Taubman Centers: Some Like It Illiquid

|
About: Taubman Centers, Inc. (TCO), TCO.PJ, TCO.PK, Includes: SPG.PJ
by: AvoidingBigLosses
Summary

High-quality REIT preferred shares can offer attractive returns with fairly low risk.

These returns can be even greater if you buy and sell opportunistically.

Patience is essential with such securities.

Investors should be very sensitive to the share price when it comes to both buying and selling.

Liquidity

Liquidity is the degree to which an asset can be bought or sold quickly without causing the price of the asset to change. A US Treasury note is highly liquid. Raw land is highly illiquid.

Generally, investors like liquidity. It allows them to enter or exit a position easily at any time. No single investor buying or selling can move the price very much, and with many participants, there is no need to wait days or weeks to enter or exit even a large position.

But the lack of liquidity can also provide opportunities.

Separating the good from the bad

Illiquid securities often come with a variety of risks:

  • They may be small companies, highly dependent on the health of a single customer or asset.
  • They may be unprofitable or lack easy access to additional capital.
  • A major product line may be unproven or face obsolescence.

Every now and then one can deliver spectacular returns...but a lot lead to major losses.

But then there is a separate class of illiquid securities: those of high-quality companies that are thinly traded for some other reason. I believe that preferred shares of certain high-quality REITs fit this category.

How to approach these securities

While preferred shares are not bonds, they can be somewhat bond-like in nature, providing a fairly reliable fixed stream of payments. A major difference is that the small capitalization of some preferred classes means the share prices can be very volatile. If you're willing to have a limit order sit quietly for weeks or even months, you can occasionally buy shares at a very attractive price. Then, you can place a limit sell order and some overzealous buyer may buy your shares in a few weeks for a price at which you'd eagerly dump them. You can collect a modest capital gain along with any dividends earned along the way.

Of course, there are some risks, tradeoffs, and limitations to these preferreds.

  1. Dividends are not increased with earnings. Exceptions exist in the case of a few securities.
  2. You're not likely to make an enormous return with one trade. The idea here is to get a few easy base hits, not to swing for the fences.
  3. Many REIT preferreds are callable, now or in the future.
    • In setting a limit order to sell the shares, you have to keep in mind that the issuer may call them. Setting too low a price may mean giving part of your profit to someone who read the news before you could cancel your sell order.
    • That said, in the current interest rate environment, retiring or replacing preferred shares may not be economical for many REITs.
  4. The purchasing power of shares will fall if inflation is high.
  5. An extreme downturn could interrupt dividends or lead to a loss of capital.
  6. Opportunity cost may be a factor. This strategy is focused on placing buy and sell orders that may sit for weeks or months...or may never be filled. You may miss out on nice returns elsewhere, or have your capital tied up for a long time.
  7. Even if you don't sell your shares, it's possible that you won't earn much of a dividend if the issuer forcibly redeems them in the near future - as many issuers already have the right to do. However, if you're buying shares well below the redemption value, this is not much of a concern.
  8. Alternately, interest rates may rise greatly and the shares might never be called. Bonds have a maturity date, but preferred shares don't (with perhaps a few exceptions).
  9. It's common to only have part of a large order filled in a given day, which can increase commission costs as a percentage of an investment.
  10. This strategy may work well if you want to invest 5 or 6 figures into a single preferred series. If you want to invest 7+ figures into one position, you're likely to have a hard time getting enough shares. This is only a peripheral investment for me, and not the core of my portfolio (which is still BRK.B, BPR, and BAM, for curious existing readers). A smaller investor may be able to make a larger percentage allocation.
  11. Unless you employ margin debt or some very advanced order conditions, you may be forced to choose between two options:
    • You place several smallish orders for a few different REIT preferreds. With more targets, you're more likely to get an order filled...but it may not make a huge difference in your overall portfolio return as only a little capital is involved.
    • You focus on one REIT and place larger orders. It's simpler, but it also means you may miss an opportunity in a different preferred.

A prime example

Taubman Centers, Inc. (NYSE:TCO.PK) is a REIT that owns several of the best retail assets in the USA, along with an interest in Korean and Chinese retail properties. It has three classes of publicly-traded shares, all of which trade in US dollars on the NYSE:

  • Common shares (TCO)
  • Series J 6.5% Preferred Shares (TCO.PJ). Currently redeemable for $25 plus any unpaid "partial quarter" dividends. Also traded as TCOPRJ, TCO/PRJ, or TCOPJ.
  • Series K 6.25% Preferred Shares (TCO.PK). Currently redeemable for $25 plus any unpaid "partial quarter" dividends. Also traded as TCOPRK, TCO/PRK, or TCOPK.

Note that brokerages use a variety of ticker symbols to refer to the preferred shares. It may take a little trial an error to find the preferred shares on your trading or research platform, but hopefully it should be easy to distinguish the J shares from the K shares.

