I was speaking with a fellow investor the other day, and the subject of preferred stocks came up. We were talking about the risk and return characteristics of the preferred market, and I thought it might be a decent time to dig a little deeper into the subject and share my results. As the conversation, and subsequent research, was focused on REITs, the data presented herein is also REIT focused. In the near future, I will broaden out the data set and focus on the financial sector.
For the purpose of this note, I am focused on returns to the REIT preferred space, the risk/return profile of the space (using the Sharpe Ratio as a measure, as it is often used by institutions despite its limitations) and the sensitivity of the REIT preferred space to interest rates.
During the course of this note, I will be using the following indices:
- Wells Fargo Hybrid and Preferred Securities REIT Index ("WHPSR"),
- MSCI U.S. REIT Index ("RMZ"), and
- FTSE NAREIT Mortgage REIT Index ("FNMR").
There are limitations to the data/information. The returns available take place during a period of historically low rates, where "yieldy" investments were/are often valued beyond what might normally be acceptable (as were most financial investments). Using indices exposes returns and risk to survivorship bias, where failed companies fall out of the index. The survivorship bias should be limited as bankruptcy/insolvency within the REIT space has been de minimis.
All data/charts are created from my spreadsheets.
With these caveats in place, let's begin.
The following are the returns to the indices mentioned above:
While not completely unexpected, the returns to the mortgage REIT sector have led the pack, followed by REIT preferred, with REIT equity bringing up the rear.
Of course, there is more than one way to look at performance. While returns often drive decisions, many investors prefer to look at risk adjusted returns. While the definition of risk will vary from risk manager to risk manager (investors are ultimately risk managers), one common way to view risk adjusted returns is through the use of the Sharpe Ratio.
The Sharpe Ratio
The Sharpe Ratio uses standard deviation to measure a fund's risk-adjusted returns. The higher a fund's Sharpe Ratio, the better a fund's returns have been relative to the risk it has taken on. Because it uses standard deviation, the Sharpe Ratio can be used to compare risk-adjusted returns across all fund categories.
The Sharpe Ratio measure quantifies an investment's return in excess of a risk-free rate (I used the 10-year Treasury) relative to its standard deviation. The higher the Sharpe Ratio, the better its returns have been relative to the amount of investment risk (volatility) it has taken.
The higher the standard deviation, the higher the returns need to be to earn a high Sharpe Ratio. Conversely, investments with lower standard deviations can have a higher Sharpe Ratio even with lower absolute returns. Ultimately, a higher Sharpe Ratio indicates a better risk-adjusted performance but does not imply a lower-volatility investment. A higher Sharpe Ratio just means that the risk/return relationship is more proportional or optimal.
The data for our indices:
As the numbers above show, the REIT preferred index has the highest Sharpe Ratios over the longer five- and ten-year period while the mortgage REIT equity index has the highest Sharpe Ratio over the three-year period (followed pretty closely by the preferred index).
I have also looked at the Sharpe Ratios of the REIT preferred index versus other yield alternatives, namely:
- J.P. Morgan EMBI Global Total Return Index (emerging market bonds) and
- Bloomberg Barclays US Corporate High Yield Total Return Index.
The results were:
Over the three- and five-year time frames, preferred stocks have done very well versus these other assets. They have trailed in the ten-year time frame from a risk-adjusted standpoint.
Sharpe Ratio bottom line: Preferred stocks have performed very well on a risk adjusted basis over the last 10 years. The asset class has outperformed REIT equity over all periods, mREITs over the longer time frames, and high yield and emerging market bonds over the three and five-year time frames. That is strong performance for an under-utilized asset class.
Then, of course, we have the concern about preferred stocks and interest rates. Preferred stocks, often being perpetual in nature, are viewed as having significant duration risk, or price sensitivity to interest rates. In order to assess the extent of this risk, I took a quick look at a graph of the index and the 10-year Treasury rate (note that the rate axis is inverted in order to show directionality):
The chart above shows that the directionality of rates and preferreds is consistent with the view that rates will have a significant impact upon the preferred stocks of REITs. Naturally, I wanted to test this further by looking at the correlation between the change in price of REIT preferreds (and the other indices) and the change in rates (using the same one-month data used earlier). To my surprise, I got the following results:
Over a longer period, the correlation is minimal, but over a shorter period (more heavily influenced by the current tightening cycle), the correlation is higher.
To get a sense of the relationship over time, I calculated the rolling 12-week (3-month) correlation over the last 10 years:
As the chart shows, the relationship is not consistently negative, it is, at times, positive. The problem with this period is that it takes place during the last ten years, the majority of which have seen central bank intervention (QE) in rates, which may serve to influence the correlation.
For what it is worth, we have seen a similar thing in the mREIT market:
As well as the equity REIT market:
And the overall preferred market, as reflected through the iShares U.S. Preferred Stock ETF (PFF):
I have also graphed the Invesco Preferred Portfolio (PGX) and PFF and rates as well, for a broader picture of the market:
Invesco Preferred Portfolio:
iShares U.S. Preferred Stock ETF:
Finally, I thought it might be helpful to show the yield differential between preferred stocks and other yield alternatives.
Equity REITs, RMZ:
High Yield - Bloomberg High Yield:
As the charts show, preferreds currently offer higher yields than other yield alternatives as well as asset classes.
Preferred Bottom Line: Preferred stocks continue to outperform other income/yield focused alternatives in terms of yield and risk-adjusted returns. While the asset class does have its limitations (size, depth, liquidity), it is under-utilized and often misunderstood. This is, perhaps, why it continues to offer the value it does. REIT preferreds should be part of any REIT/real estate portfolio due to the incremental yield and lower volatility.
Forbes - REITs' relationship with rates.
S&P - Impact of rising rates on REITs.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: The analyst has no positions in the ETFs mentioned, but has multiple positions in REIT preferred (equity and mortgage), REIT equity (equity and mortgage) as well as shipping preferred (and equity).