Switching to Offense
In our last communication, I profiled a couple of triple net lease REITs, suggesting they would be good defense in an inflationary economy.
On May 4th the Fed raised rates by 50 basis points and effectively promised they would make similar moves in each of its next two meetings. Since bond prices move inversely to interest rates, the announcement caused long dated fixed income securities to continue the decline that began at the start of the year. In the real estate world, markets sold down notes and preferred shares and revealed an opportunity for rising income and potential capital appreciation.
Thus far, we have identified and vetted 20 separate preferred issues that will convert from fixed to floating rate coupons over the next 6 to 30 months. We know their call/conversion dates. We know the rate schedules they will pay when they convert from fixed to floating. They are currently trading at discounts of 7-20% to redemption price so we can calculate our capital appreciation if they are called or the yield escalation if they remain outstanding.
Even though the Fed is directing the level of short-term interest rates, much of the market’s concern focuses on the longer term rates of the 10y Treasury or 30 year mortgages. These preferred issues, however, are typically pegged to 3 Month USD LIBOR. As the table below details, since the beginning of the year, 3 Month LIBOR has moved from 0.21% to 1.44% while the Fed Funds rate has risen 0.75%. The aforementioned 100 basis point hike in the coming months will move LIBOR rates higher. Consensus estimates put the year-end Fed Funds rate at 2.50% versus today’s 0.75% -1.0% target.
With the first issue coming callable on 10/15/22, we can buy those shares for a 7-7.5% going-in yield and a 7.5% gain if they are called. If they are not called the dividend rises with LIBOR.
We will carefully take the offensive and seize opportunity in this time of extended volatility.
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