The ABCs of REIT Preferred Stocks

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bonds:   Sometimes a yield of  say 7% looks good to investors and sometimes it looks paltry.    Holding constant the perceived risk of dividend suspension, the thing that brings about the good-to-paltry or paltry-to-good transition is changing prospective return on alternative assets.   In other words, if investors can get, or think they can get, more than 7% on something else with the same level of certainty, then the price of your preferred stock will fall.  One way this can happen is if interest rates rise.   If investors can get 8% on relatively good bonds, or newly-issued preferred stocks of similar quality, then they will not accept 7% on the preferred stock you are holding.  The stock price will fall.  The fall in the price of your preferred holdings makes their market yield rise to a competitive level.    

Like junk bond prices, preferred stock prices  are more responsive to business prospects than interest rates.    When and if we return to a strong economy, interest rates on money market instruments and AAA bonds are likely to rise, as the Fed moves away from stimulus and toward restraint, and as demand for money increases in credit markets.    This is not all bad for investors in REIT preferreds.     Yes, the rise in interest rates is a rise in the prospective return of competing assets and that’s a downward force on your REIT preferred stock prices.   But, at the same time, an improving economy means greater demand for the REIT’s rental space, therefore lower vacancy and higher rent levels, therefore more cash flow, therefore lower risk of a dividend suspension on the preferred.    It is not at all clear which way the net effect works out — does the price of your REIT preferred stock appreciate due to lower perceived risk to the dividend?  Or does it decline due to improved return on competing assets (bonds)?     Lower quality (i.e. riskier) preferred stocks will respond more to the improvement of business conditions while the best quality REIT preferreds, where there wasn’t much perceived risk of dividend suspension even in hard times, may be more influenced by the competition from rising bond yields.

On the other hand, your preferred stock yielding 7% and selling below its call price could deliver a capital gain for you if market conditions change so that 7% starts looking very, very fat in relation to other opportunities in the market with comparable risk characteristics.   And this brings us to the discussion of returns.

Returns

The most obvious source of return from preferred stock investing is the dividend stream.   But, it is also possible to reap a big capital gain from preferred stocks if you buy them when they are very depressed.   When it looked like the whole world financial system might collapse in late 2008 and early 2009, many REIT preferred stocks fell to the low teens or even single digits.   These were stocks issued at $25 per share (sometimes more) and they were still paying their dividends.   Apparent dividend yields were in the double digits.    As it happened, the world did not end, the dividends continued, and most of the preferred stock prices recovered.   So, if you bought during those scary times, you reaped a big capital gain in addition to a fat dividend yield calculated relative to your cost.

If you are very good or very lucky you might pull off a similar investing coup identifying troubled companies that you believe are destined for a successful turnaround, even without the context of a general market panic and market recovery.  Of course, you also might get burned trying to do that if you guessed wrong.

Some REIT preferreds have another potential source of return:  A conversion right.   These are called “convertible preferred.”   This is an option of the preferred stockholder to present his preferred shares and demand a certain number of common shares instead.   The conversion ratio — number of common shares to be given for each preferred share — is stated in the prospectus.    A convertible preferred can fully participate in the appreciation of the common, once the common stock price has risen (or the preferred stock price has fallen) enough so that the market value of the preferred is equal to the market value of the number of common shares it is convertible into.    Example:   Suppose the conversion ratio is 4 common shares to each preferred share, and suppose the preferred is selling at 24.   If the common is selling at 6, then the preferred is worth just as much as a preferred as it would be worth converted into common stock.   Therefore, if the common stock goes up 10%, you can expect the preferred to go up10% as well.   On the other hand, if the common stock goes down quite  a bit, the preferred probably won’t go down as much because it still has its underlying value as a straight preferred without reference to any conversion right.    This is heads-you-win-tails-you-don’t-lose-as-much!   It’s rare that the planets align so perfectly as to give us a REIT preferred selling near its conversion value, but I have had the privilege of buying a few.

Trading

REIT preferreds are thinly traded.   The spread between bid and ask is often large.   The prices can move rapidly in response to large orders, or even small orders.   So, you dare not use market orders.   You have to look at the bid and ask and the recent trades and put in a limit order, or else you could get badly burned.

Because they are thinly traded, there are market inefficiencies.   If you are a small investor, so your trades are small in relation to the market for individual REIT preferreds, you might be able to exploit these inefficiencies through careful and astute trading.    But, the deck is stacked against you due to the typically large market spread, so tread carefully.

Where to Begin

A great place to begin researching REIT preferreds is a website called Quantumonline.com.    You can find out a tremendous amount there on specific REIT preferred issues.   For most, there will be a link to the original offering prospectus, and there you can find the details on call provisions, conversion privileges, etc.   The website also has the basic info on call dates, dividend levels and par values in table form.

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