PLDGP - Dislocation In The Equity REIT Fixed-Rate Preferred Market

2023-09-08 04:30:34 ET

Summary

• Market is ignoring factors such as interest rate sensitivity, upside to par, call date, and risk shifting in pricing preferred stocks.
• Mispricing is evident in the relative pricing of hotel REIT preferred stocks with similar risk factors.
• Investors should consider total expected annual return, interest rate sensitivity, and upside potential when evaluating preferred stocks.

Pricing action in the preferred market continues to be dominated by some measure of current yield as compared to general risk level of the company. These are great parameters to look at, but mispricing is introduced when these are the only factors being considered.

There is ample evidence in market pricing as of today to suggest the market is completely ignoring the following factors.

• Interest rate sensitivity (favorable or unfavorable)
• Upside to par
• Call date
• Risk shifting (differing reward schema for preferred compared to common)

Some of the mispricing we discuss today will be preferreds that are clearly overpriced, while others represent buying opportunities.

Upside to par and Interest rate sensitivity

Mispricing related to this concept is evident in the relative pricing of 3 hotel REIT preferreds. DiamondRock (DRH) Preferred A ( DRH.PR.A ) trades at an 8% current yield.

Summit Hotel ( INN ) preferred F ( INN.PR.F ) trades at 7.93% current yield and Pebblebrook ( PEB ) Preferred G ( PEB.PR.G ) trades at 8.06% current yield.

The three companies are fairly similar in terms of risk factors, each being long tenured, well operated and profitable. The yields are high because of the risk factors inherent to the volatile hotel business.

However, it should be the total expected annual return sitting around 8%, not the current yield.

See, the 8% current yields have very different compositions. DRH.PA has an 8.25% coupon and trades above par while the other preferreds have much lower coupons and get to their 8% yields by trading well below par.

Looking at PEB-G, for example, it is trading at $19.77 against a $25 par value, which results in its 6.38% coupon being a current yield over 8%.

The difference here comes in interest rate sensitivity and upside to par.

Total return for DRH.PA is capped at its current yield because the market price can really only go down. If interest rates stay where they are it just sits here churning out the dividend but because of the premium to par both rising rates and falling rates are negatives.

If rates rise, DRH.PA would have to drop in price to make its current yield match the then even higher demanded return.

If rates fall, DRH will redeem the preferred at $25 upon the redemption date in about 2 years and replace it with cheaper capital. Investors lose whatever premium to par they paid for the shares.

In contrast, rate changes act far more favorably on heavily discounted securities. If interest rates rise, PEB.PG would perform similarly to DRH.PA, but if rates fall, PEB.PG gets up to 26.5% capital gains along with the dividend.

It is worth noting that falling rates over the next few years is well within the market consensus.

Thus, the market is trading these preferreds of similar risk at a similar current yield and assuming they have similar risk to reward.

However, if one puts even a moderate possibility of interest rates declining into their forecast the total return outlook of PEB.PG is substantially higher. If, for example, rates drop in 3 years, PEB.G would have a total return of about 50% over those 3 years, while DRH.PA would only return about 24%.

That is far too much of a difference given that these 2 stocks are subject to the same risk factors inherent in the hotel industry. In my opinion DRH.PA is priced about right while PEB.PG is priced too cheaply as its upside potential is not being recognized.

INN Preferred F is in the same opportunistic boat as PEB.PG due to also having an extreme discount to par.

Worth noting here is that INN-F is clearly better than INN-E with more upside to par and a higher current yield. Investors presently owning INN-E have an easy opportunity to switch over to the F and improve both their yield and upside potential.

Call date

For discounted preferreds the date at which it becomes redeemable is usually a non-event or in some cases a time at which par value might be realized.

For those trading at premiums, however, the date at which the issue becomes callable should be viewed as a looming threat. Any premium paid above par is at risk of evaporating on that day.

This risk is spelled out in plain English in the preferred documents yet time and time again the market completely ignores it. As a specimen of the market's oversight, we can look at Prologis (PLD) Preferred Q (PLDGP).

If one buys PLDGP today and holds it until call date, they will earn a whopping negative 0.63% over the just over 4 year hold.

PLD has access to much cheaper capital, so they will very likely choose to redeem these shares at the $50 par value resulting in investors losing the $7.20 premium.

We alerted the market to this phenomenon in 2021, and it has dropped slightly since then but remains far above where it should trade. PLDGP is still dead money.

Risk shifting between tranches

Some people view DigitalBridge (DBRG) as a powerful tech infrastructure play of the future.

Others, myself included, view it as an amalgamation of random tech related infrastructure assets acquired by a series of management teams that all seem to share an interest in self-enrichment. Check out these stock compensation figures.

I don't think I have ever seen numbers that high on a company with a market cap as small as DBRG's.

Maybe the innovation will be so extreme that it can be a winning stock despite the money grabs, but certainly there is a lot of risk here. It is not particularly profitable in its current form, and it is unclear to me when it will be GAAP profitable. For reference, consensus estimates also don't see the profits.

The basic idea here is rather simple: DBRG is high risk but perhaps, depending on one's viewpoint, high reward potential.

This is where the risk shifting between tranches comes in. If it turns out DBRG is a home run, the common equity can go however high is warranted. The preferred, however, is capped at $25. It is trading at a discount, so that would be about 16%-18% upside, depending on the issue.

When investing in preferreds, stability is almost always going to be better than binary moonshots. Preferreds only have limited participation in the upside so it doesn't matter how extreme the upside might be.

As a preferred investor, one really just wants the chance of failure to be low. Don't get suckered in by promises of tech-hype upside because you don't get to capture it anyway.

Wrapping it up

The equity REIT preferred market remains substantially mispriced with the market's tunnel vision on current yield. Avoid the high risk and overpriced as there are plenty of quality preferreds with significant upside to par.

For further details see: