Real estate investment trusts (REITS) have recovered from the coronavirus with the broader market, but real estate investors now face the prospect of persistently low rates, high volatility and slow economic growth.
One potential bright spot in this challenging environment is US REIT preferred securities. This lesser known part of the real estate capital structure has historically offered higher yields and lower volatility than REIT common stock as well as better downside protection and a preferred position in the capital stack. Since average dividend yields are currently above 8%, REIT preferred securities1 could also offer an attractive value opportunity that may generate equity-like total returns with fixed income-like risk.2
Understanding REIT preferreds. REIT preferred stock is a type of hybrid security that exhibits both equity- and bond-like characteristics. Like equities, preferred stocks are a permanent source of capital which does not count as debt on the balance sheet. Within the capital stack, REIT preferreds have a senior claim on assets, earnings and dividends relative to common stock, but are junior to corporate bonds. Like bonds, REIT preferreds typically make fixed payments on a quarterly basis, and the dividends are often considerably higher than those paid on common stock. In addition, most REIT preferreds offer cumulative dividends so that the issuer is obligated to make up any missed payments before issuing a dividend on any common stock. If a preferred security goes six quarters without a dividend payment, the preferred shareholders can elect two new board members who remain in place until all distributions have been paid.
Moreover, REIT preferred shares are generally issued at a par value (often $25) that can rise or fall but have historically remained in a tight range. REIT preferred shares have no voting rights, although the owners can benefit when shares are trading at a discount to par. REIT preferreds are often callable at par five years after issuance. This feature gives the REIT management team flexibility in its financing, while the five-year non-call period gives shareholders the potential for both income and capital appreciation.
Why issue REIT preferred stock? There are several reasons why REIT managers might elect to issue preferred stock instead of common stock or corporate debt. For example, preferred stock does not fully appear as debt on the company’s balance sheet and there is no requirement of principal repayment. This is a permanent source of financing that, issued in place of debt, allows the company to operate with lower leverage on the balance sheet, an appealing factor for investors, analysts and rating agencies. A wide variety of REITs have issued preferred stock including residential, office, retail, industrial, self-storage, data center, infrastructure, healthcare and lodging sectors. While the investable universe of US REIT preferreds is relatively small by number of issuers and total capitalization, the potential benefits of these securities to both issuers and investors have historically been compelling.
Comparing REIT preferreds to REIT common stock. From the global financial crisis in October 2008 to April 30, 2020, US REIT preferred stock has outperformed US REIT common stock with slightly more than half the volatility (see Figure 1). However, selecting different time periods will generate different performance results, some of which will favor REIT common stock. But choosing any period that includes sharp downdrafts or volatility spikes in the market will generally favor REIT preferreds over REIT common stock. The reason why is that the higher level of income generated by the preferred shares, coupled with better downside risk mitigation and the potential for capital appreciation on discounted securities, has allowed this segment of the capital structure to generate excess returns.
Figure 1: US REIT Preferreds Performance
Competitive Risk-Adjusted Returns
We recognize that interest rates in the US are extremely low today and the Federal Reserve may not begin raising the Fed Funds rate for quite some time. But higher rates are always a risk for fixed income investors, so it is significant that from the global financial crisis through April 2020, US REIT preferred stock has tended to outperform2 US REIT common stock during periods of rising rates (see Figure 2). We believe that the higher yield spreads versus the 10-year Treasury note and other preferred sectors have insulated these securities and enabled them to outperform on a relative basis during periods of rising rates. At the same time, the subsequent one-year performance of the REIT preferred universe was slightly below REIT common stocks, although REIT preferreds outperformed broader equities and fixed income. As of March 31, the US REIT preferred market had an average yield of 8.82% compared to the 4.66% yield of the FTSE NAREIT All Equity REITs Index.4
Figure 2: US REIT Preferreds and Rising Rates
Real Estate Securities Performance During Rising Rates
Given the historically elevated yields of US REIT preferred stocks, investors could properly question the sustainability of these distributions. In this regard, financial preferreds have experienced certain periods of double-digit payment defaults. In contrast, the average annual default rate for US REIT preferred stock has been below 0.50% over the last 20 years, reflecting the potentially stable and predictable cashflows generated by real estate-related companies over that period.5
Potentially attractive valuations. Both common and preferred shares of US REITs traded sharply lower during the height of the pandemic-related market turmoil, and both have partially recovered from the market bottom in late March. Regarding the common stock, US REITs over the last 30 years have traded close to net asset value (NAV) on average versus private real estate valuations. As of March 31, 2020, US REITs traded at a discount of -21.9% to NAV.6 Discounts of this magnitude have only historically been observed during the 1990 Gulf War recession and the global financial crisis in 2008/09. These periods have historically provided investors with a window for deeper value opportunities as there was a fragmentation between underlying real estate fundamentals and asymmetrically steep declines in valuation. We may see something similar in this current environment.
