Considering REIT Preferreds
Board: Real Estate Investment Trusts
YIELD VS RISK
My wife and I were on a cruise for the past two weeks, beginning in Boston and visiting Acadia National Park, Nova Scotia, Quebec and Montreal, during which I did my best to avoid watching this ever-frustrating stock market. Upon returning home late last week I found that equity prices hadn’t changed much. However, bond yields have come down. The yield on the 10-year Treasury note declined to about 2.6% from 3.0% earlier in September, despite the prospect of a partial government shut-down and even a Federal debt default. The internecine warfare among the bozos in D.C. seems as though it will never end. Bring back Bill and Newt – at least they managed to resolve their differences eventually.
I have long been a fervent believer in the continuation of “New Normal” and sub-par economic growth; underemployment remains a big issue, and businesses are likely to remain cautious about hiring and capital spending due to substantial uncertainty regarding tax policy, healthcare insurance issues and the ever-increasing toll of government regulation. I therefore continue to believe that bond yields won’t push much higher over the next 12 months or so.
That said, there’s a pretty good chance that the US economy will eventually grow faster – and bond yields are still very low historically. Bond investing thus remains a very tricky, perhaps even dangerous, endeavor. But many investors do need substantial current income. As stated in prior Block Party posts, I believe that REIT preferred stocks are a great way to invest for income, while keeping default risk to a minimum. But, as we’ve experienced since May, price depreciation risk is another story.
Is there a way to enjoy the yields of REIT preferreds and yet limit the risk of price depreciation in a rising rate environment? Maybe. REIT preferreds are normally issued with five years of call protection, and a number of them were issued when bond (and preferred) yields were higher than they are today (or have since improved in credit quality). Finding above-market coupons, yet with a couple of years of call protection, will limit “duration,” i.e., these higher coupons will reduce the expected life of the preferred because of the expectation of a call in the near future. The prices of these preferreds have held up better than most since last May, and should continue to do so if bond yields drift back up.
Consider, among others, the following: CubeSmart Pfd A (CUBEpA), Essex Properties Pfd H (ESSpH), Kimco Realty Pfd H (KIMpH), Pebblebrook Pfds A and B (PEBpA, PEBpB), Public Storage Pfd O (PSApO), Sunstone Hotel Investors Pfd D (SHOpD) and Terreno Realty Pfd A (TRNOpA). All of them have been recently trading above par value ($25), suggesting that their coupons (i.e., annual dividend rates) are somewhat above today’s rates. They yield somewhere between 6.5% and over 7%, and are of pretty good credit quality. They have less price upside if bond yields decline (there is no free lunch), and yields to first call will be less than current yields because of the trading premium over the call price. However, they are likely to be less volatile than lower coupon issues. They may be good choices for those who need income but are worried about the risk of rising bond yields.
On a different topic, but still in the realm of yield vs. risk, last Saturday’s Wall Street Journal contained a story about non-traded REITs (September 28, page B9). It seems that non-traded REITs are alive and well today, despite the concerns they present to investors. The WSJ, citing Robert A. Stanger & Co., states that, through August of this year, non-traded REITs have raised $12.87 billion, already beating the prior record of $11.5 billion set in 2007.
These REITs have long been criticized for their illiquidity, high sales commissions (which can reach 15%), lack of transparency regarding assigned share values and other disclosure, and the conflicts of interest between the investors and their sponsors (sponsors have tended to own very small equity interests in their non-traded REITs, and may have incentives that are inconsistent with the shareholders’ best interests). Although their lack of liquidity may be regarded as a positive by some investors – I suppose not being able to get daily pricing of one’s investments can be soothing for ostrich wannabees – the inability to liquidate an investment is a major drawback, in addition to the other concerns, and such an investment ought to be priced accordingly. Industry observers have suggested a holding period of as long as six to twelve years. Yikes – many beautiful large dogs don’t even live as long as that.
But often the criticism of non-traded REITs fails to adequately compare them to public REITs. The REIT industry has grown and prospered for over 50 years in large part because of excellent REIT management teams. We have, of course, experienced a number of blow-ups over the years, most often due to the perils of excessive debt leverage, but the average annual total return of equity REITs over the past 40 years has been over 12%, and they have, until very recently, been a lot less volatile than most equities – and deserve to be so, given their stable cash flows, assets anchored by properties than can, more or less, be readily valued and by their higher-than-average dividend yields.
I believe that one of the primary drivers of success of public REITs has been that the management teams (and Boards of Directors) have aligned their interests with those of the public shareholders with respect to equity ownership. Risking one’s own capital does wonders for the decision-making process. Equity ownership by REIT management, as a percentage of the total outstanding shares, has come down over the years due to the transition from founders of private real estate empires to younger, more professional executives. However, strong equity incentives remain in place within the vast majority of public REITs. They know that even the perception of excessive risk-taking or capital misallocation will have a significant effect upon share prices, and will certainly affect their own net worth.
Public REITs also manage and enter into leasing transactions regarding their own properties and, even when refraining from commencing ground-up developments (due to market conditions or their own lack of experience in doing so), often redevelop and otherwise improve their properties at very attractive risk-adjusted returns. They also, at times, are able to acquire properties at attractive prices and expected total returns. These activities usually create incremental value for shareholders, which eventually is reflected in REIT share prices. Private REITs, as far as I can tell, do not do this.
Promised dividend yields on newly-issued shares of private REITs can exceed 6-7%, compared with about 3.7% for your average equity REIT. That’s probably enough of a difference to get many inexperienced investors on board. However, anyone who buys an investment on the basis of the dividend yield alone needs some serious investment counseling – preferably from an investment advisor who doesn’t earn commissions from its sale. There has always been a direct relationship between current yield and risk – the latter rises when the former exceeds certain levels, depending on current market conditions. This may be one of the world’s few eternal verities, consistent with the no-free-lunch principle.