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Read Before Buying REIT Preferreds

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May 28, 2013 – Comments (1)

Board: Real Estate Investment Trusts

Author: yodaorange

REITnut and Yoda strongly urge you to READ this before buying REIT preferreds

REIT preferreds have become a favored asset class for many investors on this board. Many own them and understand their characteristics. As with most investments, there are pluses and minuses. There is one MAJOR risk that new investors might not understand. We consistently see investors in the marketplace that do NOT understand this risk. In many cases, investors suffer significant losses in the range of ~ 5% to 15% on their investment. The risk is “Yield to First Call” aka YTFC.

There are about 200 different REIT preferreds that are actively traded. About 95% can be “called” by the issuer, usually after five years from the date of issuance. Let’s use an example to illustrate the concept:

1) REIT ABC sells 1 million shares of “cumulative preferred Series A” stock on January 1st, 2008 for $25.00 per share. The REIT will pay the owner a dividend of $2.00 annually, or 50 cents/share on April 15, July 15, October 15 and January 15 each year. Let’s call this issue ABC-prA. Different brokerage houses have different naming conventions for the REIT preferreds. You will need to check with your own brokerage to get the exact ticker.

2) The total annual dividend is 4 * .50 = $2.00/ share. This is a yield of 8.00% on the original purchase price. This yield is called the “coupon yield.”

3) After the initial offering, the preferred will trade on the open market, just like any other stock.

4) As interest rates rise or fall, and/or risk perceptions change, the value of this preferred will also change. For purposes of this discussion, we will ignore the credit quality of the issuing REIT. We will assume that the marketplace has 100% confidence that all dividend payments will be made on a timely basis.

5) Interest rates, i.e., dividend coupons, on newly issued REIT preferreds have been falling the last several years, like most other interest rates and bond yields around the US. Let’s assume that REIT ABC can now sell a new REIT preferred at a 6.0% coupon yield. So they sell 1 million shares of cumulative preferred Series B aka ABC-prB for $25.00 per share

6) What are the implications for the old Series A preferred? Vastly simplified, its price in the market place will rise until it is yield 6.0% (or perhaps a bit more to compensate for the call risk). This means it would theoretically increase to $33.10. You can see this yields 6.0% by dividing the 2.00 dividend by the $33.10 stock price.

7) If you bought the series A back when it was issued, you would be very pleased to see your shares now valued at 33.10. But there is a CATCH . . . Nearly all REIT preferred shares are “callable” at the discretion of the REIT. The REIT will have the ability to buy all of the 8% shares and sell more 6% shares. It will save the REIT 2% of interest every year.

8) REITs typically promise that they will not call a preferred for the first five years after it begins trading. In our case of the Series A that was first offered on January 1st, 2008, the REIT could NOT call the issue until January 1st, 2013. From that day on, the REIT has the choice of calling the issue and paying the holder $25.00 per share, plus any accrued dividends to the date of call.

9) The MAJOR RISK is that investors that bought the Series A for greater than $25.00 per share will suffer a capital loss measured by the difference between the purchase price and the $25 call price. For illustration purposes only, if you bought shares yesterday for $33.10, you would be at risk of having them called by the REIT for $25.00 per share. You would LOSE $8.10 per share in one day.

10) Thus it is very important you understand the YTFC. This is the yield you would achieve assuming the issue is called on the earliest possible date. The YTFC takes into account both dividends that will be paid and the price change of the share. In our case, as would be true in almost all cases, the Series A would NOT be trading at 33.10 today. Sophisticated investors understand YTFC and tend to price issues such that they have “reasonable” YTFC’s.

11) The problem is that we consistently see REIT preferreds trading at elevated prices with NEGATIVE YTFC’s. If the issue is called by the REIT, investors that bought at the current market price WOULD LOSE money. A recent dramatic case was CMO-prB on May 8th, 2013. It closed @15.30 on May 7th. On May 8th, the REIT (CMO) announced they were calling the issue @ 12.50 in ~ 30 days. The price dropped from 15.30 to 12.59 in ONE DAY. Any investor that recently bought shares in the 15.30 range lost about 15.30-12.59= 2.71 per share. That is a HUGE percentage loss.

12) The challenge that investors face is that YTFC is NOT readily or easily available, to our knowledge. We do not know of any free web site that lists YTFC in real time or near-real time. Investors are left to calculate YTFC on their own.

13) There are broadly four different classifications of REIT “Preferreds”

a. Regular issues that have first call date in the future, generally any issue that first traded in the last 4 years.

b. Regular issues that are PAST the first call date. The REIT can call the issue on any date, typically with a 30 day notice. CMO-prB was in this category. NOTE that the REIT is NOT required to call the issue, even if they could save money by refinancing with a new one. For example if interest rates rise substantially, the REIT would not call the old, lower interest preferred issue. Or, they might not call an issue if the cost savings would be minimal.

c. Securitzed bonds/notes that have a definite maturity date. Example issues are CWHN, CWHO, GOODN, VNOD, VTRB and WRT.

d. “Convertible” issues that allow the shareholder to convert the preferred shares into common shares under certain conditions. Typically these issues are NOT callable, except if and when the stock trades above the convertible price for a specified time period. They also do NOT trade solely on the basis of yield. So YTFC is NOT pertinent. Example issues are: AREEP,EPR-prC, ESSFO, HCN-prI and RPT-prD.


14) It is ABSOLUTELY VITAL that you understand the exact characteristics of the any preferred issue BEFORE you but it. The reference website we use is: http://www.quantumonline.com/

DO NOT USE THESE COMMENTS ABOUT “TYPICAL” REIT preferreds for your issue. These comments are for illustration purposes only and YOU MUST check any and all issues first.

15) You can calculate YTFC in an Excel spreadsheet. The calculation is very precise for issues that have call dates in the future. It is LESS precise for issues with call dates in the past (which are callable).

You can enter this formula into Excel to calculate YTFC.

Yield to first call= (annual interest + (Call price-today’s price)/Years to call)
Divided by
(Call price + today’s price)/2

If you want, you can download a sample spreadsheet with the formulas already entered.

Link: https://docs.google.com/file/d/0B5dFSqhA4gKERUh0NGo4c1o1R1k/...


16) We will NOT go into the details of why YTFC is more difficult to calculate for an issue that is past its first call date. Think about it in these terms.

a. Call date is before today, i.e. the issue can be called at any time by the REIT

b. The issue is trading above par, typically $25.00 price

c. The preferred is “accruing” or building up a future dividend every day it is active

d. IF the issue is called, the REIT will pay the accrued dividend and the par amount

e. If you pay more than the accrued dividend and par amount, you are at SIGNIFICANT risk of losing money if the issue is called.

f. Keep in mind that most of these presently-callable issues trade at a modest, but real, premium over par value + accrued dividend; for some issues, a modest, i.e., 10-15 cent, premium may be worth the risk, but much depends upon the likelihood of the issue actually being called.

If you have any questions about YTFC, please speak up. There are plenty of knowledgeable folks on the REIT board that will be happy to help you out.

Thanks,

REITnut and Yodaorange

1 Comments – Post Your Own

#1) On May 28, 2013 at 9:02 PM, awallejr (75.87) wrote:

Well this can apply to many nonREIT preferreds as well.  Any time you pay over par you can run the risk of loss if you don't read the fine print.  But a good "heads up" blog.

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