REIT Preferred Stock - A Niche Market Opportunity
Investors seeking solid current income and preservation of capital
Overview of REITs:
A Real Estate Investment Trust (“REIT”) is a company that owns, operates, or finances real estate. REITs have historically provided investors of all types with regular income streams, diversification by geography and property type, and long-term capital appreciation. Unlike traditional corporations, which pay entity-level taxes, REITs pay no entity-level taxes on the bulk of their income so long as they distribute 90% of all taxable income to shareholders in the form of dividends.
REITs have historically delivered competitive total returns based on high, steady, dividend income and long-term capital appreciation. In contrast to investing in real estate directly, which requires unique expertise and may require a greater capital commitment or asset concentration than investors may desire, REITs offer diversified portfolios, professional management, and significant economies of scale with respect to both operations and financing.
Types of REITs
Equity REITs – Owns or operates income-producing real estate including office, industrial, retail, hotels, self-storage, multifamily, and single-family homes for rent. Most equity REITs specialize in one type of asset.
Mortgage REITs (“mREITs”) - Invest in and own commercial and residential mortgages. These REITs lend money to real estate owners and operators directly and through the purchase of mortgage-backed securities.
Agency mREITs – Invest exclusively in securities issued by Government Sponsored Entities (GSEs), such as FannieMae or FreddieMac. No credit risk, but some risk relative to the spread earned between assets and liabilities, as well as the rate at which borrowers prepay their mortgages.
Hybrid/Credit mREITs – Invest in both GSE securities and mortgages that do not carry a GSE guarantee, which may include loans secured by both single-family homes and income-producing properties. Some credit risk on non-GSE securities, the spread between assets and liabilities, and the rate at which borrowers prepay their mortgages.
Commercial mREITs – Invest in mortgages, usually originated directly, secured by income-producing properties. Most loans are floating rate and typically secured by “transitional” properties, such as those under construction or undergoing a major renovation or repositioning. Credit risk relative to property-level performance.
How to Invest in REITs
Direct Ownership of Shares
Actively Managed Funds – may include dedicated sector funds and diversified funds.
Exchange Traded Funds (“ETFs”)
Why REIT Preferred Stocks
Investors can generate 8-10% 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-rate and 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 over 150 different issues of non-convertible REIT Prefs, from over 70 publicly-traded issuers, with an average coupon of ±6.75% (including mortgage REITs), which is over 250 b.p. higher than the dividend yield on the MSCI US 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. REITs are dramatically more transparent than banks and other financial institutions.
Most REIT Prefs are issued with a redemption value of $25.00 per share and typically trade within a tight (±5%) 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.
Where do the Returns Come From?
Security selection is critical to maximizing returns because REIT prefs are typically evaluated based on both current yield (dividend/price) and yield-to-call (YTC). 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 $25.00. An investor who pays a premium for a REIT Pref (something above $25.00, 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 YTC may be acceptable, but it’s essential to understand the concept.
From a tax perspective, REIT Prefs are not treated as “Qualified” dividends subject to maximum Federal tax rates of 15%—20% but are treated instead as ordinary income. Nevertheless, given the much greater transparency and much lower leverage of REITs vs. banks, the trade-off in tax treatment seems worth it, as no REIT has ever had a “London Whale” or paid billions in penalties for opening unauthorized accounts.
Advantages of Investing in the REIT Pref Market
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% 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% 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.
REIT Pref vs. REIT Common Performance
REIT Prefs have historically generated competitive returns with lower volatility than REIT common stocks over extended periods of time.
Low to Moderate Correlation
REIT Prefs have low to moderate correlation to the broader equity markets, REIT common stocks, and high-yield corporate bonds, among other things.
REIT Pref Performance During Rising Interest Rates
Since November 2001, in all nine periods when yields on the 10-year U.S. Treasury note rose significantly (from 60 to 160 b.p. increases), the BAML REIT Preferred Total Return Index generated a positive return six months after rates stopped rising (from 4% to 54%).
Since preferred shares are typically perpetual in nature and interest rates are near historic lows, it’s 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.
What are the Potential Risks Associated with REIT Prefs?
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 a dedicated 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.
Lower Liquidity: REIT Prefs don’t enjoy the same liquidity as other asset classes, such as REIT common shares.
Capacity Constraints: The current REIT Pref market size of $30 billion is small relative to REIT common shares or the bank preferred share market. REIT Prefs don’t “move the needle” for major institutional investors.
Special thanks to:
Talbert Capital LLC
Jeff Talbert is the Managing Member of Talbert Capital LLC, which manages the Talbert Capital Preferred Income Fund LP, a dedicated vehicle invested exclusively in REIT Preferred.