond, which is trading at around 4.5% YTM and has the same rating as PSA (see below). So PSA-E at 5-5.5% yield is attractive compared to Kimco's 4.5%. Fourth, I usually don't recommend shorting, but as it can be seen in the table above, one could pursue various arbitrage strategies where one could go long PSA-E and short some other series.
Cons of PSA - E
First, the management can always issue significant amount of debt and pay a special dividend to the common equity investors. What this does is squeeze the preferreds and increase their leverage. While this could be done, I do not think that the existing management intends on doing that. Financing the operations through preferreds is a very old strategy of the company. They had ample opportunities to lever the company, but management never levered the company and has always maintained a very conservative and top notch balance sheet in the REIT universe (probably the best).
Second, the duration of PSA-E is very long given the relatively low dividend yield of 4.9%, it is highly unlikely that PSA will redeem this particular series at its optional redemption date in Oct 2021, making this a very long bond susceptible to interest rate shocks. One mitigant to this could be that the yield at which a security trades depends on the base rate (Tsy) and the trading spread (T+Spread). If base rates go up, there could be a scenario where the spreads could tighten as it happened very recently for PSA-E (which I have shown above). Also, another mitigant that I can think of is that given the basis (12% of capitalization, 38% cap rate etc.), I will be happy owning PSA-E and earning a 5% current yield for a very long time. Again, this will depend on each investor's personal circumstances and preferences.
Third, the dividends are not qualified dividends. Do not have a mitigant for this.
I think REIT preferreds offer a good alternative to bonds and should be part of the fixed income portfolio. They are generally lowly levered and offer yields in the 5-7% range in the current environment.
PSA-E is a REIT preferred issued by PSA and is at a very attractive credit level (12% of capitalization, $31/sf and 38% cap rate). At the current price of about $24.5/share, the current yield is 5% and a yield to call is about 5.5%, which could be attractive for some investors and worth exploring.
Stay tuned for Part 2 and Part 3 of the series.
Disclosure: I am/we are long PSA-E, IRET-B, AHP-B, PEB-D, SHO-F. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.