The Hidden Yield: A Trader's Guide to REIT Preferreds

In the hunt for yield, many traders overlook one of the most attractive corners of the REIT market: preferred stocks. These hybrid securities offer a compelling combination of high income, lower volatility than common stocks, and a senior claim on a REIT's assets. For the discerning trader, REIT preferreds can be a effective tool for generating consistent income and managing portfolio risk. This article will provide a comprehensive guide to understanding and trading these often-misunderstood securities.

What are REIT Preferreds and How Do They Work?

REIT preferreds are a class of equity that has characteristics of both stocks and bonds. Like bonds, they pay a fixed dividend (coupon) and have a par value. Like stocks, they trade on an exchange and can be bought and sold throughout the day.

The key feature of preferred stocks is their seniority to common stocks in the capital stack. This means that in the event of a bankruptcy, preferred shareholders must be paid in full before common shareholders receive anything. This seniority makes preferred stocks less risky than common stocks.

The Allure of REIT Preferreds: High Yield and Lower Volatility

The primary attraction of REIT preferreds is their high yield. They typically offer a dividend yield that is significantly higher than the yield on a REIT's common stock and the yield on most corporate bonds. This makes them an attractive option for income-oriented investors.

In addition to their high yield, REIT preferreds also tend to be less volatile than common stocks. This is because their price is more closely tied to changes in interest rates than to the underlying performance of the REIT's properties. This can make them a good addition to a portfolio for diversification and risk management purposes.

Types of REIT Preferreds: Understanding the Nuances

Not all REIT preferreds are created equal. There are several different types, each with its own unique features and risks:

• Cumulative vs. Non-Cumulative: If a REIT misses a dividend payment on a cumulative preferred stock, it must make up the missed payments before it can pay any dividends to its common shareholders. This provides an extra layer of security for preferred investors.

• Redeemable vs. Perpetual: Most preferred stocks are redeemable, which means that the REIT has the right to buy back the shares at a specific price (the redemption price) on or after a specific date (the call date). Perpetual preferreds have no maturity date and can remain outstanding indefinitely.

• Fixed-Rate vs. Floating-Rate: Fixed-rate preferreds pay a fixed dividend for the life of the security. Floating-rate preferreds pay a dividend that is reset periodically based on a benchmark interest rate, such as LIBOR or the 10-year Treasury yield.

Trading Strategies for REIT Preferreds

Here are some of the key trading strategies that can be employed with REIT preferreds:

• Yield to Call (YTC): When a preferred stock is trading above its par value, its yield to maturity is less important than its yield to call. The YTC is the total return that an investor will receive if they buy the stock today and hold it until the call date. A high YTC can be a sign of an attractive trading opportunity.

• Stripped Yield: The stripped yield is the yield on a preferred stock after accounting for the accrued dividend. This is a more accurate measure of the true yield of a preferred stock than the simple dividend yield.

• Credit Spreads: The spread between the yield on a REIT preferred and the yield on a comparable-maturity Treasury bond is a measure of the market's perception of the REIT's credit risk. A widening spread can be a bearish signal, while a narrowing spread can be a bullish signal.

A Practical Example: Analyzing a Hotel REIT Preferred

Let's consider a cumulative, redeemable preferred stock issued by a hotel REIT. The stock has a par value of $25 and a coupon of 6.5%. It is currently trading at $26 and is callable in two years.

The simple dividend yield is 6.25% ($1.625 / $26). However, the YTC is only 4.8%. This is because the investor will lose $1 in capital if the stock is called in two years. In this case, the trader might decide that the YTC is not high enough to compensate for the risk that the stock will be called.

REIT preferreds are not as exciting as common stocks, but they can be a valuable addition to a trader's toolkit. By understanding the nuances of these securities and by employing a disciplined and data-driven approach, you can generate a steady stream of income and reduce the overall risk of your portfolio.