Safe Sex for REITs
Board: Real Estate Inv. Trusts: REITs
Credit Jim Luckett for the subject of this post. A few weeks ago he cleverly explained how dividends are like sex. (See: http://boards.fool.com/emfreak-dividends-are-like-sex-in-mar...). Well, if dividends are like sex, then we REIT preferred shareholders want to make sure that sex is safe!
What’s the biggest threat to your REIT preferred dividend? Some would argue credit risk. A REIT with a weak balance sheet and ineffective management may end up suspending the preferred dividend, especially in a downturn. Others would argue inflation is the biggest threat. The preferred dividend is fixed, so rapidly rising inflation could seriously erode the purchasing power of the dividend. And then others would claim that rising interest rates are the greatest risk. Rising interest rates not only would have an impact on REIT operations, but also could negatively affect REIT preferred prices.
Besides credit risk, rising inflation, and rising interest rates, there is additional threat to your preferred dividend -- takeover by another company. It’s a risk that some REIT preferred investors may underestimate, and could be your biggest risk, according to Simon Wadsworth in his book Cash is King: Investing in REIT Preferreds to Generate Long-Term Income.
In his book Wadsworth tells the story of Walden Residential Properties, how it was acquired through a leveraged buy-out, and how preferred shareholders of Walden lost money on the deal. Since then situations where takeovers occur and preferred shareholders experience loss have been referred to as “Waldenization”. He says there have been at least six cases of Waldenization, the most notorious occurring in the period 2007-2008. It’s the granddaddy STD of REIT preferreds.
So how can you, the preferred shareholder, protect yourself from Waldenization? Wadsworth cites several steps you can take to reduce your risk from Waldenization: (1) maintain adequate portfolio diversity; (2) weight your REIT preferreds to investment grade REITs, larger REITs with strong balance sheets and effective management, and REITs with anti-takeover measures in their charter; (3) watch your portfolio companies for warning signs of an impending sale; (4) focus on REIT preferreds that have special provisions for change of control.
It’s the last safeguard he mentions – provisions for change of control – that have made their way into the offerings of several unrated REIT preferreds since the latter half of 2010. These provisions generally come in two flavors – a one-time increase in the dividend yield or a one-time right to convert into common shares. Kite Realty Preferred Series A (KRG-A) is an example of the one-time rate increase provision. In the event of a takeover or a delisting of the preferred, the dividend rate is increased by 4%. Cogdell Spencer Preferred Series A (CSA-A) is an example of the one-time common share conversion provision. It was with foresight that Wadsworth used the example of Cogdell Spencer. In December 2011 Ventas (VTR) made an offer to acquire Cogdell Spencer for $4.25 in cash. Look what happened to CSA-A’s price before and after the Ventas offer.
So far this discussion has been academic, but now I want to apply it to a ‘real-life’ situation – my own REIT preferred portfolio. All of my REIT preferreds are either unrated or speculative grade, and mostly smaller companies. What change of control provisions are in place for these REIT preferreds?
Alexandria Real Estate Series D Convertible (AREEP) – The IPO was in March 2008, well before share conversion provisions made their way into new REIT preferred offerings. However, AREEP is a convertible, so shareholders have the right to convert their shares anytime into the common. This in itself would not be adequate protection in case of a takeover, but AREEP has special provisions in the prospectus in case of a “fundamental change”. The provisions are too complicated to explain fully here, but essentially it describes conversion of shares to common based on some high-end and low-end caps, and also the right of Alexandria to repurchase the shares. My take is this preferred has reasonable safeguards in place in the event of a takeover.
CubeSmart Series A (CUBE-A) – This is a newer issue and has the ‘conversion to common’ provision. In the event of a change of control, preferred holders can convert to common, with a cap of 5.1546 shares. Most of these conversion provisions have a cap, which is the minimum number of shares issued after dividing the preferred par price by the price of the common. In this case, the cap equates to a common share price of $4.85 (CUBE’s common price is currently $11.66). In the event of a takeover, if CUBE’s common was below $4.85 and you wanted to convert, then you would lose money, if you bought at par. CUBE also has a right with change of control to redeem the preferred at par within 120 days. Again, my take is that these provisions are adequate in case of a takeover.
DuPont Fabros Technology Series B (DFT-B) – Has the conversion to common provision, with a cap of 2.105 equating to a common price of $11.88 (current price is $26.08). Can also redeem at par if change in control. My take = adequate provisions in place.
Equity Lifestyle Properties Series A (ELS-A) – Has the conversion to common provision, with a cap of .8615 equating to a common price of $29.02 (current price is $69.10). Can also redeem at par anytime. My take = adequate provisions in place.
Excel Trust Series B (EXL-B) – Has the conversion to common provision, with a cap of 4.1701 equating to a common price of $6.00 (current price is $13.12). Can also redeem at par if change in control. My take = adequate provisions in place.
Ramco-Gershenson Series D convertible (RPT-D) – Like AREEP above shareholders can convert anytime, but there are also special conversion options in case of takeover. The cap under change of control is 7.9808 which equates to a price of $3.13 (current price is $11.90), but there are also other provisions more complicated which I’ll leave it up to you to read. My take = adequate provisions in place.
So, after all this, are my preferred dividends safe? Probably not. They are not well-diversified and are mostly smallish companies, speculative graded or unrated. However, from a takeover perspective, I think the provisions in place for each of these are the best I can hope for in these times.
Would be interested to hear your opinions.
THIS IS NOT A RECOMMENDATION TO BUY OR SELL ANY OF THE SECURITES LISTED ABOVE.
THIS IS NOT IN ANY FORM INTENDED AS INVESTMENT ADVICE.
THE SOLE PURPOSE HERE IS TO SUGGEST IDEAS FOR DISCUSSION AND FURTHER STUDY.
Disclosure: I own AREEP, CUBE-A, DFT-B, ELS-A, EXL-B, and RPT-D, but do not
own any of the other securities mentioned above.