US REIT preferred shares also sold off sharply during the recent market turmoil. Investors frequently analyze preferred securities based on their yield spreads to risk-free securities, including the benchmark 10-year US Treasury note. Over the past five years, US REIT preferred securities have traded between 400 to 500 basis points (bps) above 10-year Treasury yields, with occasional and limited excursions outside of that range (see Figure 3).
Figure 3: US REIT Preferred Spreads
As of March 31, 2020
However, as news of the coronavirus pandemic started to roil markets, US REIT preferred spreads widened to levels not seen since the global financial crisis. In particular, spreads widened to 900 bps above Treasuries before falling slightly to end the first quarter just below 800 bps. As of March 31, US REIT preferred shares, represented by Wells Fargo Hybrid & Preferred REITs, had an average yield of 8.82% versus 0.67% for the 10-year Treasury note, 1.59% for US Bonds, and 1.22% for Global Bonds.7 By the end of Q1 2020, REIT preferreds were trading over 300 bps wider to 10-year Treasuries than their five-year averages.8 Accordingly, we believe, on both an absolute and relative basis, that yields and spreads for US REIT preferred securities could represent a potentially attractive value opportunity.
To be clear, there are many uncertainties with respect to the current global health and capital markets environment, and REIT preferreds have their own potential risks as well. For example, many REIT preferred securities are less liquid than REIT common stock. Since a significant portion of the total return for REIT preferreds typically comes from dividends, these securities are subject to interest rate risk. During steep market downturns, they are also subject to potential dividend deferrals. However, we believe that in any forthcoming market recovery, REITs with higher quality assets operating in relatively supply constrained markets, healthier balance sheets and the prospect for above average earnings growth may present a potentially attractive investment opportunity.
Key takeaways. Looking beyond the current turmoil to a period when the capital markets have stabilized, investors can likely expect structurally lower interest rates, higher levels of volatility and slower economic growth. A low rate and slow growth environment has historically been favorable for commercial real estate and may prove to be so again. In addition, US REIT preferred securities, with their historically higher yields and lower volatility than REIT common stock, may help investors generate attractive levels of income with less downside risk in a low-to-zero-rate world. In the event of another steep downdraft in the market, REIT preferreds reside higher up the capital stack, and they offer the potential for attractive total returns in light of their overall yields and historically attractive spreads. In summary, the Invesco Real Estate team believes that the utilization of US REIT preferred stock (in portfolios allowing these securities) may enhance returns, reduce volatility and generate income over time compared to a pure REIT common stock portfolio.
While the industry has traditionally focused on real estate strategies that invest exclusively in REIT common stock, we believe that by leveraging different parts of the capital structure, investors may be able to generate higher risk-adjusted returns over the long term. By pairing REIT common stock positions with REIT preferred stock (and considering REIT corporate debt and collateralized mortgage-backed securities in select portfolios), investors can pursue the capital appreciation and income they seek in a potentially more risk-controlled fashion. The overall goal is to generate real estate equity-like returns but with lower volatility, higher Sharpe ratios, shallower drawdowns, higher income and lower correlation to the broader equity market. US REIT preferreds can be an important part of achieving that goal.
