The growing size of the REIT industry has led to the emergence of a significant market for REIT preferred stocks. As preferred stocks have priority over common stocks, the preferred shareholders are first in line to receive dividend payouts made by REITs.
Preferred stocks are a type of hybrid security that show bond- and equity-like characteristics. The shares are issued by financial institutions, utilities and telecom companies, among others. Within the securities hierarchy, preferreds are senior to common stocks but junior to corporate bonds.
While preferred securities represent ownership interest in a company, preferred stockholders usually have no voting rights with respect to corporate matters of the issuer, but preferred securities have rights and characteristics like debt instruments.
Additionally, preferred stocks issue dividends on a regular basis, but investors don’t usually enjoy capital appreciation on par with common shares.
REITs are securities that trade like a stock and invest in real estate directly through property ownership or mortgages. Consequently, revenue is mainly generated through rents or interest on mortgage loans.
To qualify for special tax considerations, the asset also distributes the majority of income, about 90% of taxable profits, to investors as dividends, and receive at least 75% of that income from rents, mortgages and sales of property.
In addition, a majority of REIT preferred stocks are cumulative in nature, which means that issuers are obligated to pay any historical dividends, if any payments are missed, at some point in the future.
For instance, 98% of REIT preferred stocks in the Index REIT Preferred Stock Index are structured such that dividends are cumulative. As a result, REIT preferreds have significant downside protection during economic downturns relative to common stocks.
The REIT sector has a lower level of corporate debt than the banking and insurance sectors (which have only 7-10% in common equity). Despite this, all these sub-industries were classified together in the GICS classification until a few years ago.
On average, preferred securities make up 10%, common equity represents around 60% and debt represents around 30% of a REIT’s enterprise value. Although preferred securities are lower in the capital structure than debt, the amount of equity junior to preferred REITs is very substantial compared to the banking industry. This lowers the risk profile of REIT preferreds, since preferred holders must be paid before equity holders.
In today’s sustained low yield environment, REIT preferreds provide a unique opportunity for investors to generate high income with dividend yields of more than 6%. REIT preferreds have relatively low correlation to the stock market compared to common stocks and also have modest sensitivity to treasury bonds yields compared to many fixed income alternatives. Consequently, preferred stocks can offer investors attractive income with modest levels of volatility in most market environments.
InfraCap REIT Preferred ETF
The InfraCap REIT Preferred ETF (PFFR) is an ETF offering a diversified investment in preferred securities issued by REITs. The fund seeks investment results that correspond, before fees and expenses, to the price and yield performance of the Index REIT Preferred Stock Index. The index methodology has a provision to exclude preferred stocks with yield to calls below 3%.
Generally, preferred stocks with yield to calls below 3% do not reflect attractive investments. As of September 27, 2019, there were 93 preferred stocks in the portfolio. These preferred stocks were issued by 48 different companies across both property and mortgage REITs. The fund is diversified across various sectors of the real estate industry.
The fund’s exposure by REIT sub sector as of June 30, 2019 was as follows:
1.62% office property
3.96% regional malls
10.04% shopping centers
2.77% health care
4.00% single tenant
The fund’s top 10 positions as of June 30, 2019 were as follows: 3.64% Annaly Capital Management Inc, 2.04% Annaly Capital Management Inc, 1.99 % Kimco Realty Corp, 1.83% KKR & Co Inc, 1.68% AGNC Investment Corp, 1.67% National Retail Properties Inc, 1.66% Chimera Investment Corp, 1.62% Arch Capital Group Ltd, 1.56% Vornado Realty Trust and 1.54% Apollo Global Management LLC.
PFFR yields 6.66% and has an expense ratio of 0.45%.