Accessing The Power Of Stress-Free, REIT Preferred Stocks

|
Includes: CORR, EPR, KIM, QTS, STAG
by: Brad Thomas
Summary

Given the current equity market and interest rate projections (flat/lower and steady), right now could be an excellent buying opportunity.

Preferred stocks purchased below par can lead to a capital gain on the accreted discount paid.

Taking all of this into consideration, we’re very optimistic about the profits to be taken from these five preferred REIT opportunities.

Note: We are bringing back our highly-coveted preferred REIT content co-produced with Rubicon Associates. Our #1 goal here on Seeking Alpha is to help REIT investors "sleep well at night".

REIT preferred stocks (i.e., the preferred stocks of real estate investment trusts) can be very useful for the construction of an investment portfolio - diversifying both its general and cash flow characteristics.

Given the current equity market and interest rate projections (flat/lower and steady), right now could be an excellent buying opportunity.

To understand how and why that's true, it's important to first understand what preferred equity really is. Here's a working definition:

"Preferred equity is essentially the shareholders' equity on a company's balance sheet. Junior in seniority to debt, it's still senior to common equity in that preferred dividends must be paid out prior to any dividends on common equity. Yet due to the dividend rate typically stated in advance and a lack of voting rights, preferred stock also has debt-like characteristics. Preferred equity, in essence, is 'in-between' capital."

As with common equity, any associated dividends have to be approved and declared by each company's board of directors. Also like common equity, there's no maturity date involved. These dividends keep coming as a pre-established amount until:

  1. The preferred equity is redeemed by the company on or after the optional redemption date
  2. The board of directors suspends the dividend in question until further notice
  3. The company goes bankrupt.

For the record, those possibilities are listed in order of likelihood, with exception #3 being very improbable. Companies typically do everything they can to avoid cutting preferred dividends, since doing so is regarded as a failure on their part and a bad sign of things to come.

In short, it sends the market a bad signal about the business in question - the very last thing the board or management wants to do.

All the same, it can happen. And it's important to recognize that, as with any other investment out there, there is always a risk involved.

When it comes to preferred shares, this also includes:

  1. Interest rate risk. As preferred stocks have no stated maturity and the dividend rate is often fixed, a change in interest rates can affect the market price of the preferred shares. This is often referred to as duration risk.
  2. Liquidity risk. Preferred stocks are often not traded in significant volume, creating the possibility for price volatility when sizable orders are being placed and/or during periods of price discovery.
  3. Optional redemption risk. As mentioned above, preferred shares typically have an optional redemption date attached, after which the company can redeem them at par. For preferred stocks purchased above par, this can cause a capital loss on the unamortized premium paid. With that said, preferred stocks purchased below par can lead to a capital gain on the accreted discount paid. Either way, this impact is often understood and measured by utilizing the yield-to-call of the security.

REIT preferred stocks like the five mentioned at the end of this article…

Photo Source

The Good, the Bad and the Beautiful of REIT Preferred Stocks

It's important to know that most preferred stocks do allow their issuers to defer or skip payments without automatically triggering a legally recognized default. However, in those events, almost all REITs will reimburse shareholders when/if the dividend is reinstated (i.e., the dividend is considered "cumulative.")

If that "if" in "when/if" sounds alarming, it shouldn't be. Even among the dividend-paying community, REITs have a well-respected record of offering safe and reliable payouts. According to "A Preferred Approach to U.S. REIT Investments," an Invesco blog article from November 2018:

… Unlike financial preferreds, which have experienced certain periods of double-digit levels of payment defaults, since 2000 the U.S. REIT preferred universe has never seen a year with more than a 1% level of missed payments. In the past 18 years, the average annual default rate for U.S. REIT preferred stock has been a modest 0.25%, reflecting the stable and predictable cash flows generated by real estate-related companies over the period. And in the last four calendar years, there have been no defaults in the broader U.S. REIT preferred universe at all.

Even in worst-case scenarios, where a REIT has to declare bankruptcy, the "preferred" part of "preferred equity" kicks in. If there is money left to be paid out, preferred shareholders always get priority above their common counterparts.

Out of the two categories, they're always going to be repaid first and foremost.

That makes REIT preferred stocks a safer investment in many ways. And the upcoming list of potential picks build on that safety significantly - without losing out on stress-free profit potential.

Just Like Bonds. Except Different…

Another important quality to consider about REIT preferred stocks is that preferred equity is priced rather like bonds. They're issued at par (usually $25), with the price then typically moving inversely to interest rates.

