Portfolio Update - October: Those Huge Preferred Yields

One of the series we provide on our premium service is the monthly portfolio update. Since we’re posting the October update, I’ve removed the paywall from the September Portfolio Update. However, I’m also making the October Update available to all readers.

Main Points

• Treasury yield put pressure on the sector yet again. 2-year yields were roughly flat, while 10-year yields climbed even higher. They aren’t matching 2-year rates yet, but they are much closer.
• Plenty of opportunities for long-term investors looking into equity REITs as dividend growth investments.
• The preferred shares continue to catch my eye. Looking for shares that should start floating in the next 18 months or so. Yield to call is becoming relevant for many shares.
• I’m not expecting shares to actually get called, but if rates are remotely close to the forward curve implied by the market, the floating-rate preferred share dividend increases would be huge.
• What near-term positive catalysts are as large as floating rates kicking in? Huge dividend increases can drive prices up, creating big gains.

To keep things simple for our investors, the portfolio update is divided into several segments. The recurring segments are:

1. Foreshadowing Potential Trades
2. Trade Alerts (links to trades)
3. Returns to Date on Open Positions
4. Returns on Recently Closed Positions
5. Returns on Total Portfolio
6. CWMF’s Portfolio Images
7. Sector Allocation
8. Conclusion
9. Strategy (Repeated) - This explains how we invest. It helps investors understand why we place the trades we do.

Foreshadowing Potential Trades (New Section Begins)

Note on target updates: Expect negative revisions across equity REITs outside the net lease subsector (already updated). The rise in the 10-year Treasury rate is impacting costs for refinancing debt and providing investors with additional opportunities for yields.

Note on rates: The 10-year Treasury is still ripping higher (except for today) and it’s creating a big problem. The 2-year Treasury has only been climbing at a moderate rate. It surged going into mid to late July, but since then it’s only been a moderate issue. We’ve seen the inversion of the yield curve adjusting with long rates moving higher.

This section is usually prepared shortly before publishing. The goal is to quickly cover ideas for trades. We aim to foreshadow our trades here, though the market may move in surprising ways. While the article takes days to prepare and documents prices and performance from the end of the month, the potential trades section is written last to provide the most up-to-date pricing.

Based on the change in relative prices as of 10/09/2023, here are some of the trades on my radar.

Foreshadowing potential equity REIT trades

Because of the preferred shares with upcoming floating dates and most of my available cash being in tax-advantaged accounts (which are used for trading opportunities), I won’t have as much cash for equity REIT purchases. However, we should still cover the opportunities.

Housing REITs: Still cheap. Higher interest rates will have some impact on debt costs, but it is small for apartment REITs. On the other hand, higher debt costs make mortgages far less attractive, which is good for rents.

Remember that rental rates will see big headwinds in 2024 from new supply, but the situation should reverse by 2026 with low supply driving rents higher. Near-term headwinds are a challenge and may continue to weigh on prices, but gradually building a long-term position should be attractive. My recent picks have been Sun Communities (SUI), Camden (CPT), and Mid-America (MAA) as REITs that got pounded too hard. Lately, UDR (UDR) could be a contender for that reputation also.

Towers: Will have to consider adding more. I’ve often carried towers as our largest equity REIT allocation. They still are, but the weight has fallen as share prices declined. They’ve been in a pretty long slide. Floating rate debt hammered AFFO growth rates for 2023. AFFO multiples are treating stocks as if they are going to be long-term low-growth vehicles. Seems pretty pessimistic.

Industrial: I’m still leaning towards Rexford (REXR) as the choice for the sector, but the recent weakness in Prologis (PLD) looks attractive. Both are good REITs to consider. The investment philosophy here is growth in AFFO per share due to the shift towards e-commerce driving up rents. Portfolios are currently leased far below market rates, so lease expiration drives significant growth in revenue, Net Operating Income, FFO, and AFFO per share. They also have strong balance sheets, which is particularly important given today’s high interest rates.

