| Bonds Online |
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| 5/10/2013Market Performance |
| Municipal Bonds |
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S&P National Bond Index
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3.00% |
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S&P California Bond Index
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2.96% |
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S&P New York Bond Index
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3.13% |
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S&P National 0-5 Year Municipal Bond Index
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0.70% |
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| S&P/BGCantor US Treasury Bond |
400.09 |
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| Income Equities: |
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| Preferred Stocks |
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S&P U.S. Preferred Stock Index
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848.03 |
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S&P U.S. Preferred Stock Index (CAD)
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636.26 |
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S&P U.S. Preferred Stock Index (TR)
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1,701.05 |
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S&P U.S. Preferred Stock Index (TR) (CAD)
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1,276.26 |
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| REITs |
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S&P REIT Index
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174.07 |
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S&P REIT Index (TR)
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425.30 |
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| MLPs |
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S&P MLP Index
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2,469.58 |
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S&P MLP Index (TR)
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5,428.50 |
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See Data
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Preferred REITs: Even Odd Ducks Can Swim. |
Preferred REITs: Even Odd Ducks Can Swim.
I've always admired ducks; whether or not one believes in God, Creation, Intelligent Design, or none of the above, the existence of ducks, like rivers, mountains and sunsets, is one of Mother Earth's proudest attributes. And, based upon my observations – not as a Cheney-type duck-hunter but as a frequent visitor to our local Westlake lake and other bodies of water throughout the US, ducks are perfectly designed creatures. Their shape and feathers allow for efficient swimming in all conditions and environments, they can travel on land, water and air, and they have few natural enemies. And, for the most part, as evidenced by their contented quacks, the merganser crowd is a very happy one.
Of course, some ducks are perceived as "odd" – which is defined as "deviating from what is ordinary; strange or peculiar." And the term "odd duck" is often applied to unusual or quixotic individuals ("he's an odd duck"), and even to puzzling or conflicting phenomena ("our U.S. tax code is an odd duck"). A related expression is "strange bird, " e.g., "Howard Dean is a strange bird."
In recent years many REIT organizations have been issuing preferred stocks. Of course, preferreds have been widely accepted, albeit not widely followed, denizens of the investment world for many years; however, they are, in many ways, odd ducks, and REIT preferreds, the subject of the following discussion, are perhaps odder still. Let's look at the reasons for their peculiarity.
Except for an even odder duck, a handful of REIT convertible preferreds, they do not share in a REIT's growth – in dividends, cash flow or NAV accretion, even though they are considered "equities." And yet the owners of these securities, unlike bond holders, aren't creditors of the company and thus have no standing in the creditor pecking order. Preferreds, like common stocks but unlike bonds, have no maturity dates, and can theoretically remain outstanding until Armageddon (or at least until Britney Spears becomes a great-grandmother). They have fixed dividend rates, yet the dividends are not treated as interest expense and thus count towards the REIT industry's 90% payout requirement – as Public Storage and PS Business Parks have figured out. And, though treated as "equity," holders generally cannot vote on major corporate transactions (or even for the election of directors).
So are REIT preferreds ugly ducklings? Or just loveable odd ducks? Let's look closer at their characteristics, first focusing on the negatives, then on the positives.
Their personality disorders may be summarized as follows: (a) they have no claim on any growth or increase in value of the company they represent; (b) as virtually all of their returns come from yield, and as they do not benefit directly from strong economic growth, they tend to be more sensitive than REIT common stocks to rising interest rates; and (c) they are "heads they win, tails you lose" investments, as there is no maturity date offering protection from secular increases in interest rates, but the company can redeem the stock in five years after issuance should interest rates fall. Other negatives:
(d) Dividends are at the Board's discretion, and thus offer less protection than bonds should a company fall on hard times; (e) the liquidity of most REIT preferreds is almost embarrassing, e.g., most of them trade no more than a few hundred or thousand shares a day, making them comparable to the Roach Motel (where you can check in but will find it difficult to check out); and (f) in a buyout or going private transaction, holders can be bypassed entirely, exposed to higher debt leverage, and otherwise treated with neglect (benign or otherwise, perhaps as the annual Christian Coalition convention might treat an unannounced visit from Teddy Kennedy).