2018 dividend Shares Outstanding Annual dividend run rate Percent of total dividends
Common shares $2.62 61,001,357 $159.8 million 87.4%
Series J 6.5% preferred shares $1.625 7,700,000 $12.5 million 6.8%
Series K 6.25% preferred shares $1.5625 6,800,000 $10.6 million 5.8%

Total: $182.9 million

(Common share count based on weighted average shares from Q3 10-Q. Assumes common share count and per-share dividend will not change in 2019).

Share price Shares outstanding Market cap by series Percent of total market cap
Common shares $49.66 61,001,357 $3,029 million 89.3%
Series J 6.5% preferred shares $25.20 7,700,000 $194 million 5.7%
Series K 6.25% preferred shares $24.95 6,800,000 $170 million 5.0%
Total: $3,393 million

(Share prices based on Feb 7 market close).

To be clear, these are preferred shares and not debt. Preferred shareholders who don't get their dividends cannot take control of a company the way bondholders can when a company fails to make interest payments.

However, dividend payments may be as safe as interest payments from many bonds. Taubman would need to not just cut, but eliminate the dividend on its common shares before cutting the dividend on its preferred shares. Because preferred shares are a small share class and receive only about 12.6% (6.8% + 5.8%) of the total dividend, the coverage is quite comfortable. In other words, the cash going towards dividends would have to be cut about 87.4% before preferred shareholders would suffer a reduced dividend.

Taubman's $3.8 billion of debt is not insignificant. For the first nine months of 2018, Taubman paid $97.2 million in interest.

To put this in the clearest context, I'm going to use an unconventional accounting metric, but one that seems appropriate:

Consolidated revenues $473.4 m
Less all operating expenses ($435.9 m)
Add back interest $97.2 m
Add back depreciation $124.3 m
Add after-tax income from unconsolidated joint ventures $50.7 m
"Modified EBITDA" $309.7 m

(First 9 months of 2018. Calculated from data in Q3 10-Q, p3.)

As a share of this "Modified EBITDA", Taubman has the following cash outflows. I'm setting aside depreciation as a non-cash expense.

Cash outflow Dollars Percent of "Modified EBITDA"
Interest $97.2 m 31.4%
Preferred J and K dividends $17.4 m 5.62%
Common share dividends $119.9 m 38.7%

Taubman's debt is not trivial. Like many other REITs, it has an aggressive distribution policy, paying out more than its taxable income. In 2018, 42.6% of Taubman's common share dividend was in the form of a return of capital. As a hypothetical common shareholder, this would give me a little pause and likely reduce the price I was willing to pay for common shares.

However, as an occasional preferred investor, I'm not concerned. Given the spectacular quality of its assets, Taubman can handle the debt and does not need to reserve much cash. Tenants are eager for space, and Taubman's assets will be extremely valuable even when the accounting rules governing depreciation say the assets should be nearly worthless.

Tax consequences

A small additional benefit is that the dividends on these preferred shares have not been purely ordinary income. In 2018, a little less than 2% of the Taubman preferred dividend was long-term capital gain. In 2017, long-term capital gain was nearly 25% of the preferred dividend. Perhaps 2019 and beyond will include some similar benefit.

Other options

Taubman is not the only healthy REIT with illiquid preferred shares that can be attractive at the right price.

  • Simon Property Group (SPG) has some 8.375% Series J Shares (SPG.PJ) that are not callable until 2027. Before you rush to buy them, however, be aware that they trade for a 40% premium over the $50 redemption price. Of course, a selective buyer may be able to get shares at a lower premium.
  • Brookfield Property REIT (BPR), a subsidiary of Brookfield Property Partners (BPY), has Series A 6.375% Preferred Shares (BPRAP) that Brookfield has the option to redeem at $25.

But what about...

I've limited my examination to preferred shares of the healthy REITs I've examined and recently owned, which have been retail focused. I'm not as enthusiastic about this approach for:

  • Preferred shares for REITs in other industries - simply because I don't know them well. Perhaps readers can suggest some that I can examine in a future article.
  • Preferred shares for retail REITs facing some degree of financial strain. They may possibly deliver excellent returns for investors (I have my doubts), but they involve a greater risk of loss and are more a bet on a company's recovery than a low-risk approach to a quirky security's volatility. Also, a lot of people seem to be interested in them, making price changes more about fundamentals than illiquidity. I'm talking about:

Conclusion

I think the volatile nature of these high-quality illiquid preferred shares makes them an attractive option for investors with the temperament to be patient buyers and the financial security to be patient sellers.

Disclaimer: Do your own research. Nothing here is formal professional advice.

Disclosure: I am/we are long BPR, SPG. 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: I recently sold my Taubman K preferreds. I have low limit orders to buy Taubman, Simon, and BPR preferreds. I am long BPR and SPG common.