The purpose of this article is twofold: (1) share a summary of an educational piece I wrote for Institutional Income Plus subscribers on the key aspects of evaluating preferred shares and (2) demonstrate the process on an actual issuance that I own and currently recommend. While detailed, this overview will not and cannot encompass every possible situation as preferreds can be underwritten with an effectively unlimited range of characteristics. I will be following up shortly with two additional preferred share recommendations. Remember: understanding what makes a stock/opportunity attractive is more valuable than a single recommendation. Today, you receive both! Thank you for reading.
Jernigan Capital (JCAP) is a commercial mortgage REIT combined with a self-storage REIT. The firm provides debt and equity to the developers of self-storage facilities. Management would prefer JCAP be considered an equity REIT. My sneaking suspicion, however, is management really prefers the equity multiple of an equity REIT. These are two businesses within the real estate sector that have experienced strong momentum in recent years. Self-storage has been the top performing sector in total return since 1994. Those in its peer group include the likes of Blackstone Mortgage Trust Inc. (BXMT), Colony Credit Real Estate Inc. (CLNC), Ladder Capital Corp. (LDR), Granite Point Mortgage Trust (GPMT), and Starwood (STWD) on the commercial mortgage REIT side and Global Self Storage (SELF), National Storage Affiliates (NSA), CubeSmart (CUBE), Life Storage, Inc. (LSI), Extra Space Storage, Inc. (EXR), Public Storage (PSA), and Storage Capital Corp. (STOR) in the self-storage business. Blackstone Mortgage Trust Inc., in which I am long-term investor, and Ladder Capital Corp are my suggestions to take a closer look at among its mortgage peers.
Preferred Equity Due Diligence
We don’t need to dig quite as deep into the underlying company when we are interested in the preferred rather than common equity, but we still need to perform thorough due diligence. Why is this?
As preferred investors, we generally don’t participate in the company’s growth, and JCAP’s common distribution growth rate has been fairly paltry. Most material aspects of the preferred share are defined within its prospectus. How high can the preferred stock trade? Par value as stated in the prospectus plus a small discount/premium depending on interest rates and the coupon rate. What’s the distribution rate on the preferred? Also, defined in the prospectus. It is possible that an issuance pays a variable rate based on LIBOR, usually many years after its IPO, but most are fixed rate. This, of course, is also laid out in the offering documents. The real questions once we obtain a strong grasp of the preferred’s legal characteristics are:
- Is the company able to fund its preferred distributions from cash flow and with what degree of error?
- Is the underlying business durable enough to fund the preferred distributions over our investment time horizon?
- Is there potential for our position in the capital stock to be undermined or shifted to a less secure position? These are most relevant (1) during M&A such as when the company is purchased or undergoes a merger and (2) when it faces financial distress and has to restructure or raise additional capital outside its normal mechanisms.
These, particularly the last item, require more expertise and time to evaluate.
Let’s briefly go through this exercise on Jernigan Capital’s share class B (JCAP.PB). I like this particular preferred share for several reasons. To start, it pays a fixed amount of $1.75 per share or 7.00% on its par value and call price of $25.0. The $1.75 per share is higher than its closest peer group on a risk-adjusted basis and it pays the distribution on a cumulatively meaning any deferred distributions accrue and must be paid in full prior to JCAP’s common stock receiving a distribution. JCAP is a mortgage REIT paying a fully covered 6.6% yield. We need to look at the situation from JCAP management’s point of view to determine the risk to the common, and subsequently preferreds, distribution.
People don’t buy mortgage REITs for fun – they do so for the distribution. If JCAP doesn’t pay preferred shareholders, they cannot pay one penny to common shareholders. That may be an option for growth stocks during difficult times, but not for an income stock like JCAP. It cannot survive without making distribution payments to its common shareholders. It depends on its at-the-money (“ATM”) share issuance capabilities and other levers tied to the health of the common stock. Another key positive attribute of JCAP’s common equity dividend may be counter-intuitive: it’s among the lowest of its commercial mortgage REIT peers (e.g. BXMT’s 7.5%, GPMT’s 8.8%, and STWD’s 9.25% yield). Yes, JCAP yields far less than industry giants Blackstone and Starwood. JCAP management’s insistence it is more like an equity than debt REIT is a contributor to this phenomenon. It’s critical to compare factors such as yield, offering document legal parameters, and the underlying company strength.
