Co-produced with R. Paul Drake
Many individuals begin to focus on investing when they are at or near retirement. There are many reasons why, and in the aggregate these folks are a large population on Seeking Alpha.
A lot of them need income now. They don't have time to wait for the SWANs loved by some authors to grow income over decades and through market cycles. Companies like Reality Income (O), Store Capital (STOR), and CyrusOne (CONE) are great choices, if you have the time.
If you can afford to meet all your income needs by spending only dividends from such very safe and diversified investments, congratulations! This article is aimed at the rest of us.
Other authors promote systems that pay out in excess of 10% per year. It is tempting to seek whatever yield it takes to live on the dividends (or equivalent), but it can be dangerous too.
Many of the higher yields come from companies vulnerable to downturns in their industry or the economy. In general, high yield investments do not have a great track record.
We believe that classic value investing, in industries such as REITs that must pay out much of their income, is a good approach. It can provide relatively high yields with good safety.
But the markets remain fickle, and the future of the economy cannot be predicted. This leads many retirees, quite sensibly, to adopt some kind of an outramp for funds they need to spend over near-term years.
Using an Outramp
One can park cash in the outramp, earning only enough to match inflation. This, however, implies that the remainder of the portfolio needs to grow at a higher rate.
The classic thing to do with funds in an outramp is to establish a bond ladder using Treasury bonds. Buy bonds a few years out, each year, and spend all the coupons and the maturing bonds.
One can even do this these days using ETFs, to get more diversification and somewhat higher yields from corporate bonds that are held in ladders. An example is the iShares iBonds. Some of their funds hold ladders based on investment grade corporate bonds, such as (IBDM), (IBDP), and (IBDT).
These are great strategies during bond bull markets, when real bond yields are a few percent or more. We show below that they do not work so well during bond bear markets.
An outramp works better when it is augmented with some kind of decision rule about lengthening the ladder. Doing so primarily during good years for the remaining portfolio is wise and represents a form of rebalancing.
Enter REIT preferred stocks
Preferred stocks have a par value (typically $25), which they pay when called. Any dividend on common stocks must be cut to zero before the dividend on a preferred stock can be cut. All the unpaid dividends on a "cumulative" preferred stock must be paid before common-stock dividends can resume. In a bankruptcy, preferred stockholders stand above the common stockholders and below the bondholders. For a next-level overview, see this recent article by the High Dividend Opportunities authors.
Benjamin Graham, the acknowledged father of the value investing approach we follow, hated preferred stocks. He advised against buying them and remarked in The Intelligent Investor, Rev. Ed. that
"The typical preferred shareholder is dependent for his safety on the ability and desire of the company to pay dividends on its common stock. Once the common dividends are omitted, or even in danger, his own position becomes precarious, for the directors are under no obligation to continue paying him unless they also pay on the common.
However, Graham invested in an era with few Regulated Investment Companies, such as REITs. Today many companies not only desire but are legally required to pay dividends on their common stocks. REITs, required by law to distribute 90% of their taxable income, are prominent among these. In most cases, they cannot continue to get the tax advantages of being REITs without treating their preferred stockholders well.
We consider the risks associated with preferred stocks from REITs below. Before that, we attend to what they offer. REIT preferred stocks pay rates well above treasury rates. Figure 1 shows that, since the Great Recession, the average difference is above 400 basis points (4%).
Figure 1. REIT preferred stocks have paid significantly more than treasury bonds. Source.
1950 to 1979 is a good surrogate for the next few decades
Figure 2 shows the history of 10-yr treasury rates and inflation in the US. The period most relevant to the US today is that from 1950 to 1979.
Rates stayed flat and inflation low for a long time, as memories of the Great Depression faded. Rates eventually began to rise, as did inflation, and both increased on average through the 1960s and 1970s.
After 1979 was a major spike in rates, which we ignore below as idiosyncratic. So long as the Fed remains independent, there is a good chance we won't see again the high rates of 1981. However, if congress enables populist presidents to control the Fed, then South American inflation and interest rates could easily follow.
Figure 2. Long-term, 10-year Treasury bond rates and inflation rates (CPI-U). Charts by author from source.
REIT ladders beat the pants off bond ladders
Let's look at ladders of either REITs or bonds, using that period from 1950 to 1979 as an example of an era when bond markets are flat or bearish.
First we look at the behavior of four hypothetical ladders. $1000 is invested each year. We discount the returns for each year by the observed historical price inflation.
Two ladders are of treasury bonds, one 3-year and one 5-year. In each year, the investor receives all coupons plus the principal on the maturing bond. We used the 10-yr treasury rate, which usually will over-estimate the returns of such ladders.
The other two ladders are ladders of REIT preferred stocks. One ladder has a yield spread of 4% above the 10-yr rate and the other has a spread of 6%. In each year, the investor receives all dividends, in addition to the sales price of the stocks reaching their 3-year call date.
Since interest rates are climbing, we treat each REIT security as perpetual. We sell it at the corresponding price after three years. This is a pessimistic assumption. The actual performance will be better.
For all the securities, the total income each year is used to evaluate a real, "effective" Cumulative Annual Growth Rate ("CAGR") based on the length of the ladder. This calculation is attributes all the income in the present year to the security that matures or is sold in that year.
