1 Thing Investors Are Forgetting About REITs

When it comes to REITs, preferred shares may trump the returns from common stock.

Jan 10, 2014 at 2:46PM

If there's one thing to never forget about REITs, it's that you have alternatives.

I'm not talking about the broad index, or even a REIT ETF. I'm talking about different parts of a REIT's capital structure -- its debt and preferred stock. The fact is that REIT equity is an income play: Investors buy REITs for the dividends. But the common stock isn't the only way to get a fat dividend yield.

REIT common vs. REIT preferred stock
We could talk for days about the differences between common and preferred stock. But when it comes to REITs, the big difference that matters is growth.

REIT preferred stock pays a consistent, fixed dividend. REIT common shares usually pay a consistent dividend, but one that is subject to change. For the most part, quality REIT common stocks like Realty Income Corp. (NYSE:O) or National Retail Properties (NYSE:NNN) pay bigger dividends over time.

But just because the dividends grow over time does not mean the common stock is a better investment. In many cases, investors may be better off owning the preferred stock, even though the dividend won't grow over time.

Thinking it through
Let's step back to Finance 101. A good way to get an idea of the very long-run return for a REIT is to add together its dividend yield plus a constant growth rate. This is, after all, how you find a basic expected return for perpetual cash flows.

If we look at National Retail Properties, we find that the common stock yields roughly 5.3%. Its preferred shares -- there are several different issuances -- yield about 7.3%.

So when investors think about buying National Retail Properties, they should ask a basic question: Can National Retail Properties grow its common stock dividend by more than 2% per year? Over very long periods of time (we're not swing trading, here), National Retail Properties common stock dividends would have to grow by 2% per year just to match the returns of the preferred shares.

The same simple question exists with a company like Realty Income. The common stock yields about 5.8% per year. Its preferred shares yield about 6.9%. For the common stock to outperform the preferred stock, Realty Income would need to increase its dividend at a 1.1% annual clip.

Keep in mind that this is from a buy-and-hold perspective. I'm ignoring the potential that a REIT's shares could double overnight, even though such an event is improbable.

Who makes the grade?
Historically, Realty Income has been a much, much better dividend growth stock than National Retail Properties. Realty Income has historically grown its dividend at a rate of 4.1% since IPO, excluding its recently large, one-time dividend hike in early 2013. If we assume Realty Income can continue to grow dividends at 4.1% per year, the common stock is much more attractive than the preferred stock.

For National Retail Properties, which has grown its dividend at a 1.8% annual rate since 1990, the preferred stock may be a much better choice. The preferred shares offer a solid and consistent 7.3%, likely in perpetuity, which makes for a much more certain return profile without speculating on future dividend increases. Of course, with preferred shares, there's also the added benefit that you get paid first in the event of a downturn.

The Foolish bottom line
Buying REIT common stock just for the sake of a growing dividend is a fool's (not a Fool's!) mistake. A buy-and-hold investor should carefully study alternatives, especially preferred stock, before buying the common stock. In some cases, mispriced markets offer the opportunity to get consistently high yields from preferred shares, which also have added downside protection because of their seniority. 

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