By JACK HOUGH
Income investors have scant choices as the moment. The 10-year Treasury bond pays just 2.1%, and safe corporate and municipal bonds are similarly stingy. U.S. stocks have dividend yields averaging just over 2%--but they've frightened buyers since summer with breakneck price swings.
Last week I outlined the opportunity in real estate investment trusts, or REITs (see "REITs, Don't Fail Me Now"). These are professionally managed portfolios that turn land into income using all manner of rentable structures: hotels, hospitals, warehouses, apartment buildings and malls, among others. Financing rates are favorable for real estate investors, and in certain commercial markets, demand is strong and supply tight. For investors, REIT yields of 6% and plentiful.
Here's a REIT opportunity I didn't mention in that column: preferred shares. Preferred shares mostly pay fixed dividends instead of variable ones, so they tend not to grow in value over time as rents rise and real estate becomes more valuable. But they also pay more than common shares. REIT preferred shares have yields in the mid-6% to low-8% range now, says Mark Snyderman, manager of the Fidelity Real Estate Income Fund (FRIFX), who generally invests 10% to 15% of his funds assets in preferreds.
REITs often use a combination of bonds and preferred stocks to raise money for their real estate investments. For them, the appeal of preferreds is that there's no maturity date, and thus a lower possibility of a financing crunch if credit markets dry up. Also, for bookkeeping purposes, preferred shares count as equity and not debt, and so help keep leverage ratios conservative.
For investors, the appeal of preferred shares is pretty straightforward. They pay more than bonds, all else held equal.
But there are four potential negatives for preferred stocks that investors should consider before they buy, says Mr. Snyderman. First, they're generally callable, which means the issuer can pay them off early if, say, it finds it can refinance at a better rate. A typical new-issue preferred is sold at $25 and gives the issuer the right to call it back at $25 any time after five years. So preferred buyers should make sure they're not paying a big premium to the call price, or that they have several years of call protection left, or both.
Second, preferred stocks are riskier than bonds from a credit standpoint, because they don't have "covenants" or rules that protect investors, for example, from companies taking on too much debt.
Third, preferreds are also junior to bonds when it comes to which investors get paid in the event of financial trouble. That makes it important to stick with financially strong issuers.
Fourth, the lack of a maturity value means that if interest rates spike, and fixed-income investment including preferred stocks lose value, a preferred holder can't just wait until maturity to get all of his money back.
There's one more hitch: dividends on preferred REIT shares don't qualify for the dividend tax rate, which is currently lower than the income tax rate. So these are best used in tax-deferred retirement accounts or by investors like retirees who aren't in high income tax brackets.
If that doesn't scare you off entirely--and for many investors, it shouldn't--there are good yields to be found in preferred from issuers like Vornado (VNO),
Not all of the preferred listed on that page are issued by REITs. What makes REIT issues particularly attractive is the pass-through nature of these trusts. In order to avoid being taxed as corporations on their real estate income, they must pay the bulk of it to shareholders as dividends. That means REITs can't cut their dividends on a whim, like banks can.
Here's a tip on picking safer REIT preferred shares, from a director at a large REIT who asked not to be named due to company restrictions. Many REITs pay both common and preferred dividends, and as the name suggests, preferred dividends must be paid first. So open a company's recent financial statement and look at the dollar amounts it spent on dividends. A ratio of $5 in common dividends for each $1 in preferred dividends should provide plenty of protection against payment cuts.
Most individuals shouldn't load up on REIT preferred shares but rather invest a modest portion of their assets, says Mr. Snyderman. Of course, another option is to invest through a REIT mutual fund that owns common and preferred shares, which gives a combination of healthy income and growth potential. Mr. Snyderman's fund yields over 5%.