Preferred Securities Part 2 - The best global REIT opportunities are in North America
Article10 mins01 December 2023
This article is part of a series, for part one click here
In part 1 , we explained the six structural advantages of REIT preferred securities and explained why these securities are attractive right now. Here, we’ll explain our team’s research process and look at two US preferred securities to show how our process unfolds in practice.
Whilst this might sound mundane, the potential returns are not. In one case, after buying a preferred security at a 40% discount to its par value, we secured an 85% capital gain in 12 months. In addition, we also secured a 12% distribution yield1, paid quarterly.
Such returns are only possible after first examining every aspect of a REIT’s fundamental and financial characteristics. The process for assessing a preferred security is like that of an ordinary REIT, albeit with a more specialised checklist, including the following factors:
1. Size and liquidity: Before purchase, it pays to think about the likely exit and the circumstances under which you’re likely to sell. In preferred securities, the size and liquidity of an issue is crucial. This should determine how large a position you can reasonably take whilst still maintaining a portfolio with appropriate liquidity.
2. Call date: REIT preferred securities are issued at a particular face value and are often both perpetual in nature and callable. This means they usually have no stated maturity date but come with call options, typically at the five or 10-year mark, after which the issuer can redeem them at face value. The call date therefore determines the length of the potential income stream. Without examining the call date, you can’t estimate overall potential returns.
3. Par Value: Most US REIT preferred shares are issued with a par value of $25 and are callable, which is to say can be redeemed, after a certain period (typically years) at the par value.
4. Call risk: This is the possibility of the issuer redeeming the security at par value when it is potentially trading either above or below it. Viewed in the context of potential total returns, it helps illuminate the overall risk of the investment.
5. Fixed charge coverage ratio: This ratio that expresses how a REIT’s fixed charges, including interest expense and preferred dividend payments, are covered by its cashflow (EBITDA). Generally, the higher the coverage, the more reliable the distribution.
6. Change of control provisions: Triggered by a merger or acquisition, these provisions determine whether the preference share need to be paid back in cash at par value. Change in control provisions offer added protection to REIT preferred shareholders.
7. Cumulative vs non-cumulative dividends: If a dividend is cumulative, any missed REIT preferred dividends must be paid in full before a common dividend can be paid. If they are non-cumulative, they do not.
Examining these issues informs our assessment of risk, especially around future distribution yield and total return from potential price appreciation. Ultimately, this guides our decision making and, should we proceed to purchase, position sizing.
This approach has been honed over the years. As the chart below shows, in the early years of the Dexus Global REIT Fund, a sizable portion was devoted to preferred securities (this was at the height of the pandemic). More recently, as further opportunities arose, we have again expanded our exposure.
Dexus Asset Management data set
The Fund currently has a portfolio allocation of 7.4% to US REIT preferred securities, across five different issuers with an average running yield of 10.3%1. We expect each of them to provide relatively defensive income-based returns plus the potential for attractive capital growth.
This is an exciting niche of the global REIT market and one we’re happy to have found plenty of opportunities. The sector offers capital growth opportunities but is also consistent with our ‘property for income’ philosophy.
The following case study summaries illustrate the unique aspects and appeal of US preferred securities.
Case study summary #1: RPT Realty Series D Preferred
In early 2020 as the pandemic took hold, many REIT preferred securities were heavily sold off, along with their common equity counterparts. The result was that many were trading at steep discounts to their par values.
One was RPT Realty’s Series D preferred security. On a par value of US$50, it offered a 7.25% yield. But in April 2020 its price had fallen to US$30, a 40% discount to its par value. At the time it entered the portfolio the distribution yield had reached 12%, paid quarterly.
Having purchased the security at the height of the pandemic-induced sell-off in April 2020, about 12 months later we started selling at US$54.95, banking an 85% capital gain plus very healthy distributions.
Case study summary #2: Hudson Pacific Properties Series C Preferred (HPP-PC)
Another preferred security in which we’re currently invested is HPP-PC. We began purchasing it in June this year at a price around US$8.55. Offering a yield of 13.9%, this was a 66% discount to its $25 par value.
Hudson Pacific Properties is a US office REIT with properties located mainly in Los Angeles, California. As with many other office REITs, its common equity and preferred shares have performed poorly over the last few years.
In addition to the sector’s growing vacancy rates and stagnant rents, the Hollywood writer’s strike added to these fears—many of its buildings were rented to Hollywood producers. Despite suspending its common dividend, the REIT has continued to pay distributions on its preferred security, which are cumulative if not paid.
This emphasises the ‘preferred’ nature of preferred securities. Having avoided the REIT’s common equity, we’re pleased to have purchased the preferred shares at heavily discounted prices as its distribution is well covered.
The negative headlines and general fear in the sector delivered the opportunity, which is now performing well. In September, HPP received an upgrade from a local broker after suspending its common dividend and disposing of two L.A. office properties, using the proceeds to paydown debt.
Both the common and preferred stock prices have recovered significantly from their June 2023 lows. HPP-PC is currently trading at $10.77, a 26% premium to our initial investment in only a few months.
Both investments illustrate the scope of opportunities in the preferred securities sector. The distribution yields we have been able to secure, as well as the capital returns, are simply unavailable to AREIT investors.
Best of all, we’re once again seeing many more such opportunities in this highly attractive but relatively undiscovered sector of the global REIT market.
This article is part of a series, for part one click here.
Note 1: Current running yield is calculated daily by dividing the annualised distribution rate by the latest entry unit price. Distributions may include a capital gains component. Distributions are not guaranteed and past performance is not an indication of future performance.
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