HTIBP - Preferred Arbitrage With HTIA

2023-07-07 23:10:22 ET

Summary

• Preferreds of the same issuer with the same terms have the same risk level.
• They should therefore have the same expected return.
• Yet there is a large gap, making a clear arbitrage opportunity.

I feel like I am writing too many articles on preferred mispricing these days, but the market isn’t giving me a choice. It seems like just about every day a new and different mispricing surfaces. There is a 110 basis point spread in current yield and $1.40 spread in discount to par in 2 preferreds from the same issuer with virtually identical risk profiles.

This time the source of mispricing is Healthcare Trust Preferreds A ( HTIA ) and B (HTIBP). The A should trade at a higher price because it has a 25 basis point higher coupon (7.38% versus 7.125%) and slightly more liquidity with a modestly larger issue size. However, as of 6/9/23 it trades $1.40 cheaper than HTIBP.

This is just mathematically incorrect and a clear mispricing. Since the risk is essentially identical, the expected returns should be identical but they are clearly not. Given the clear mispricing, it behooves us to dig further and ask a few questions.

1. How did this happen?
2. How protected are the dividends and liquidation preferences?
3. Is HTIA too cheap or is HTIBP too expensive?

How it happened – Trading volatility of underfollowed issues

As interest rates rose, just about all fixed income instruments sold off to reflect the now higher interest rate environment.

Those with good institutional following sold off with mathematical precision to whatever new yield the market deemed appropriate, but the trading was significantly sloppier in small issues with low liquidity. This effect is exacerbated for HTIA as even though it is publicly traded, the underlying company is still not listed on an exchange.

As such it has an even smaller following than one would expect for a roughly $100 million preferred issue. Single errant market orders can move the price by multiple percentage points which makes its market price swing around from day to day and at times such as the present it gets rather far from fair value. It looks like the current bout of mispricing began in May as it diverged from the pari-passu HTIBP.

The spread has gotten juicy enough for us to find it interesting so we shall take a look at the company which pays the dividends.

Fundamentals of underlying issuer

This is not a great company. As it is not listed there is technically no realized gain or loss yet for shareholders, but I believe most of the original shareholders are sitting on a slight loss.

It is part of the AR Global family and followed their modus operandi of raising a few billion dollars and immediately buying assets in the target asset class. This means acquisitions are timed to fit when the capital is raised as opposed to when they are opportunistic. Healthcare Realty Inc. bought just over 50% medical office and just under 50% senior housing.

Since their inception, medical office as a sector has been stable while senior housing has struggled at an industry level. Healthcare Inc has suffered in its senior housing along with SH focused REITs like Ventas (VTR). There have been impairments and profitability is not great.

So while HTI spent close to half of its capital on senior housing, the NOI breakdown is 77% MOB.

Most analysts believe the senior housing industry is recovering and I agree with this outlook. It will not return to 100% but it will quite likely be better next year than it was in 2022 and 2023. So that makes the outlook at an asset category level stable for HTI’s medical office and modest growth for its SH operating portfolio.

While I think common shareholders are sitting on a loss, the preferreds are a different vehicle. They only care about stability and profits/balance sheets staying above key thresholds.

HTI operates at moderate debt with $2.6B gross property investments versus $1.2B of liabilities.

Even with the impairments, there is a large equity base underneath the preferreds.

From a profitability standpoint the key threshold is full dividend coverage of the preferreds which occurs at a minimum FFO or $0.

The SEC filings are of course in GAAP so we have to make some adjustments which I highlighted in yellow.

Depreciation of $20 million is greater than the $14 million net loss to common stockholders which leaves about $6 million to pay preferred dividends which cycle at a rate of $3.45 million quarterly.

Thus, preferred dividends are fully covered with a small but meaningful amount of breathing room

We are generally not a fan of the way AR Global manages their REITs because they tend to grow for the sake of growth. It dilutes shareholders and their public companies (GNL, RTL, NYC) have a terrible total return track record. However, in an odd way, this is somewhat beneficial to the preferred because each time the common gets diluted with more issuance the equity base under the preferred grows.

Overall, I view the preferreds as stable but above average equity REIT preferred risk.

Is HTIA cheap or HTIBP overpriced? Both

The obviously good trade is for those who currently own HTIBP to swap into HTIA. It improves yield, and improves capital appreciation potential with no real downside other than the effort of executing the trade in a cautious way with use of limit orders.

For those who don’t currently have a position it is a matter of determining where appropriate valuation would be. HTIA being better than HTIBP doesn’t help much if HTIBP is really overpriced. By my judgment, HTIBP is slightly overvalued and HTIA slightly undervalued.

Given the fundamentals of the issuer discussed above and the current interest rate environment I think the proper trading yield for these is around 9.50%.

Thus, I see HTIA as a moderately good opportunity. It is not a huge gain as I don’t think it will return fully to par, but even just trading to a 9.50% yield would be a market price of $19.40 so that is about a 10% upside to fair value on top of a double digit dividend yield while you wait.

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