PREFERRED REITS They can offer equity-like returns with fixed income-like risk. Lynn Strongin Dodds explores the case for preferred shares of REITs
In the never-ending search for yield, preferred REITs became the darlings of the US listed property world in the wake of the financial crisis. They have since lost their lustre due to the spectre of the Federal Reserve whittling down its $85bn (€62bn) monthly bond buying purchases and rising interest rates. However, many industry participants still believe they have a role to play in a diversified real estate portfolio.
Although they have garnered a great deal of attention since 2008, preferred securities, which have both bond and equity characteristics, have been a firm fixture on the US real estate scene for several years. They are often compared to mezzanine debt in a private real estate trans- action due to their higher yields and riskier nature, but they differ in terms of liquidity and lower leverage. Preferreds are typically issued at a par value of $25 per share, pay a fixed dividend quarterly or twice a year, and rarely have a fixed life span but are almost always callable at $25 after five years.
In the first half of 2013, US REIT preferred shares held up well and outperformed other fixed-income assets such as corporates and Treasuries
According to research from Samuel Sahn, portfolio manager, global real estate securities with Canadian based Timbercreek Asset Management, there are 145 issues with a total market capitalisation of $22.8bn, which translates to an average issue side of around $157m. Issuance was running at record levels through the first nine months of 2013, with more than $4bn across 22 issues.
The pipeline was virtually dry over the last quarter of 2013, but as Tim Pire, managing director and co-portfolio manager of Heitman’s North American Public Real Estate Securities Group, notes, “preferred securities have always been an important part of the capital structure for REITs in the US for a number of reasons”.
He adds: “First, the market capitalisation is dominated by companies located in the country which has approximately $18bn worth of preferred securities outstanding. The market outside is notably small by comparison. Further, the companies that issue preferred securities always evaluate the cost and availability of other forms of capital such as debt and equity. Earlier in 2013, the issuance was quite high, as the yield on new issuances of preferred securities was very low. Now, with interest rates moving higher, investors require a higher yield on preferreds.
“Lastly, investor appetite has appeared to be strong in almost every time period outside of the global financial crisis. Investors are not only attracted to the higher yield compared to common stock but also the higher priority in terms of both dividend payments and security relative to common stock. During the modern REIT era in the US, there have been only a handful of companies that ever stopped paying the dividend on their preferred securities.”
Sahn agrees. “During the financial crisis, common dividends were frequently cut, suspended or paid in shares, while preferred dividends continued to be paid in cash on a quarterly basis,” he says. “The ability of preferred shareholders to elect two members to the board of directors, in the event of dividends staying in arrears for six or more quarters, is a key protection right. It is one of the main reasons why they generally trade around par, have low volatility and act as a capital preservation tool. In the first half of 2013, US REIT preferred shares held up well and outperformed other fixed-income assets such as corporates and Treasuries.”
However, they took a hit over the past few months. Research from Invesco Real Estate shows that, by the end of September 2013, US REITs had sold off 14% since their peak in mid-May, mainly due to investor overreaction to rising interest rates.
Preferreds, like their common-stock counter- parts, struggled, falling 13% during that period, with yields widening to approximately 480bps over the 10-year Treasury compared with a historical average of 350bps between 2003 and 2007 (excluding the financial crisis). In fact, this risk premium is comparable to levels during the fourth quarter of 2008 − the beginning of the crisis.
The other negatives, aside from interest rate sensitivity, are call and re-investment risk, as well as limited secondary market liquidity. For example, it can be difficult to invest sizeable amounts quickly and to liquidate large positions. Market participants, though, believe the pros outweigh the cons, especially in view of their track record of delivering equity-like performance with fixed income-like risk over the past 12 years, according to Sahn.
His research shows that, since 2000, the market has generated average annualised returns of 10.2%, outshining the 2.6% annualised return of the S&P 500, while essentially matching the MSCI US REIT index. Over the past five years, the performance has been even more impressive, turning in a 13.8% hike, far surpassing the 1.7% of the S&P 500 and 5.6% of the index.
“The tapering discussions throughout the summer, though, put some pressure on the sector and impacted all yield-oriented securities, which presents a buying opportunity,” Sahn says.
Bob Thomas, portfolio manager at AMP Capital, agrees, “I think today is a good time to invest but I would not have said the same thing six to nine months ago,” he says. “The market had been dominated by large institutions and close-end funds who drove the spreads down. I think they are now priced more attractively and investors should look at them as long-term investments.”
As with any investments, though, institutions are advised to do their homework. “Investors are concerned about a rising-rate environment, but I think the market has already largely priced that in,” says William Scapell, senior vice-president at Cohen & Steers.
He continues: “Investment-grade REIT preferreds have been pressured in recent months with the changed rate environment and offer substantial discounts to par, with yields of 7% or more, which is where they were on average in the five years before the financial crisis. This compares to the 2.85% current yield on 10-year Treasuries. They are a good long-term investment for asset-liability-matching strategies, but investors do need to recognise that they are perpetual instruments and therefore high-duration assets.”
Pire adds: “Investors should look at the financial health of the issuers, ensuring that they have a reasonable leverage level and stable operating metrics for the underlying real estate. They should pay particular attention to a company’s dividend pay-out ratio for the common stock, ensuring that they are low. Investors should also identify companies with improving risk profiles in the event there is potential for spread contraction.”