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Searching for REIT Preferreds



July 25, 2012 – Comments (0)

Board: Real Estate Investment Trusts

Author: yodaorange

REIT Preferreds: Searching for Value and Dodging Increased Risk of Call

This post is a collaborative effort between Ralph, aka REITnut [1], and Yodaorange. Fellow REITsters have likely seen the changing landscape for our beloved REIT preferreds. So far in 2012, 36 issues have been called. Public Storage aka PSA floated its latest issue, PSA-pU with a coupon yield of 5.625% - and it’s now trading at a premium! Last week Vornado announced a new issue with a 5.7% coupon.

The Federal Reserve has been effective in steering many yield seeking investors out of CD’s and money market funds. Some of those investors have likely discovered the desirable characteristics of REIT preferreds. However, it is also likely that some of the lesser informed investors do NOT understand the call features of REIT preferreds. It’s quite likely that some of these investors bought issues north of $26 or $27, not expecting them to be called at $25.

Our goals for this post are to survey the landscape using mechanical formulas and to produce a list of all REIT preferreds, and to highlight those that Ralph knows and is comfortable with. Reasonable minds, of course, will differ, and Ralph’s opinion is only that. We used the following factors to categorize and separate the issues:

1. Is the issue “convertible” into shares of common stock or is it a “pure” cumulative preferred?

2. The earliest call date when the issue CAN be redeemed at the par price, most commonly $25 per share. Note that this does NOT mean that the issue WILL be called. It only means that the REIT has the right to call it at that date or any subsequent date.

3. The earliest call date is used to calculate the number of years before an issue can be called. For issues that have already passed their first call date, we assume the REIT will provide a 30 day notice to call the issue. This is why many of the issues show “.09” years in the “Years to First Call” column.

4. Coupon yield is the yield when the issue trades at “par” pricing. This marks the REIT’s true capital cost for preferred issues.

5. Current yield is the dividend divided by the current price. If the issue is trading at a higher price than par, the current yield will be lower than the coupon yield. This is the most common case. Assuming the issue is NOT called, this is the yield that an investor will receive if they purchase the issue. However, in all too many situations, THIS IS NOT A VALID ASSUMPTION; WE SUSPECT THAT SOME INVESTORS MISS THIS VITAL FACT.

6. Yield to First Call includes both the dividends AND the effect of the price change from today’s price to par. For example, if the issue is trading at $25.90 and is called 30 days from now, the investor will lose $25.90-$25.00= $.90. The REIT will pay a dividend when the issue is called, but it MIGHT not be enough to compensate for the loss of principal. Many REIT preferreds currently trade at NEGATIVE Yields to First Call, which assumes a call occurs within one month. Any investor that purchases the issue today will be at great risk of losing money if the issue is in fact called. This is NOT an exact science. A REIT MIGHT never call the issue, so the investor will realize a positive return. Our data highlights the POSSIBILITY of low returns assuming that the issue is called.

With this background, this is how the issues were categorized:

1. 14 issues that are convertible to common stock. This is because the Yield to First Call MIGHT not be a valid metric for these issues. You will need to perform your own due diligence before purchasing these issues.

2. 8 issues that are currently NOT paying their dividends. Consider these as wild gambling speculations only. NOT RECOMMENDED for conservative investors!

3. 27 issues with Yield to First Call >= 7.5%. This is an arbitrary cutoff, but it indicates that the market views them as high risk. Historically the market has been wrong in that very few REIT preferreds discontinue their dividend. However, as witnessed by the 8 issues that are currently not paying their dividends, the risk is NOT zero. Particularly if the economy enters a recession or worse, the dividends on these 27 issues would be in at least some doubt.

4. 76 issues with a first call date of less than 2 years. Many of these are immediately callable which shows up as .09 years in the data. 65 of the 76 have negative Yields to First Call, due to the assumption of call within 30 days. Thus, depending on whether the issue is, in fact, called, many of these will have very disappointing returns. Investors should only buy these issues if they are convinced that the issue will NOT be called in short order. Ralph doesn’t rate these, although he owns some of them; he’s willing to accept the risk of near-term call because he either doubts that they will be called, or because they are trading close to par, which minimizes the dollar loss if called. Each of these should be carefully analyzed on its own merits.

5. This leaves 54 issues that are NOT convertible, are paying dividends, are not callable in the next two years and have Yield to First Call of less than 7.5%. We have separated them into the NAREIT sector and sub-sector. Then we rank them by descending Yield to First Call. Note that some of these issues have low Yield’s to First Call, so there is still risk of low investment returns.

Ralph tracks some but not all of REIT preferred issues and has given ratings to those he tracks.

These ratings are as follows: A = acceptable for the reasonably conservative investor. LTL = lower than appropriate total return, given balance sheet quality, management strength, business strategy and other factors. Ralph would avoid these unless and until they are priced more reasonably. RS = reasonable speculation, although not appropriate for the conservative investor.

If there is NO rating by Ralph, it does NOT mean that issue is a “Sell.” It only means that he has not figured out how to go sleepless for months on end to track all REITs.

Reitnut and Yodaorange

[1] Ralph Block, Bloomberg Book, “Investing in REIT’s”, 4th edition

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