Fortunately, for both the common and preferred equity holders, JCAP’s common distribution has been only 50-55% of its earnings per share (“EPS”) in recent quarters. The FFO payout ratio is similarly favorable. This is superior to all the peers I mentioned at the start of the article – without exception. JCAP has covered its common equity distributions with GAAP earnings since 2016; this is better than it sounds, given JCAP only went public in 2015. JCAP’s overall leverage is also very low, and it prefers to use its aforementioned AT program for incremental capital needs.
We know the market respects the durability of JCAP’s common distribution due to its low relative yield. We respect it because the EPS payout ratio is very conservative at 50-55%, and the firm’s aggregate leverage is well below the peer average. A fortified common distribution means an even stronger preferred distribution.
Occupancy at the firm’s properties is strong and exceeding initial projections as of the end of Q3. JCAP’s position as non-recourse to the property developer means less risk to the firm and less risk to us. As the potential owners of the hybrid debt and equity security preferred share, we are as concerned with tail risk (unexpected major financial distress due to a low probability but nonetheless severe problem) just as much as whether a good payout ratio is maintained. With limited upside, preferred shareholders, like those higher in the capital stack that own bonds or loans, cannot afford to lose because our “big” winners are capped at 8-10% annualized.
The portfolio’s resiliency is derived from its geographic diversity, asset quality, and concentration in top MSAs. The unique 49.9% equity ownership JCAP maintains in every transaction provides it higher growth potential long term. As of December 31, 2018, the firm had no outstanding balance on its credit facility and a capacity of $235 million with a syndicate from KeyBank, Raymond James, and BMO Harris Bank N.A. The firm also has additional means of obtaining more acquisitions, which in aggregate, are more than sufficient to maintain its business model.
JCAP.PB ranks junior to the company’s debt, which includes credit facilities/revolvers, equally with other preferreds, and senior to common shares. The firm also has $122.14 million or 125,000 shares of Series A preferred stock outstanding as of the end of last quarter. The Series A preferred stock has certain corporate governance rights and covenant protection that could disadvantage the Series B. The Series A issuance has a mandatory redemption clause the Series B do not. In certain circumstances surrounding a merger, business combination, or other transaction, it’s possible the mandatory redemption of the Series A shares could damage the outcome for Series B investors. The primary risks are only when the firm is in financial distress. This is when certain provisions of the Series A preferreds could be the detriment of Series B. I consider JCAP sufficiently financially stable that these parameters, albeit important, are not currently material.
Most preferred investors do not take the time to evaluate other parts of the capital structure that may impact them. That is a mistake. It is also why investors need to monitor the companies behind their preferred shares carefully even if their particular issue continues to trade new par (or hire someone like us to do it).
Lastly, call risk and liquidation preference are important to consider. Because we’ve chosen to evaluate an issuance that trades below par value ($22-24 vs $25), call risk is immaterial. If we were investing in an issuance trading well above par, we’d need to take into account the (1) principal at risk if the issuance was called and (2) the timeline and legal parameters around how the issue could be called. The probability of fixed rate preferred shares being voluntarily called by a company in a rising rates environment is almost zero. If the stock were to rise above $25 per share due to interest rates decreasing between now and 1/26/2013 (or JCAP de-risking to the point of being upgraded several times by the credit agencies), which is this preferred’s call date, we’ll need to reconsider our outlook. Due to the sharp decrease in rates and the cost of credit more broadly following the Great Recession, almost all the once juicy bank preferred shares from companies like Bank of America (BAC), JPMorgan (JPM), and Wells Fargo (WFC), as well as those from non-financial companies like Ford (F), were called and no longer exist.
Recommendation Summary and Suggestions
- If possible, purchase in a retirement account as REIT preferreds do not qualify for the 15% highly favorable taxable treatment.
- Be patient and wait for a favorable entry point. This issuance recently traded near $22.
- ALWAYS USE LIMIT ORDERS when buying illiquid securities such as preferred stocks.
- Ideally, target a yield on cash of approximately 8% for JCAP.PB.
- Stay posted for two additional preferred share analyses; one from a real estate finance company and the other yielding 10% yet supported by one fastest growing, lowest levered mid-cap energy companies.
Thank you for reading. Please let us know if you have any ideas you’d like us to explore.
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Disclosure: I am/we are long BXMT, JCAP.PB, F. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.