The ABCs of REIT Preferred Stocks
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contribution to the capitalization of the company with new money raised by issuing new preferred stock.
So, the call provision makes preferred stock partly a “heads-I-win-tails-you-lose” proposition, where “I” denotes the company and “you” is you. But only partly. The sense in which it is asymetrically stacked against you is this: If the company does poorly and/or market conditions sink preferred stocks in general, then you are stuck. You can sell at a loss or hold at the depreciated value, but the call provision is not going to bail you out, and there is no maturity date. You generally do not have a “put” provision allowing you to force a redemption. But, if the company’s prospects improve making the stock less risky (dividends more secure) and/or market conditions boost preferred stocks in general, then your potential gain is capped by the call provision. Once the call date arrives or soon after, the company will probably call the stock away from you. Even if it doesn’t, fear that it will, generally keeps preferred stocks from rising much above their call prices.
So given this unattractive assymetry created by the call provision, why would anyone hold REIT preferred? Income! REIT preferred stocks generally yield more than common stocks and bonds issued by the same company. So, life is full of tradeoffs. Like marriage, parenthood, and drinking, preferred stock investing has its attractive aspects and it’s unattractive aspects.
Risks
There are 2 main risks associated with preferred stock investing, besides the risk of call, and one remote risk:
- The dividend may be suspended, causing an interruption of your income stream and probably a fall in the stock price.
- Market conditions may change so that the dividend stream paid by your stock is no longer considered a competitive return at the stock’s former market price, and so the price falls.
- There is also a remote risk of the company being taken private and your preferred stock not being liquidated as part of the transaction. In that case, there might cease to be a market for the stock. The new private owners might not care about continuing dividends on the common stock, and therefore might suspend all dividends, including yours. It doesn’t happen often, but it could happen.
Dividend suspensions generally occur when companies fall on hard times. The rules say a company cannot pay anything on its common stock (no dividend) if it is not paying its preferred stock dividend in full. So, you have the comfort that you stand ahead of common stock holders in the dividend hierarchy. But, you stand behind bond holders and other lenders. Most REIT preferred are “cumulative” prefered, which means if they suspend the dividend, they have to pay all the missed dividends before they can reinstate any common dividend.
When and if prosperity returns to the company, if it wants to retain its REIT status, then it must resume dividend payments. REITs are not taxed at the corporate level, but to retain this tax exemption, they must pay out 90% of tax-basis earnings (or more) as dividends.
To evaluate the risk of dividend suspension, one looks at the REIT’s historic net operating income (revenue minus operating expenses) in relation to its debt obligations and preferred stock dividend obligations, and its future prospects for same. One must also evaluate the debt maturity schedule and the REIT’s ability to repay or refinance principle on maturing debt obligations. If the REIT can’t meet obligations to lenders, you, as a preferred stockholder, are surely out of luck.
Many REITs pay a fat dividend on their common stock, and you as a preferred stockholder with a senior claim on that cash flow, can take comfort from that. That, plus any cash flow the REIT is able to retain on an annual basis, is your cushion against interruption of preferred dividends. In the 2008-09 financial crisis, many REIT common dividends were cut, eliminated or paid in stock. But nearly all REIT preferred dividends were paid as scheduled, in cash.
The dividend, by the way, is a fixed dollar amount, not a fixed yield on the stock’s market price. If you hear of a preferred being called “XYZ company 6.25% preferred” that just means the dividend is 6.25% of par value, and that’s a fixed dollar amount you can compute once you know par. Par doesn’t change, even though the actual stock price changes all the time. The actual yield will be higher if the stock is selling below par or lower if it is selling above par (and paying its dividend as scheduled), by simple arithmetic.
A preferred stock dividend can be suspended by a simple vote of the board of directors. It is not a default. No court action is required and no court remedy is available to you, provided the common dividend is also suspended or eliminated. In fact, it requires board action to declare and pay the dividend you are expecting. This makes preferred dividends quite different from bond interest, which is a contractual obligation. A company cannot suspend payment of bond interest without consent of the bond holders or protection of a court in bankruptcy. If it did, it would get sued and it would probably lose.
The other main risk to REIT preferred stockholders is an unfavorable change in market conditions for preferred stocks and (continued)