REITs offer investors a variety of investment choices that can be used to accomplish their investment objectives while adhering to their risk profile and constraints. Many REITs have publicly traded common equity, preferred equity, and bonds.
Each has its own risk return profile. And each can be used or combined to create a customized risk and return profile for your particular portfolio. By combining a REITs’ sector diversification benefits with its capital structure diversification investors can construct a portfolio that will provide a steady cash flow stream across economic cycles.
The following table shows the REIT capital structure, complete with average ranges per level:
REIT CAPITAL STRUCTURE
|Secured Bank Debt||X||Y|
|Unsecured Bank Debt||X||Y|
|Senior Unsecured Debt||50-60%||X||Y|
Within a REIT’s capital structure, common stock both holds the highest risk and the highest return potential. As a voting owner, common stock investors share in a company’s profits as well as its losses.
Due to the risk characteristics, they need to focus on a REIT’s fundamentals and business outlook to stay profitable.
Also known as equity capital, common stock is a huge advantage for REITs. Essentially, it serves as a traditional source for financing. The issuance of common stock provides the most permanent type of financing.
After all, there’s no actual obligation to repay it, should things go wrong.
This isn’t to say that there’s no pressure on the REIT at all. Only that it’s not legally responsible if its common shareholders lose out.
A worthwhile company with reputable management, of course, will care anyway though. Deeply. It will work hard to add leverage to its capital structure in order to increase its real estate portfolio and, as a result, the returns to its investors.
Preferred equity is essentially the shareholders’ equity on a company’s balance sheet. Junior in seniority to debt, it’s still senior to common equity. This means that preferred dividends must be paid out prior to common stock dividends.
Yet, due to the dividend rate typically stated in advance and a lack of voting rights, preferred stock also has debt-like characteristics. You can think of it as “in-between” capital.
Put a little differently, preferred stock does share some characteristics with common equity. For one thing, it’s subordinate to the debt portion of the capital structure. For another, it has equity-like characteristics.
Unlike common equity, however, it has a stated dividend rate. Expressed through yield and periodic dividends, this keeps its cash flow transparent on a known and followable daily amount. But, in return, these investors don’t have voting rights or nearly as much say in how the business is run.
Preferred stock is often attractive to investors with a low risk tolerance. It can also be smart to add into a largely common share-focused portfolio. That way, it can create a more personalized risk-and-return profile that takes into consideration individual return/cash flow needs.
This is especially true considering its hybrid debt/equity asset qualities… while not being actually easily replicated by either.
Preferred stock dividends have to be approved and declared by each company’s board of directors. Incidentally, no maturity date is included, only an optional redemption date. These dividends keep coming as a pre-established amount until:
- The preferred equity is redeemed by the company on or after the optional redemption date
- The board of directors suspends the dividend until further notice
- The company goes bankrupt.
For the record, those possibilities are listed in order of likelihood, with exception #3 being very unlikely. Companies typically do everything they can to avoid cutting preferred dividends. Otherwise, it would be regarded as a failure on their part and a bad sign of things to come.
In short, it would send the market a bad signal about the business in question – the very last thing management wants to do. All the same, it can happen. And it’s important to recognize how, as with any other investment out there, there’s always a risk involved… including:
- Interest rate risk. Since preferred stocks have no stated maturity date and the dividend rate is often fixed, a change in interest rates can affect their market price. This is often referred to as duration risk.
- Liquidity risk. Preferred stocks are often not traded in significant volume. This creates the possibility of price volatility when sizable orders are being placed and/or during periods of price discovery.
- Optional redemption risk. After an optional redemption date, a company can redeem a dividend at par. For preferred stocks purchased above par, this can cause a capital loss on the unamortized premium paid.
With that said, preferred stocks purchased below par can lead to a capital gain on the accreted discount paid. Either way, this impact is often understood and measured by utilizing the security’s yield-to-call.
When the current equity market is flat to lower – and when interest rate projections are steady – it can make for an excellent buying opportunity.
Here at iREIT, we’re fond of REIT debt in the credit space. That’s because of the financial covenants REIT debt typically contains, as well as its attractive spreads. The notes are typically issued from the operating partnership. They’re also often unconditionally guaranteed, jointly and separately, on a senior unsecured basis by our current and future subsidiaries.
While most REIT debt is senior unsecured, those of industrials and banks specifically can be multi-layered. No matter what, it’s always important to know how much debt comes ahead of you in terms of seniority.
Fortunately, they have some of the best covenants (i.e., legal contracts) in the investment-grade debt space. Plus, they do a bang-up job reporting on them. The covenants contained within REIT bonds often focus on the following metrics:
- Unencumbered asset coverage of unsecured debt
- Maximum amount of total debt
- Maximum amount of secured debt
- Minimum income coverage of debt service
As for iREIT, we focus on the financial covenants often contained in REIT bonds. Those help protect investors at all levels of the capital structure by limiting the amount of leverage a REIT can take on… while simultaneously helping to ensure that unsecured assets cover unsecured debt.
Reading the prospectus is an important piece of any analysis. This is not something to take for granted.
Operating Partnership Units
Many REITs today utilize operating partnership units, or OPUs, by accepting units that the seller can use to defer capital gains. Becoming an umbrella partnership (UPREIT) or a DownREIT – a contract between a REIT and a real estate owner – may give the trust in question a significant advantage in acquiring properties from sellers who want to defer paying off capital gains taxes.
This is similar to a 1031 exchange, except that the seller gets shares in the REIT instead of a new replacement asset.