The Intelligent REIT Investor Guide. Brad Thomas
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Plus, most preferred stocks specify that common dividends cannot be paid unless preferred dividends are current.
Credit agencies treat preferred stocks as equity when everything is said and done. As for the companies themselves, they regard them as permanent capital that doesn't dilute common‐stock‐related interests, which sounds about right.
Most preferred dividend rates are set when they're first issued and remain that way for as long as the shares are outstanding. And since they have little if any appreciation potential on their own, their holders don't participate in the company's earnings growth. It's also important to know that the issuer can typically redeem them after a period of time – usually five years after issuance – at their original price. So if interest rates fall, the shareholder may be deprived of a good, high‐yielding investment.
Then there's liquidity. It can be difficult to buy or sell large amounts of preferreds at a time. And there's often a significant spread between the bid and ask prices. Additionally, in admittedly abnormal cases where the issuer is acquired or goes private, preferred shareholders can be negatively affected by lack of disclosure concerning company information or by higher debt leverage at the newly private company.
These assets still appeal to many though because of their higher dividend yields compared to most common shares and corporate bonds (assuming comparable credit quality). This, alongside their payouts having priority over common stocks, makes them especially attractive during uncertain times, such as the 2020 pandemic.
Other High‐Yielding Equities
Two better REIT comparisons to make include higher dividend‐yielding publicly traded entities such as utilities and master limited partnerships (MLPs). Utility stocks, for one, have been a long‐standing and reliable staple of the investment world. The industry's total market cap is in excess of $1 trillion, and the top 20 utility stocks have a combined value of $775 billion.
These businesses provide basic services such as electricity, natural gas, water, and wireline telephony to individuals and businesses. Competition isn't practical in most of these areas, allowing many of them to form what amounts to legal monopolies.
This is both good and bad for their shareholders. On the one hand, the utility doesn't have to compete with other providers, so its earnings and dividends are often quite stable. On the other, that stability can equate to very, very slow growth: perhaps 2–4% annually. Plus, these entities can only charge customers what the regulatory authorities permit, so they run the risk of fickle and sometimes politically motivated pricing.
In recent years, some utilities have been “unbundled,” as it were. Those that generate or purchase power, and sell it to other service providers, for example, have become much less regulated. So their growth prospects are now better. Then again, their earnings are much less certain, and their dividend yields tend to be much lower.
Accordingly, utility stocks like those of Duke Energy and Southern Company may compete with REITs for investment dollars to some extent, especially because they've proved to be less volatile than REIT shares in recent years. As such, they can be good choices for people with very modest capital appreciation expectations and total return requirements.
MLPs, for their part, aren't limited so much by industry in a legal sense. Yet the vast majority of publicly traded ones are engaged in energy infrastructure such as gas pipelines and storage facilities, varying in how much exposure they have to natural resource prices.
According to MLP and energy analyst Alerian, the total market capitalization of the energy MLPs has grown rapidly to around $225 billion ($350 billion including Canada) as of September 30, 2020. The sector was almost $800 million in 2014, but MLPs have been consolidating since 2018.
Their dividend yields in November 2020 were close to 8%, which is generally higher than those of REITs. So they can provide investors with significant current income and diversification capabilities. And thanks to depreciation and other tax advantages applicable to the oil and gas industry, much of those cash distributions are not currently taxable as ordinary income.
MLPs are like other pass‐through stock classes such as REITs, business development corporations (BDCs), and YieldCos because they're largely dependent on external capital markets and their unit counts generally rise over time.
They may trade like stocks, but they actually fall into a completely different category. Their legal structure means that investors receive a partnership K‐1 form at the end of each year, which can make tax‐return preparation challenging, to say the least. Also, if held in an individual retirement account (IRA) or other tax‐deferred account, they can potentially give rise to “unrelated business taxable income.” This would then open up their dividends to other forms of taxation under certain circumstances.
Rather like REITs, MLPs distribute most or all free cash flow to their partners. This means they'll need to raise outside capital from time to time if they want to grow, and such capital isn't always available.
All told, MLPs do compete with REITs for investment capital. However, they're different enough from each other that investors don't have to choose one over the other if they have enough capital to spread between the two categories.
Other Real Estate Investment Vehicles
As an asset class, real estate is usually a very good and stable investment as long as it isn't financed with large amounts of debt. A well‐situated, well‐maintained investment property should grow in value over the years, as should its rental revenue. While buildings may depreciate over time and neighborhoods may change, only a finite amount of land exists on which apartment communities, retail centers, and office buildings can be built. So if you own such a property in the right area, it can be – if not a gold mine – a continuing cash cow. New competitive buildings don't just pop up for no good reason, after all. They're only built if rents or property values are high enough to justify the cost of development.
In either such event, owners of existing properties will likely be better off.
This does once again bring up the issue of inflation. But the extent to which it affects commercial real estate owners isn't all that clear. There have been studies done on this issue, including that of David J. Hartzell, former professor of real estate at the University of North Carolina. He and R. Brian Webb concluded that property “returns tend to exhibit stronger relationships with inflation and its components” during periods of low vacancy rates. Therefore, inflation might not be a benefit to landlords when property markets are weak.
Direct Ownership
As we've mentioned before and will continue to explore, real estate has historically behaved differently from other assets. It therefore adds another dimension of diversity to stock, bond, cash, and even gold and art investments.
REITs are hardly the only way to take advantage of these factors though. Plenty of people choose direct ownership, for example, by being in the real estate business. In which case, they (hopefully) asked themselves questions like: Do I have the time to manage property? Do I know the best time to buy or sell? Do I have or can I obtain the insider information necessary to make it worth my while? Can I attract and retain the best tenants?
Depending on the market climate, buying real estate on the cheap to sell “on the expensive” is often more profitable than holding and managing it. That's why flipping houses holds such an appeal.
Then again, there's a reason why people can lose just as much as they can make on such ventures. Judging the markets appropriately, not to mention the costs and efforts involved, requires access to constantly evolving data. As for buying and holding to rent out to others, this necessitates effective and efficient property management. These cautions can't be overstated, especially since individuals often lack the time, money, and/or expertise to handle those tasks on their own.
It might seem intensely more profitable to keep all the profits from real estate instead