Preferred REITs Pay Off

Followers of this page know that I rarely write a discouraging word about real estate investment trusts. Trouble is, REITs are riding high — maybe too high. After another grand year, shares of property-owning REITs yield just 3.5%, on average, and a lot of the big ones yield less than 3%. What's more, most REITs trade above the value of their underlying assets, an unusual situation.

The exuberance of REIT investors is not entirely irrational. Property values and rents are rising steadily as the economy perks up. But when the shares of Public Storage (symbol PSA) trade at $146, or 26% above the REIT's net assets per share of $116, or when Health Care REIT (HCN) commands a price of $62 for $47 per share worth of property, it's clear that the stocks already reflect much of the good news.

Preferred solution. There is, however, a way to tap into the property boom and snag the 6%-to-7% yields that REIT fans once took for granted. The ticket is preferred stocks, bond­like securities that REITs use to raise permanent capital that doesn't count as debt on the balance sheet.

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Preferred stocks are hardly exotic. They are issued at a par value of $25 per share, pay a fixed dividend quarterly or twice a year, and rarely have a fixed life span but are almost always callable at $25 after five years. Detractors say preferreds are dumb because prices don't grow much in bull markets for real estate and yet, like bonds, preferreds will still lose value when interest rates rise or the issuer's credit standing deteriorates. But preferreds work well for those seeking substantial income, and many REITs have turned into growth stocks that happen to pay dividends because the law requires them to do so.

The chief risk today is that you'll buy a preferred REIT at a premium to par value, then get a notice that the stock is being redeemed. If you buy a preferred for $27 a share and it's called at $25, you'd better be sure you've collected at least $2 per share in dividends. And that's just to break even. You should aim higher.

Because no-load and exchange-traded real estate funds generally ignore REIT preferreds, you'll need to shop for individual issues. Simon Wadsworth, an avid REIT investor in Memphis who served as chief financial officer at a REIT before retiring, advises against paying more than $25.50 for any preferred and suggests diversifying among at least ten issues. If you're new to preferreds, that's a lot of work, but you can build your collection gradually.

I would add some other guidelines. One is to avoid REITs (or REIT sectors, such as hotels) that have a history of slashing dividends on their common stocks. That's a sign of cyclicality that could endanger even the preferred dividends someday. Another is to pick brand-new preferreds or ones that are less than a year old. That assures you four to five years of fixed dividends. Fortunately, the flow of new issues is constant.

Worthy resources for researching these hybrids include Preferred-Stock.com and Epreferreds.com. (You can buy 30-day passes to the sites for $20 and $45, respectively.) When I searched on Epreferreds.com, I came up with 309 REIT preferreds. When I asked for those with call dates in 2017, I found, among others, Pennsylvania REIT (PEI-PB), trading at $25.32 for a current yield of 7.3% and a yield to call in October 2017 of 7.2%; Entertainment Properties Trust (EPR-PF), at $25.14 with a current yield of 6.6% and a yield to call in October 2017 of 6.5%; and SL Green Realty (SLG-PI), selling at $25.43, with a current yield of 6.4% and a yield to call in August 2017 of 6.0%. If you're more comfortable with the giants, you can find preferreds from Health Care REIT, Public Storage and Realty Income. All trade at about $26 and show yields to call of about 5%. In today's environment, that's not bad.

Jeff Kosnett is a senior editor at Kiplinger's Personal Finance.