1. Source: Invesco Real Estate and Wells Fargo as of 3/31/20. US REIT Preferreds represented by Wells Fargo Hybrid & Preferred REIT Index.
2. Source: Bloomberg L.P. as of 5/13/2020
3. Sources: Wells Fargo and Zephyr Style Advisors as of 4/30/2020
4. Sources: Bloomberg L.P. and Morningstar Direct, 5/8/20; Invesco Real Estate and Wells Fargo, 3/31/20. US REIT Preferreds are represented by the Wells Fargo Hybrid and Preferred REIT Index.
5. Sources: Invesco Real Estate, Bloomberg L.P. and Wells Fargo. Data as of 12/31/19 and updated annually. US REIT Preferred represented by Wells Fargo Hybrid & Preferred Securities REIT Index. US Financial Preferred represented by Wells Fargo Hybrid & Preferred Securities Financial Index.
6. Source: Invesco Real Estate estimates based on consensus data, 4/1/20. Past performance does not guarantee future results. US Real Estate Securities represented by FTSE Nareit All Equity REITs Index.
7. Sources: Bloomberg L.P. and Morningstar Direct, 5/12/20. US Bonds represented by Bloomberg Barclays US Aggregate Bond Index and Global Bonds represented by Bloomberg Barclays Global Aggregate Bond Index. An investment cannot be made directly into an index.
8. Sources: Invesco Real Estate and Wells Fargo as of 3/31/20. US REIT Preferreds represented by Wells Fargo Hybrid & Preferred REIT Index.
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NAREIT is The National Association of Real Estate Investment Trusts
The Sharpe Ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk
The capital stack refers to the organization of all capital contributed to finance a real estate transaction or a company.
The standard deviation is a statistic that measures the dispersion of a dataset relative to its mean.
Standard deviation is a statistical measurement in finance that, when applied to the annual rate of return of an investment, sheds light on the historical volatility of that investment.
A yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, issuer, or risk level, calculated by deducting the yield of one instrument from the other.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
The Barclays US Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.
The Wells Fargo Hyrbid & Preferred REIT Index is designed to track the performance of preferred securities issued in the US market by Real Estate Investment Trusts. The index is composed of preferred stock and securities that, in Wells Fargos judgment, are functionally equivalent to preferred stock including, but not limited to, depositary preferred securities, perpetual subordinated debt and certain capital securities.
The Wells Fargo Hybrid and Preferred Securities Financial Index is a market capitalization-weighted index that tracks the performance of preferred stocks and securities that are functionally equivalent to preferred stock including, but not limited to, depositary preferred securities, perpetual subordinated debt and certain capital securities issued in the US market by financial institutions.
The Wells Fargo Hybrid and Preferred Securities Index is a market capitalization-weighted index that tracks the performance of preferred stocks, as well as certain types of “hybrid securities” that are functionally equivalent to preferred stocks, that are issued by US-based or foreign issuers and that pay a floating or variable rate dividend or coupon.
Global REITS are represented by FTSE EPRA/NAREIT Global Index is designed to track the performance of listed real estate companies and REITs in both developed and emerging markets
US REITS are represented by FTSE NAREIT All Equity REITs Index is an unmanaged index considered representative of U.S. REITs Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions, there can be no assurance that actual results will not differ materially from expectations. An investment cannot be made into an index.
Common stocks do not assure dividend payments and the amount of a dividend if any, may vary over time. There can be no guarantee or assurance that companies will declare dividends in the future of that if declared, they will remain at current levels or increase over time.
Preferred securities may include provisions that permit the issuer to defer or omit distributions for a certain period of time, and reporting the distribution for tax purposes may be required, even though the income may not have been received. Further, preferred securities may lose substantial value due to the omission or deferment of dividend payments.
Mortgage- and asset-backed securities are subject to prepayment or call risk, which is the risk that the borrower’s payments may be received earlier or later than expected due to changes in prepayment rates on underlying loans. Securities may be prepaid at a price less than the original purchase value.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.
The opinions expressed are those of the author, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds, and is an indirect, wholly owned subsidiary of Invesco Ltd.