And yet, these funny feathered creatures do boast some positive attributes: (a) yield spreads over the common stock of the same company are much wider today than has been the case in prior years – the typical REIT common yields just 4.3% today, vs. something like 7.7% for the average preferred, i.e., a 340 bps advantage; (b) preferreds are not volatile – a welcome change from our REIT common stocks these days; (c) due to the stability of REITs' cash flows, preferred dividends are, in the vast majority of cases, very safe (even Mills will probably continue to pay its preferred dividends); and
(d) Perhaps most important of all, as prospective returns on REIT common stocks have declined due to today's low cap rates and modest external growth opportunities, the 7 ¼ - 8 ¼% returns available on REIT preferred stocks today look a lot more competitive with REIT commons than has been the case during much of the past six years. We can get 7.6% today from Kilroy's preferreds; can we get a lot better than 8-9% total returns on its common stock over the next three years? Perhaps – but more likely not.
So are REIT preferreds worthy of inclusion in diversified portfolios? Much depends upon one's investment return expectations, a.k.a. one's "greed factor," as well as a willingness to accept liquidity that, at times, is so low as to cause even press secretary Ari Fleisher to pull his hair out (at least what's left of it). Another issue for investors might be their willingness to accept the risk of unrealized losses that could stretch out for many years should interest rates rise on a secular basis – the preferreds may trade below par value (and one's cost basis) for quite some time.
But if stable income is a prime objective, then these little guys rank right up there with bonds; indeed, their yields are higher than bonds of a similar risk profile, perhaps due to their lack of creditor status and limited liquidity. For example, Vornado has a bond (5.6% due 2/2011), which recently traded at a 94 bps spread over the comparable US Treasury note (5-year duration). But VNO's preferreds, e.g., the series E, F, G, H and I all yield something like 7.2%, where their spread over the 30-year US T-bond was about 200 bps (7.20% vs. 5.17%) at May 26. Those extra 100 bps are quite attractive if one isn't terribly worried about liquidity; furthermore, a failure to collect dividends or interest payments on either Vornado's preferred stock or its bonds is as likely as Sammy learning to play the saxophone.
It is also possible to find some unusual bargains in the world of REIT preferreds. Check out non-rated issues of high quality companies, whose preferreds trade as though they are almost junk. Examples include Cousins, Kilroy, LaSalle, SL Green and Sunstone. The only reason that the SLG preferreds, for example, trade at a 7.6% yield is that they are not rated – but those who know the company would rate SLG's credit as high as that of virtually any other high-quality REIT.
For individual investors, REIT preferreds are particularly attractive. Unlike bonds, almost all are listed on the NYSE (or, in some cases the ASE). And, also unlike bonds, they can be traded in small quantities and dollar amounts, often with modest bid-ask spreads.
Of course, very few (if any) REIT investors should substitute REIT preferreds for REIT common stocks. Over any reasonable time period, e.g., 3-5 years, total returns will be better on REIT commons. However, REIT preferreds are excellent complements to the fixed-income portion of investment portfolios and, for those cognizant of the peculiar risks inherent in REIT preferreds, including a lack of maturity date, perhaps even a substitute for medium-grade, long-term bonds.
REIT preferreds are odd ducks, for sure. However, like most ducks, they are normally friendly little creatures, well designed for the purposes for which they were created. I own several of them myself, and can assure you that they require no feeding and very little maintenance, while rewarding me with much more income than I get with my REIT commons – albeit at the cost of upside in dividends and capital appreciation. But do be aware of their oddities, and be very careful when attempting to adopt these friendly little fellows or when finding them a foster home elsewhere, e.g., when you want to sell. On some days there are simply no bidders for a particular quacking odd duck.
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Income Security Recommendation January 2013 Issue.
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