Co-produced with Beyond Saving
At High Dividend Opportunities, we have been beating the preferred equity drum. In our opinion, preferred equity is an underrated portion of the capital structure, especially when it comes to investment structures like REITs, which are required by law to distribute a significant portion of their taxable income.
Our primary goal is to have a portfolio that provides a high level of recurring income. We all know that some super high yielders could be volatile, and that dividend cuts can sometimes be unpredictable. Certainly, COVID-19 has shown how quickly once “safe” dividends were reduced by some companies to preserve cash and strengthen their balance sheet.
Prior to COVID-19, we were recommending to our investors to have 40% or more of their portfolio invested in fixed-income investments, like preferred equity. Currently, we have 54 preferred stock recommendations. This helps provide our portfolio with a solid bedrock of dividends, even during difficult economic times.
While prices of preferred shares were not immune to the wrath of the market in March, the dividend payments have proven to be very stable. We did experience a few dividend suspensions, Two Harbors (TWO) and Invesco Mortgage Capital (IVR) are examples of companies that suspended their preferred dividends in March.
We recommended to keep holding the TWO preferred stocks before and through the suspension and the dividend was resumed in a matter of weeks. The IVR preferred was a newer recommendation to our members at the height of the panic. Buying shares of Invesco Mortgage Capital, 7.50% Fixed/Float Series C Redeemable Cumulative Perpetual Pfrd (IVR.PC) for under $5 we were able to lock in a yield of more than 37% and are currently sitting on unrealized capital gains of more than 300%.
The best part is, that while both companies had suspended their dividends, it turned out to be a mild inconvenience delaying the payments a month. Inconvenient, sure. A little scary, maybe. However, it illustrates the power of being in preferred shares over the common equity. It also is a good reminder not to panic when the market loses its mind and sells off to ridiculously low prices. 37% yield might be too good to be true, it also might be an indicator that the market is overreacting.
The strength of preferred shares is that the common equity cannot receive a dividend until the preferred are paid in full. Additionally, preferred dividends are often cumulative, meaning that if the company misses a payment, they have to pay it in the future.
Today, we take a look at preferred shares which are in a very strong long-term business that has been particularly hard hit by COVID-19. It’s also a perfect illustration of the benefit of preferred shares over common equity, as the common dividend has been cut, but the preferred shares continue to be paid, and are collecting a yield over 8% at current prices (June 8).
Cedar Realty Trust
Cedar Realty Trust (CDR) is a REIT that specializes in grocery-anchored shopping centers. The model of these types of centers is quite straight forward. Find a quality anchor that gets a lot of traffic like a grocery store, or maybe a home improvement store like Lowe’s (LOW) or Home Depot (HD) and then use that big name to attract smaller “in-line” tenants.
If you are opening up a restaurant, barber shop, or specialty retail store, you will be willing to pay a premium to be conveniently located next to the big name that draws a lot of traffic.
Think about your local area. You can probably identify the really successful centers near you that are “always busy.” It will have an anchor that does very high sales, and the inline space is likely always busy. You are likely aware of a few centers where the anchor left and it’s a big empty box that has been sitting there for years and you might see a few of the spaces, but the parking lot is in disrepair and there is no significant traffic.
To have a successful center, you need to:
- Sign and keep attractive anchors – consumer perception of the center will be almost entirely tied to the anchor(s).
- Keep the common areas and parking lot well maintained – people love going four wheeling, but not when they are trying to go to the grocery store. Replace the signage and provide a facelift to the exterior from time to time.
- Stay on top of leasing – success begets more success in this business, and failure begets more failure. The anchors have brands too, and they do not want a reputation for being in “dumps.”
CDR has spent the better part of the last decade upgrading the average quality of their properties. Selling off properties in lower traffic, lower population areas and acquiring properties in higher-traffic, higher-population areas. The result is a leaner, much higher quality, and higher rent, portfolio.
Source: CDR Presentation
At 93.8% occupancy, they are well above average and their tenants include a whole host of well-regarded national brands.
Source: CDR Supplement
The last time we wrote about CDR, we discussed their redevelopment efforts. CDR had a very strong Q1 with FFO/share of $0.18, up 64% year over year. CDR’s numbers were up across the board with revenue up 15%, EBITDA up 30%, and interest expense down 6%.
The quarter beat expectations and put CDR easily on track to hit, or exceed, their guidance. However, as we have discussed with other investments, Q1’s stellar results don’t matter because of COVID-19.
The celebration over CDR’s strong quarter was short lived. CDR cut their common dividend from $0.05/quarter to $0.01/quarter. They drew down on their line of credit to carry more cash on their balance sheet, withdrew guidance for 2020, and cut capex.
This is not dissimilar to what we have seen with numerous REITs. The core problem is that a lot of tenants were unable or unwilling to pay rent in April. While all of CDR’s centers have remained open, thanks to many of their tenants being considered “essential,” CDR collected approximately 70% of rent in April. They will likely collect a similar amount in May.
