Investors can generate 8 percent to 10 percent returns from a diversified and conservatively leveraged portfolio of REIT Preferred Stocks (REIT Prefs) with lower volatility and far greater security than a portfolio of REIT common shares. In contrast to the over $1 trillion market for REIT common stocks, the less than $30 billion market for fixed or fixed-to-floating (not convertible) REIT Prefs is a niche market especially well suited to family offices, wealth managers and high-net-worth individuals seeking solid current income and preservation of capital.
There are currently more than 150 different issues of non-convertible REIT Prefs, from more than 75 publicly traded issuers, with an average coupon of ±6.75 percent, which is nearly 250 basis points higher than the dividend yield on the MSCI U.S. REIT Index of common shares. REIT Prefs, therefore, earn a higher current return while being more senior in the capital stack than an issuer’s common shares. Many REIT Prefs carry investment-grade ratings, and even those below investment grade feature solid and transparent balance sheets. Banks and other financial institutions are the largest issuers of preferred stock, but a major advantage of REIT Prefs is that it is much easier to assess the composition of a REIT’s assets and liabilities versus a large-cap bank.
Most REIT Prefs are issued with a redemption value of $25 per share and typically trade within a tight (±5 percent) range over extended periods of time; this price stability makes the use of moderate portfolio-level leverage (say, 1:1) much safer than with REIT common shares, which are subject to wider price swings. Other features of REIT Prefs that make them ideal for investors focused on capital preservation include:
- REIT Prefs are incredibly secure because the public market strictly polices the amount and nature of debt that public REITs may carry, with debt/enterprise value for equity REITs typically below 35 percent and EBITDA coverage through all debt and preferred shares above 4x; by contrast, many banks employ leverage that is well over 10x their equity.
- REIT Prefs carry cumulative dividend covenants such that any missed dividends must be paid in full before any distributions to common shareholders may be made.
- The requirement that REITs must pay out at least 90 percent of their taxable income severely limits the risk that management will not pay preferred dividends without very good cause.
- During the most recent financial crisis, REIT common dividends were frequently cut, suspended or paid in shares while preferred dividends continued to be paid, in cash, on a quarterly basis.
- Since preferred shares are typically perpetual in nature and interest rates are near historic lows, it is useful to look at how REIT Prefs have performed when rates rise. Contrary to conventional wisdom, REIT Prefs have historically performed far better than expected in rising rate environments because credit spreads and risk premia typically compress as economic conditions improve, which materially offsets expected price declines.
- Since November 2001, in all eight periods when yields on the 10-year U.S. Treasury note rose significantly (from 60 to 160 basis point increases), the BAML REIT Preferred Total Return Index generated a positive return six months after rates stopped rising (from 4 percent to 54 percent).
Security selection is critical to maximizing returns because REIT Prefs are typically evaluated based on both current yield (dividend/price) and yield-to-call. Most new issues of REIT Prefs feature five years of call protection before the issuer may redeem the stock, typically at its issue price of $25. An investor who pays a premium for a REIT Pref (something above $25, including any accrued dividends), will, if that issue is called in the future, amortize the premium paid over the holding period. Both the current yield and yield-to-call may be acceptable, but it is essential to understand the concept.
From a tax perspective, REIT Prefs are not treated as “qualified” dividends subject to a maximum federal tax rate of 20 percent, but are treated instead as ordinary income. Nevertheless, given the much greater transparency and much lower leverage of REITs versus banks, the trade-off in tax treatment seems worth it, as no REIT has ever had a London Whale (a trader who lost billions) or paid billions in penalties for opening unauthorized accounts.
The ultimate question, therefore, might be, “If this is such a great idea, why does it exist in an efficient market and why aren’t institutional investors buying up all the good paper and driving down returns?” The answer is lower liquidity and greater capacity constraints relative to the market for REIT common stock. At less than $30 billion, the market for U.S. REIT Prefs doesn’t “move the needle” for major institutional investors, which leaves outsized returns available in a sector that flies largely below the radar. The absence of an ETF that tracks REIT Prefs also minimizes the risk-on/risk-off swings often seen in the market for REIT common shares. In summary, REIT Prefs are worth a serious look for family offices, wealth managers and high-net-worth individual investors seeking solid current income and preservation of capital.
Jeff Talbert is the managing member of Talbert Capital.