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 of these levels of the capital structure has its own risk return profile and can be used or combined to create a customized risk and return profile for your particular portfolio. By combining REITs’sector diversification benefits with the 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 the capital structure of a REIT, common stock has the highest risk but also offers investors the highest return. Common stock gives investors the risk and return characteristics of company ownership. As a voting owner, a common stock investor shares in the profits of the company as well as the losses.
Due to the risk characteristics, investors here need to focus on the fundaments of the REIT and its business outlook in order to stay profitable.
Common stock, or equity capital, is a huge advantage for REITs because it serves as a traditional source for financing. The issuance of common stock provides the most permanent type of financing, since 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, only that it’s not legally responsible if its common shareholders lose out. A worthwhile company with reputable management, of course, will care about that. 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.
In order to review a REIT’s preferred stock, it’s necessary, of course, to first understand what it is. So here is a working definition:
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 in that preferred dividends must be paid out prior to any dividends on common equity. Yet due to the dividend rate typically stated in advance and a lack of voting rights, preferred stock also has debt-like characteristics. Preferred equity, in essence, is “in-between” capital.
Put a little differently, preferred stock shares some characteristics with common equity in that it’s subordinate to the debt portion of the capital structure and has equity-like characteristics (e.g., dividends have to be declared, and the REIT has no obligation to declare them).
Unlike common equity, preferred stock has a stated dividend rate (expressed in terms of yield and periodic dividends) that keeps its cash flow transparent. It’s a known and followable amount day to day. In return for that kind of certainty, this category of investor does not have voting rights and has an otherwise limited say in how the business is run.
Even so, preferred stock is often attractive to investors with a low risk tolerance. It can also be a good idea to add into a largely common share-focused portfolio to create a more personalized risk and return profile that takes into consideration individual return/cash flow needs.
This is especially true when REIT preferred stock can appear to behave like a hybrid debt/equity asset… but it isn’t actually easily replicated by either.
Dividends on preferred stock have to be approved and declared by each company’s board of directors, with no maturity date involved. 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 in question until further notice
- The company goes bankrupt.
For the record, those possibilities are listed in order of likelihood, with exception #3 being unlikely. Companies typically do everything they can to avoid cutting preferred dividends, since that 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 those in charge want to do. All the same, it can happen. And it’s important to recognize how, as with any other investment out there, there is always a risk involved. This also includes:
- 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, creating the possibility of price volatility when sizable orders are being placed and/or during periods of price discovery.
- Optional redemption risk… As mentioned above, preferred shares typically have an optional redemption date, after which the company can redeem them 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 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 because of the financial covenants REIT debt typically contains, as well as its attractive spreads. The notes are typically issued from the operating partnership and will often be unconditionally guaranteed, jointly and separately, on a senior unsecured basis by our current and future subsidiaries.
While most REIT debt is senior unsecured, debt of industrials and banks can have multiple layers. In any case, it’s always important to know how much debt comes ahead of you in terms of seniority. Fortunately, in addition to having some of the best covenants (i.e., legal contracts) in the investment grade debt space, they also 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.
The following is an example of the bond covenants and compliance metrics taken from Kimco Realty’s fourth quarter 2018 supplemental:
Source: Kimco website
As for iREIT, we focus on the financial covenants often contained in REIT bonds as these covenants 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.
According to NAREIT, as of February 28, 2019, REITs’ total market capitalization was approximately $1.08 trillion; and their total average monthly trading volume was around $7.4 billion. As viewed below, U.S. REITs have grown in size such that institutional investors are now able to establish large positions without affecting current market prices.