This is a challenge that many REITs are facing. While CDR’s anchors have mostly remained open, except for the fitness centers, their inline tenants often fall into categories that have been very hard hit, frequently more local or independent businesses that do not have the resources to absorb being closed for so long.
CDR has been in contact with their tenants, providing deferral with payback by the end of 2021. Still, it is very likely that some smaller salons, barbershops, and other independent stores might not have the financial resources to ever reopen. As of today, the total impact on CDR is unknown.
What 70% Looks Like
Perhaps one of the larger testaments to the durability of REITs is that only collecting 70% of rent is not the end of the world. Here’s a look at CDR’s cash flow assuming 70% rent collection off of Q1 numbers and assuming zero reduction in any expenses:
Even with CDR at 70% of rent, they are covering the immediate expenses with $6.4 million/quarter to spare. We do have to consider capex, which amounts to approximately $2 million/quarter in TI costs, which they are contractually committed to, approximately $2 million/quarter in maintenance capex which can be deferred for a little bit but not indefinitely and their preferred dividend is approximately $2.7 million/quarter.
So at 70%, CDR is really tight, but they are covering the bills, and with some expense cuts, they are even able to cover the preferred dividend. This is the reason why we are so comfortable with a preferred position. 70% rent collection is enough to cover the necessary bills and avoid a solvency crisis. As the year goes on, we expect rent collections to improve.
The Path Forward
Across the country, states have been lifting restrictions and businesses are reopening. Part of the downside of focusing on higher population areas is that CDR also is exposed to some of the areas that were hardest hit by the epidemic.
Pennsylvania, CDR’s highest concentration, is using color-coded phases. All of the counties in the “red” phase, which is the most strict, were expected to transition to yellow on June 5.
As businesses reopen, they will be able to more easily pay the rent they owe CDR. It’s reasonable to expect that the 70% rent collection is likely to span most, if not all of Q2. However, from July on, we would expect rent collection to be better.
The unknown is how many businesses will fail to reopen at all. That number will not be zero. However, the key to this sector is the anchors, and most of CDR’s anchors never closed and never stopped paying rent. We expect that within 3-4 quarters, CDR will be able to backfill any inline space that ends up remaining vacant.
Among their anchor tenants, the fitness anchors are at the highest risk. 24-Hour Fitness is expected to file for bankruptcy soon. They only account for one CDR location. Their other fitness tenants, Planet Fitness (PLNT) and LA Fitness, are much larger and might actually benefit from their competitors going out of business.
This will prove to be an interruption of CDR’s cash flows, not a permanent impairment. As businesses reopen, CDR will resume collecting full rent and those who can’t pay will close down and be replaced.
We always have favored the preferred shares for CDR. As illustrated above, even at 70% rent collection, CDR is capable of covering the preferred dividend. As stores reopen, any improvement in rent collection will make the preferred shares more secure.
In addition to being covered by cash flow, the preferred shares are well covered by assets, with asset coverage at 3.2x. The preferred shares currently offer significant upside to par value, a higher yield than the common shares and in the unlikely event of a liquidation, we believe the value of the assets easily covers them.
CDR has two preferred share issues with current yields over 8%:
Cedar Realty Trust, 7.25% Series B Cumulative Redeemable Preferred Stock (CDR.PB)
Cedar Realty Trust, 6.50% Series C Cumulative Redeemable Preferred Stock (CDR.PC)
Looking at the current prices, there’s no question as to which one is the better deal right now.
CDR-C has a more distant call date and more upside to par value. Investors can collect a generous yield of over 8% with the likelihood of achieving over 30% in capital gains when prices normalize. (price and yield as of June 8).
Preferred shares can frequently produce a superior and lower-risk opportunity to take advantage of market panic. Since dividends are cumulative, there’s much less reason for companies to suspend them unless absolutely necessary, and there’s an incentive to resume them sooner rather than later if possible to prevent the obligation from growing.
We have been recommending to our investors to take advantage of special situations in the preferred stock space, where the selloff has created a unique buying opportunity. The CDR preferred shares are one of these special situations, and are trading at extraordinarily low prices. On several of our picks, we already are sitting on large capital gains that our investors can realize at their leisure.
CDR is a quality company with quality properties that are capable of taking care of their necessities, even collecting only 70% of rent. As the country reopens, CDR is going to be able to collect a higher percentage. CDR’s grocery stores, dollar store and home improvement store tenants are rock solid, with strong performance even when everything else is shut down. Some inline tenants will close permanently, but the dynamics of the property type means that new tenants will be interested in filling spaces that are close to these strong anchors.
It’s probably going to take time to get back to pre COVID-19 levels, but we can have confidence that the preferred dividend will be covered and that cushion is going to increase with time. Eventually, the market will realize that and the share price will climb back towards the $25 par value.
Right now, for income investors, you can add with confidence, enjoy the high yielding dividend, and wait for the capital gains to materialize. The CDR preferred could be the big winners in your high yield portfolio!
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Disclosure: I am/we are long CDR.PC. 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.