Figure 3 shows the results. Ladders of REITs paying 4% to 6% more than Treasuries beat the pants off ladders of Treasury bonds throughout this reference period. Their average effective, real CAGRs are 2.9% and 4.9%, respectively, vs < 1% for the bond ladders.
The reader may have noted that any preferred stock or bond paying these yields could be placed in such a ladder. The reason we prefer REITs for this purpose is security, discussed next.
Figure 3. Because of their higher yields, REIT ladders strongly outperform bond ladders in periods of rising interest rates.
REIT preferreds are safer than high yield bonds
Historically, general preferred-stock dividends were most at risk during severe recessions and depressions. Yet REITs (equity REITs, the only type we consider here), which in most cases today have long lease durations, long-term debt, and low leverage, have proven to be recession resistant, especially with regard to their preferred stock dividends. They have rarely suspended dividends even on their common stock.
Holders of preferred stock are also more at risk in bankruptcy, since they get nothing until the bondholders are made whole. What matters here is that publicly traded REITs have also been spectacularly resistant to bankruptcy.
To our knowledge, only one bankruptcy of a publicly traded, equity REIT was connected to the Great Recession. It was that of General Growth Properties. One other such REIT (NYRT) liquidated in recent years.
It is possible that some earlier (equity) REITs liquidated or went bankrupt. We would appreciate hearing about them in the comments. It remains clear that the absolute numbers are small. We believe that 10 is a good upper limit.
There have been around 160 operating, publicly traded REITs since 1993, soon after Taubman (TCO) invented the current corporate structure. So we are near 3,900 REIT-years.
The number of bankruptcies or liquidations is apparently less than 10 total. The implied bankruptcy rate is thus below 0.25%. Figure 4 compares this with default rates for corporate bonds from Moody's.
Figure 4. Default rates for corporate bonds and an upper limit for REITs, whose actual rate may be up to ten times smaller.
Our guess is this: as more decades of operating experience occur and the safety of the REIT form becomes more proven, credit ratings on REITs will gradually drift upward.
Suspension of preferred stock dividends
If you are with us so far, you are probably asking now "but what if they suspend their preferred dividends." This risk exists. Any company can suspend preferred stock dividends without defaulting on their bond payments.
However, suspending dividends on preferred stocks is quite problematic for REITs. To maintain REIT status, they can only do so if they have no taxable income whatsoever.
Having no taxable income is not easy to do if you are collecting a lot of rent checks. This is why CBL is projected to restore their common stock dividend in 2020, and has not cut the preferred stock dividend. They would love to put that money into necessary redevelopment, but they can't.
We recommend using cumulative (and non-convertible) preferred stocks for your ladder. For these, all missed dividends on the preferreds must be repaid before the resumption of common stock dividends.
As a result, the value of such a preferred stock can stay high and even go up when the dividend is suspended. Your goal should be to avoid such cases, and High Yield Landlord can help with this. But if you end up in such a case, it is not the end of the world.
Let's take a look at the six REITs that SP Global identified as having suspended common-stock dividends as of February 1, plus (CBL). Table 1 shows these.
Table 1. REITs with recent dividend suspensions
Of these seven REITs, four have current preferred stocks. Of these, three are maintaining the dividend. In one case, that of Wheeler REIT (WHLR), the preferred stock dividend is suspended. This is a convertible preferred stock that we would not have recommended for that reason.
Beyond that, nobody with any sense would have recommended that company. As Seeking Alpha author Beyond Saving wrote,
"WHLR is a case study in how not to run a public REIT. It is over-leveraged, owns sub-standard quality and routinely makes very poor decisions."
Another REIT, Supertel Hospitality - now Condor (CDOR) - suspended its preferred stock dividend for several years before eventually restoring it. Seeking Alpha author The Owl made good money on these developments.
The bottom line here is that the suspension of preferred stock dividends is difficult for REITs. More importantly, if you get good advice and avoid landmines then your chances of suffering this fate are quite small and may not cost much. This is much better than the story for high-yield bonds.
Conclusions and Recommendations
If you are not wealthy enough to live on your dividends alone, without taking undue risks, consider using a ladder composed of preferred stocks from REITs. The REIT ladder can provide secure income, and also can help protect the rest of your portfolio from undue drawdowns when it has a bad year or two.
Table 2 shows candidates for such a ladder, paying yields from just under 6% to just over 8%. This is an incomplete list of those paying these yields. You can find others with any stock screener.
We neither recommend nor reject the options shown in Table 2. Consider them a starting point for due diligence.
Table 2. REIT preferred stocks paying roughly from 6% to 8% yield.
In the High Yield Landlord chat, we discuss both our real-money portfolio and many other possible REIT investments. These range from stocks intended as value investments for high total return to preferred stocks suitable for use by retirees for income or outramps.
We recommend that you adopt a mix of income investments, value investments, and SWAN investments. Retirement hopefully lasts a long time. Do also afford some SWANs, or something else solid and reliable for growth over time. As you succeed over time and your portfolio grows, increase their fraction. Doing this, in a couple decades you might then be in a position to live safely on the dividends alone.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
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