Also like bonds, preferred equity can be - and often is - issued with a call provision. The company has the right, but not the obligation, to redeem or call the preferred stock at par any time after a set period has passed. This is most often fixed at the five-year mark.

To be clear, that can limit investors' upside potential. Calling the stock at par erases any previously recognized price increases. So decreasing interest rates are not always preferred stock owners' friends.

Conversely, companies often bypass their call rights when interest rates are on the rise. In times like that, businesses are prone to choosing cheaper options to raise permanent capital.

It's also important to know that their close connection to interest rates can make REIT preferred stocks more prone to price swings in certain economic conditions.

Again, many of these qualities make REIT preferred stocks or any other kind of preferred stocks very much like bonds.

But here's where they start to differ… The investment trusts themselves, of course, are limited in the amount of capital they can designate to the debt portion of their capital structure (e.g., their bond and loan covenants).

Both preferred equity and common equity, on the other hand, can be used in limitless fashion.

REIT Preferred Stocks Are Looking Particularly Good Right Now

Once you understand the risks and rewards associated with buying REIT preferred stocks, you're ready to check out our carefully crafted list. It's filled with well-researched possibilities for generating extra income and rounding out your portfolio.

And it comes at a time when REIT preferred stocks could be poised to be particularly beneficial.

At least so said LDR Capital Management - an investment adviser that is laser-focused on real estate - in a December 21, 2018, release. Here are the three reasons it listed, verbatim, in its report titled "REIT Preferred Securities Present Significant Opportunity:"

  1. Macro trends for 2019 appear to set up well for REIT preferreds. Positive GDP growth, more modest interest rate expectations and positive REIT fundamentals all combine to potentially drive strong performance from REIT preferred securities.
  2. Attractive price-value at current levels. We believe investor redemptions and tax loss selling across the entire REIT preferred universe has caused market pricing to disengage from underlying value, thereby creating a significant opportunity and attractive entry point.
  3. High, tax-advantaged income. With the 2018 Tax Cuts and Jobs Act now in place, REIT preferreds offer yields that compare favorably to yields offered in many other income-oriented asset classes.

That sounds like compelling commentary all on its own. Yet even if that wasn't the case, the five following picks can stand on their own just fine.

Let's get right to them then…

Your Stress-Free REIT Preferred Stock Portfolio

The following five preferred stocks were chosen due to their issuing REITs' moderate financial profiles, safety and competitive positions within their sectors. They've also been appropriately diversified to mitigate the impact that negative trends may have on any one sector (as we've seen in retail over the last year).

Plus, they trade below par to skew a potential redemption to investors' interest.

The following table lists the five choices as well as descriptive details:

Source: Rubicon Associates

As you can see, we've included issuers involved in energy infrastructure, entertainment, anchored shopping centers, datacenters and industrial warehouses in order to diversify away from too much sector-specific risk.

The following table lists the current market characteristics of the selected issues:

Source: Rubicon Associates

With one exception, these preferred opportunities are currently priced below par. And in the case of STAG Industrial (NYSE:STAG), the 6.28% yield-to-call makes up for that difference in our assessment.

All told, the portfolio has a handsome 6.86% stripped yield.

(Note on stripped yield: Preferred stocks trade "dirty," meaning that the accrued dividend is embedded in the price. A stripped yield therefore factors in the yield at a price net of the accrued dividend. In other words, it strips out the accrued).

As stated earlier, preferred stock investors give up their voting rights in order to obtain a pre-specified dividend amount. Due to this tradeoff, it's often helpful to determine the price of dividend stability - before purchasing an investment.

There is no universally right or wrong amount to invest, but if someone is on the fence between investing in preferred and common equity, the price of stability can help frame the discussion.

The following table presents the preferred yield advantage of the selected securities. With equity REITs, preferreds often have a higher yield than common equity due to their lack of upside. Though, in some cases, preferreds will showcase a lower yield if the equity dividend is considered riskier.

Source: Rubicon Associates

Shown graphically:

Source: Rubicon Associates

As a final reminder, 60% of the preferred stocks have higher yields than their common counterparts (typically). The remaining two issuers have been under pressure in the equity market, which has increased their common yields.

Taking all of this into consideration, we're very optimistic about the profits to be taken from these five preferred REIT opportunities.

Preferred Picks referenced: (CORR), (EPR), (KIM), (QTS), and (STAG).

Author's note: Brad Thomas is a Wall Street writer and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos and be assured that he will do his best to correct any errors if they are overlooked.

Finally, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking.

Disclosure: I am/we are long CORR, EPR, KIM, QTS, STAG. 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: Brad Thomas owns the common shares of these 5 REITs, and not the preferred.