Other: I added to our position in Alexandria (ARE) already this month. Under $100 it’s about a 5.0% dividend yield. Reasonable payout ratio. Management responds to the market by selling properties at cap rates that are dramatically below the cap rate implied by share prices. There is extra lab space in development courtesy of the low rates + high inflation in 2021, but that may dry up. I don’t see demand for lab space plunging. AI may assist in running experiments, but it will still need large amounts of data put into the system. My biggest concern is probably the demise of office real estate and some office-to-lab conversions. Many potential conversions didn’t make sense when a hypothetical office building cost $150 million. Drop that price tag to $50 million and suddenly the conversion is much more attractive.

Foreshadowing potential BDC trades

I’m not expecting to be active in the BDCs at the moment. Depending on volatility, it could happen. If I see Scott buy something or we see significant underperformance by one of the shares in the bullish range, then I might put some capital to work here.

Foreshadowing potential mortgage REIT trades:

Rithm Capital Corp (RITM) and Ready Capital (RC) could be candidates for raising positions. Risk ratings are relatively low for the sector and discounts to targets are pretty high.

Foreshadowing potential preferred share trades:

This is the area where I’m most interested in being active.

• I’m going to have a separate article coming up very soon for our paid members to cover the opportunities I see there.
• There are too many to fit here.
• The emphasis will be on shares that are floating in less than 18 months.

Trade Alerts

Below, you’ll see links to our trades from the month:

• 9/06/2023: Trade Alert: FBRT-E
• 9/11/2023: Trade Alert: RC-E, AGNCP, CIM-B
• 9/22/2023: Trade Alert: CIM-B, CIM-D

Note: Since October began, I purchased shares of Alexandria (ARE) and more shares of CIM-D.

Returns to Date on Open Positions

We will start with the open positions as of the end of the month. It often takes a few days to prepare this article, but the screenshots below are from the end of the prior month.

The cell with the ticker is grey if the position is in a taxable account. This was a request by a few members and there was no drawback to adding the information. All of those positions are in equity REITs.

Some tickers are highlighted in orange. That’s because I discovered a typo in my sheets during the portfolio review. Any line with a correction has the ticker in orange.

Preferred shares and baby bonds:

Equity REITs:

Mortgage REITs and BDCs:

Other:

Returns on Recently Closed Positions

These are the positions closed since the last portfolio update. If you want to see positions that were closed before that, you can see the prior portfolio updates or use the Google Sheets. If we didn’t close any positions for the sector during the month, then the image will be blank.

Note: By loading the Google Sheets, you can still see all of our closed positions. To reduce the size of the huge article, we’re only highlighting the recent changes. Paid members can use this post to access our sheets.

Preferred shares and baby bonds:

Equity REITs:

Mortgage REITs and BDCs:

Other:

Total Portfolio Returns

Our performance since we began preparing for The REIT Forum at the start of 2016 is shown below and runs through the end of the latest month:

Here are our results through 09/30/2023:

We thoroughly beat the four major indexes covering our types of assets:

• MORT - Major mortgage REIT ETF
• PFF - The largest preferred share ETF
• VNQ - The largest equity REIT ETF
• KBWY - The high-yield equity REIT ETF most retail investors follow

Annual comparison vs. each ETF:

We’re still ahead of all four of the index ETFs we track. That’s great.

Returns fell quite a bit in September. Alpha improved though. We’re getting closer to the end of the year and closer to locking in another year of outperformance. With the opportunity in preferred shares, I’m feeling pretty good about this year and would love to still have some of them materially underpriced when 2024 begins.

The next chart shows the change in the value of our portfolio from month to month. We strip out the impact from contributions made during the month because obviously, contributions are not returns.

The prior year is included as well to help investors see how the calculations work. You can always access this tab, with our entire record, in the REIT Forum Google Sheets. The tab is called “Returns Chart”. It is the tab all the way to the right.

CWMF’s Portfolio Images

These images use the data from the end of the month.

Preferred shares and baby bonds:

Equity REITs:

Mortgage REITs and BDCs:

Other:

Sector Allocation Chart

The sector allocation chart helps to explain how we are thinking about risk and seeking returns:

Conclusion

I’m inclined to continue focusing on preferred shares. I appreciate the stability of having some cash in short-term Treasury ETFs. However, I am also a huge fan of getting such high yield-to-call values on shares with nice floating spreads. This looks like an opportunity for more outperformance. I can’t say whether the indexes will go up or down, but I like the risk/reward profile of including these shares. The increase in Treasury yields reinforces the appeal of these shares over most common shares. In many cases, we could expect a great return just from buying the shares and sitting on them until somewhere around the floating date and looking for prices much closer to $25.00.

