A Real Estate Play That Pays

A shrinking economy and frozen credit markets are a lethal combination for real estate investment trusts. The Dow Jones Wilshire REIT index lost 34% over the past year through February 6, as investors concluded that these toxic conditions would force many REITs to pare back generous common-stock dividends. REIT preferred shares did just as poorly.

Nevertheless, preferred issues from some of the stronger players are worth a look. They yield 9% to 12%, and their dividends are shielded by an added layer of protection: A REIT would have to eliminate its common dividend before it could reduce its preferred payout. "The reality is that most REITs aren't even going to cut their common dividend," says Jay Leupp, who runs Grubb & Ellis AGA Realty Income fund and invests 80% of its assets in REIT preferreds.

REITs own a variety of property types and usually pay out almost all of their profits as dividends. While the holders of common stock can expect rising dividends and share prices during good times, preferred investors settle for safer, bondlike returns. Preferreds pay a fixed dividend, and the share price (typically $25 when the stock is issued) normally moves in response to, and in the opposite direction of, interest rates.

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But in 2008, preferred shares collapsed, even as rates sank. Among the causes: forced selling by troubled hedge funds and closed-end funds, fears that a recession would drastically reduce REIT profits, and concerns that REITs would be unable to refinance loans and be forced to sell properties at fire-sale prices.

As a result, the average yield of REIT preferreds is almost 11 percentage points higher than that of the ten-year Treasury note (recently 3.1%). That's well above the historical spread of four percentage points, according to Kensington Investment Group, an Orinda, Cal., money manager.

Some issues may also offer a rare opportunity for price gains. Preferreds are usually callable, which means issuers can buy them back at the original face value after five years. For many issues, that would represent a gain over current price levels. More likely, issuers would use extra cash to buy shares in the open market. Either strategy could push up prices. On the downside, REIT dividends are taxable at rates as high as 35%, so the shares are best held in tax-deferred accounts.

Three good choices. You can buy REIT preferreds through most brokers. Begin your research at QuantumOnline.com, a free Web site. Look for issues, such as the three described below, from well-established REITs with relatively low debt levels. (Symbols are for common shares; preferred symbols vary according to the source.)

Series E shares of Public Storage (symbol PSA) pay $1.69 in dividends annually, resulting in a 9% yield at the recent price of $19. Leupp calls Public Storage, which is the world's largest provider of self-storage facilities and has minimal long-term debt, the "gold standard" of REIT preferreds.

PS Business Parks (PSB), which was spun out of Public Storage in 1998, owns industrial, office and retail business parks. Its low debt and $60-million cash cushion make it a safe holding despite its exposure to the struggling office and retail sectors. Series L preferred shares pay $1.90 annually and yield 11% at the recent share price of $18.

HCP (HCP) owns a mix of recession-resistant senior-housing facilities, hospitals and medical office buildings. Its series F preferred shares pay $1.78 annually. At a share price of $17, that's a yield of 10%.