Published July/August 2013
I’ve long been an advocate of REITs’ use of preferred stock as a financing tool and believe it’s attractive to both issuers and investors. A number of REITs, including many with large market caps such as Kimco Realty Corp. (NYSE: KIM), Public Storage (NYSE: PSA) and Vornado Realty Trust (NYSE: VNO), believe firmly in the virtues of preferreds and use them regularly – but others are somewhat agnostic.
The skeptics may acknowledge the principal benefits of preferred stock, such as its being quasi-debt that never has to be repaid, the ability to redeem it after just five years and perhaps treatment as equity by some credit rating agencies. However, they don’t like its cost relative to seven-year or 10-year debt. Many REITs have been able to issue 10-year paper at interest rates that begin with a “3,” and they aren’t all that excited about issuing new preferred stock at coupons that can reach or exceed 6 percent.
This is, of course, a reasonable perspective. I personally believe that an extra, say, 250 basis points isn’t too high a price to pay for capital that never dilutes equity holders and never has to be repaid. But I am just a humble investor, and reasonable minds will differ.
"A convertible preferred, because of its potential upside for investors, can be priced at a significantly lower dividend rate."
And, yet, there is an alternative that should be of interest to many of those preferred-dubious REITs. Why not issue convertible preferred stock? This isn’t a revolutionary concept, and it has been used successfully by some REITs in the recent past, including Alexandria Real Estate Equities (NYSE: ARE), Digital Realty Trust (NYSE: DLR) and Ramco-Gershenson Properties Trust (NYSE: RPT). Using such stock would provide a REIT with several significant advantages.
First, a convertible preferred, because of its potential upside for investors, can be priced at a significantly lower dividend rate. Depending upon the nature of the capital markets at the time of issuance, the conversion price premium and other terms, the REIT might be able to save 100 basis points to 150 basis points versus a straight preferred.
Second, assuming eventual conversion of the preferred stock into common, the REIT would be issuing new common stock at a price significantly above its current market price. This would be much less dilutive than a straight common stock offering, and in many (or even most) cases, it would be very accretive to the REIT’s net asset value (NAV).
Third, a convertible preferred offering could attract an entirely new set of equity investors who presently are not investing in the REIT because of today’s modest equity REIT common dividend yields, which averaged nearly 4 percent as of the end of June. Many of these new investors will be pleased with their investment, especially if the conversion feature becomes profitable, and may constitute “sticky money.”
A number of REITs issued convertible or exchangeable debentures, at below-market interest rates, a number of years ago – and wish they hadn’t. These securities allowed the investors to demand repayment after periods of as short as five years, and those due dates corresponded with the credit crunch that began in 2007 – creating much angst among REIT executives and equity investors. But convertible preferred is a very different animal; there would be no Sword of Damocles hanging over REITs’ necks – holders couldn’t demand a return of their capital.
Convertible preferred stock may now be an ideal REIT financing device; many investors – both individual and institutional – are clamoring for higher current yields, and interest rates may be near a major inflection point. It gives investors the prospects of more than just yield and does so at very modest cost to the REIT with respect to both current cash flow and equity dilution. It may be a bit more expensive than 10-year debt, but not even my astute Golden Retrievers know where interest rates will be when that debt rolls over.