RioCan Real Estate Investment Trust made a small piece of history last month by being the first Canadian issued real estate investment trust (REIT) to issue preferred shares at an annual 5.25% yield on the first 5 years with the rate re-setting to a rate equal to the Government of Canada bond yield + 2.62%. Please note that the distribution is taxed as income/return on income and not dividend.

The time is not a coincidence.  Preferred (or preference) shares tend to fall out of favor during good times since preferred shares have priority to common shares to dividends/distributions but do not share in the upside of that the common shares do. But, unlike fixed income, a retail investor can initiate relatively small positions in REIT preferred shares and sell the REIT preferred shares back on an exchange. For this reason, they are often described as hybrid debt-equity instruments.

Do REIT preferred shares they have a place in your portfolio?

Theoretically, REIT preferred shares have higher yields than their common share/unit counterparts (currently not the case in RioCan but shown in American issued REITs) and government issued bonds. Since the cash flow is derived from a hard asset and leverage in well-run REITs tends to be low, the dividend is relatively secure (loan to value ratios tends to hover in the 40%-60% range in large REITs which means liquidating assets in a worst case scenario should stave off insolvency short of a fire sale happening).

Like most preferred shares, pricing volatility also tends to be quite low since many preferred shares can be called at a set price meaning the trading price tends not to swing wildly from its issuance price. Finally, the price of REIT preferred shares tend to move in opposite direction from large cap stocks (observers of REITs will know the price of  large cap stocks and REITs generally move in opposite directions historically. The effect is more pronounced in the case of REIT preferred shares as compared to large cap stocks).

As such, REIT preferred shares behave more like debt instruments with higher yield than equity and, in the abstract, most suitable for investors with a low threshold of volatility risk seeking steady returns on a hard asset. Having said that, one should avoid engaging in a should I sell my REIT common shares/units for REIT preferred shares debate since it is an apples and oranges comparison.

REIT common shares/unit are purchased as much as an income source as an appreciation source and inflation hedge. A REIT preferred share does not necessarily share that purpose. The downside, as noted, is, again, the classic risk to reward trade-off. REIT preferred shares are safer instruments but with the loss of upside. They should not form a large percentage of holdings for someone with a long investing horizon.

As a share with limited liquidity, exit strategies also tend to be problematic which is not so much a concern if a REIT preferred shares is seen as a buy and hold until I die fixed income instrument. Finally, there is the typical interest rate risk associated with any fixed income paying instrument.

Can a REIT preferred share form a part of a fixed income portfolio? It can provided the investor understands the risks and the portfolio is not already overweight in real estate. As usual, do your own due diligence, analyze your life and portfolio and proceed accordingly.

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