If we get some trading opportunities to further enhance gains, that’s even better. It’s not necessary, but it can further enhance returns. Thanks to the beauty of having a fixed date for converting to floating, the shares become more attractive each day that goes by without the price growing. We’re not only accumulating dividends, we’re also checking off days that stand between us and the floating date.

There’s certainly some risk in the macro economy, but there haven’t been that many periods where we could reasonably look at preferred shares and estimated annualized returns substantially above 10%.

This is an environment where higher Treasury yields are pushing up the required returns across many positions. Thankfully, there are many opportunities where we can expect elevated returns. The area I’ll be focusing most on is preferred shares, but there are quite a few opportunities throughout our coverage universe.

I’ll be working on that preferred share update for our paid members next.

Reminder About Cash (Repeated)

Finally, I would remind investors to make use of short-term Treasury ETFs. These are a perfectly suitable replacement for cash if you expect to know you’ll need it a few days in advance. I would normally keep at least 6 months (often more) of living expenses in cash. If you normally keep around $40k to $50k, the difference between getting paid 5% and 0.2% is around $2k per year. I’m using (SGOV) and (SHV) as my cash substitutes. Another good option is (BIL). When cash is needed, I’ll transfer it from the brokerage account over to regular checking.

Note: I use a separate account for holding this cash. It doesn’t get factored into my portfolio. It is functionally a checking account, but it is technically a brokerage account capable of owning shares. There are some alternatives for money market funds as well. Just beware of leaving significant amounts of cash in a near-0 yield checking account.

Strategy (Repeated)

For new subscribers, we should emphasize that we often treat our positions differently. We have those we consider as being primarily “Trading” positions and those where we prefer to “Buy and Hold”. A simple way to remember it is that anything with a high risk rating is probably going to be a trading position. Most of those high-risk positions are mortgage REITs and BDCs. These are two very challenging sectors where most investors (and “analysts”) simply don’t get it. Analysts who can’t predict the changes in book value for mortgage REITs or NAV for BDCs aren’t in a position to trade them. Analysts who don’t know how to evaluate the probability for dividend cuts (or raises) are in a weaker position for trading them. We have access to a great analyst (Scott Kennedy) who delivers exceptional estimates and price targets. If we only bought and never sold, we couldn’t reallocate to take advantage of the next disparity in valuations.

When we switch over to equity REITs, we usually have a long time horizon for investments. We’re thinking more about growth in AFFO per share and the long-run outlook for the sector. Consequently, we will pick REITs with lower risk ratings. The risk rating on an equity REIT correlates heavily with how much debt the REIT is using. That isn’t the only factor, but the correlation is strong. When debt levels are high, that alone can be a sufficient reason to assign a higher risk rating. Consequently, you’ll see us trading equity REIT positions far less actively. We will mostly wait for opportunities to buy a great REIT at an attractive price. We simply don’t want the mediocre equity REIT, not even at a low price. It doesn’t fit our strategy.

Preferred shares can be used in either way. However, you’ll often see our positions listing a “short” holding period. That’s because we frequently swap between different preferred shares that are at least roughly similar. For instance, we might sell NLY-F to buy NLY-I, then sell NLY-I to buy AGNCO, then sell AGNCO to buy NLY-F again. Why would we do that? They each have a risk rating of 1, trade at roughly similar prices, and will carry similar spreads when they begin floating. So what are we doing? We’re taking advantage of a change in the relative prices. By the time we’re back to the initial share, we are able to have more of them. If each time we traded between those shares we ended up with a 1% increase in the share count, we could end up with 3% more shares of NLY-F at the end of that trade than at the start. That leads to faster growth in the total portfolio. It appears that we’re selling the preferred shares quite often, but frequently it is just a change between two similar shares. We do this when we’ve found the spread in prices is large enough to let us exit one position and enter the next.

This may be different from the methods you’ve seen employed by other analysts. You may have joined us because you became tired of mediocre results. Our better results have been a function of our unique strategy.

Disclosure: I am long all shares shown in the images. I purchased additional shares of ARE and CIM-D after the end of September that are not included in the images.

Like our Portfolio Update? Share it with a friend.