Why Aren't REITs Issuing More Preferred Stock?

I may be a bear when it comes to Public Storage's (NYSE: PSA  ) valuation, but I'm all in favor of how it runs its balance sheet.

Public Storage is an outlier in real estate investment trusts. It issues very little debt, choosing to use preferred stock to finance new acquisitions and its ongoing operations. This is in stark contrast to other large REITs like Realty Income Corp. (NYSE: O  ) and National Retail Properties (NYSE: NNN  ) , which issue relatively little preferred stock.

Why preferred stock rocks
Unlike a bond issue, preferred shares are permanent sources of capital. Preferred stock is essentially a loan where the principal balance is never repaid.

Public Storage used preferred shares to lock in its financing costs forever at rates that are near historical lows. If rates go up, Public Storage's financing costs will not -- its preferred shares pay a fixed-rate dividend. It doesn't have refinancing risk.

Other REITs that use debt may have to refinance it later at much higher rates than we see today when those debt securities mature.

Neither National Retail Properties nor Realty Income has adopted preferred stock as a large part of their capital structure. On the last earnings call, Realty Income CEO Tom Lewis answered one analyst's question about the company's funding sources. Lewis commented that he was comfortable with a range of 5%-15% preferred stock funding, later noting there is room for Realty Income to add leverage from debt and preferred stock.

Clearly, Realty Income favors debt rather than preferred stock issues. The same can be said for National Retail Properties, which finances roughly 13% of its capital structure with preferred stock. Public Storage operates with a whopping 39% of its funding from preferred stock.

Source: Company SEC filings.

Pay more now for lower rates forever?
Predicting interest rates isn't as easy as some might think. Managers have to concern themselves with profitability and a capital structure that maximizes shareholder value -- a financing structure that will bring the most people to pay the highest possible price for its shares.

I think most investors have come to terms with the fact that today's interest rates may be the lowest we see in years -- perhaps even our lifetime. For that reason, it may make sense for Realty Income and National Retail Properties to adopt Public Storage's financing strategy by using more sources of permanent capital to displace the effects of rising interest rates on their income statements.

Transitioning to permanent sources of capital is fairly easy. National Retail Properties and Realty Income simply allow their debt to mature, refinance part of it with short-term borrowings at a low rate, then sell perpetual preferred stock at a slightly higher rate than 20-year debt.

Sure, preferred stock may cost more right now, but the certainty may ease investors' minds about where rates are going next. Public Storage is in a very comfortable place knowing that it doesn't have to worry about rates going to 5% or even 10% in the next 10 years. Realty Income and National Retail Properties shareholders would probably appreciate the same kind of comfort.

It's not a question of preferred stock or debt; rather,it's a question of whether or not Realty Income and National Retail Properties should make a bigger effort to lock in low-cost funding forever. With rates so low, it may make sense to lock them in for the long haul as an insurance policy for equity investors. 

Even more premium stock picks
Dividend stocks can make you rich. It's as simple as that. While they don't garner the notoriety of high-flying growth stocks, they're also less likely to crash and burn. And over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine. With this in mind, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.


Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2688033, ~/Articles/ArticleHandler.aspx, 9/23/2014 10:53:09 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement