ARMOUR Residential REIT Series C: Buy While We Wait On Interest Rates (NYSE:ARR.PR.C)

DNY59 June 7th’s surprisingly strong jobs report was the latest data point to dampen hopes for any near-term reduction in interest rates. Wednesday’s Bureau of Labor Statistics’ May CPI report showed moderating inflation, but the Federal Reserve’s two-day policy meeting comments postponed any rate cuts. Meanwhile, all varieties of income-oriented investors continued what has become a marathon task to strategize on how best to capitalize on the prospect of an imminent/ultimate decline in rates. An often-espoused strategy focuses on investment in net lease real estate; Realty Income (O), for example, might be benefited by a decline in rates. Recent history supports this thinking, but we believe current macroeconomic/market factors might prevent a repeat of the results. Things are different today, and we see other, differentiated avenues to high dividend income that carry the potential for capital appreciation due to a decline in interest rates. Specifically, we are talking about discounted REIT preferreds and, as today’s example, we will present ARMOUR Residential Preferred Series C (NYSE:ARR.PR.C). Know Your History Sometime in 1982, there began what would become a 40-year bull market in bonds and interest rate sensitive investments. Through the 1987 stock market crash to the S&L collapse to the dot-com bubble bursting to 9/11 to the 2008 financial crisis to the Great Recession to the 2020 arrival of the COVID pandemic, Treasury yields meandered, but inexorably declined from the mid-teens to near zero. For the nearly 15 years since the sub-prime mortgage collapse, the Fed employed various tools of what was commonly referred to as quantitative easing, and the result was a protracted period of unprecedentedly low interest rates. One of the investor responses to the situation was “There Is No Alternative” or TINA. In the absence of yield in bond or money markets, prices of other yield producing assets were bid up dramatically. Real Estate Investment Trusts (REITs) are just one example. If we look back to July of 2009, when confidence that we would survive the great financial crisis was just beginning to build, REITs had already begun to recover some market price strength from the beating they took after the failure of Lehman Brothers in September of 2008. Realty Income, a widely held triple net REIT, looked strong, trading at 12.0x forward earnings and paying a 7.77% dividend yield against its ~$22.00 share price. This price represented a slight premium to Net Lease REIT peers. 2MCAC with data gathered from S&P Capital IQ At the same time, the Fed had cut interest rates dramatically, so O’s 7.77% yield was compelling against the 3.67% an investor could get on a 10Y Treasury. S&P Global IQ Source: S&P Global IQ Fast forwarding to February of 2020 and the protracted, ubiquitous presence of TINA, we can see the financial markets have significantly changed. Realty Income was now trading at more than 25x forward earnings and paying a 3.38% dividend yield against its $82.44 share price. S&P Capital IQ Source: S&P Capital IQ O’s 3.38% yield is still superior to that of the 1.46% 10Y Treasury, but the yield curve has essentially flattened, and you can earn 1.43% on a 1Y Note. The yield curve had not only flattened, but it had also begun an inversion, and the longer dated 5Y Note was yielding only 1.30%. While we didn’t make note at the time, this pricing dynamic was in defiance of the norms that usually govern yield/fixed income investment. As a demonstration, we can look at the pricing of this article’s suggested alternative investment, ARMOUR Residential REIT Series C Preferred. Yahoo Finance Source: Yahoo Finance On February 19, 2020, ARR.PR.C traded about 94,000 shares at prices between $25.15 and $25.18. Though this is an equity security, it carries the conventions of a bond in that if/when it is called or redeemed, it will pay $25.00/share. Though its 7.0% dividend coupon would be highly competitive in the yield environment described above, that redemption provision produces an upper pricing limit around its $25.00 par value. Within just a few weeks, COVID’s impact was in full force, compromising liquidity in all financial markets, particularly in real estate securities, and most severely in the market for the already low-liquidity real estate preferred equities. ARR.PR.C had no ready, natural buyer’s market, so it traded into a void and share prices dropped to the single digits. Seeking Alpha charting Source: Seeking Alpha charting ARR.PR.C recovered from the March 2020 selling panic and has since tracked well with its bond market equivalents (like the iShares 7-10 Year Treasury Bond ETF (IEF)). In the trading history 1 year hence, however, something has changed in the market. Wave after wave of COVID inspired government stimulus and new zero % interest rates, have driven 10Y Treasury yields to 1.11%, 1Y T-Notes to 0.10% and TINA is going strong. S&P Capital IQ Source: S&P Capital IQ In early 2021, ARR.PR.C was again trading in the range of par. Yahoo Finance But REITs and Realty Income have not fully recovered. In the government mandated shutdowns, many landlords struggled to collect rents and some sectors, like hotels, were severely cash flow restricted. Realty Income was trading at 17.8x forward earnings and paying a 4.76% dividend yield against a $59 share price. The Advent of Inflation Many observers lay blame for the post-pandemic wave of inflation on the trillions spent in government stimulus. While real estate is often cited as a natural hedge against inflation, low interest rates have served as an engine driving real estate values/transactions for the last 15 years. The Fed’s use of rising interest rates as a cudgel to fight inflation has stalled real estate and even made it sputter. The June 12th Fed meeting left interest rates unchanged so the wait for the lower rates stimulus will continue. Based on current market pricing and the profile of the interest rate curve, we believe that if and when rates are reduced, they may not produce the significantly higher REIT share prices that are hoped for. REITs will need to have fundamental strength rather than simply riding the interest rate wave. By Friday, June 7th, Realty Income was trading at 12.6x forward earnings and paying a 5.91% dividend yield against a $53.32 share price. That is a 50% FFO multiple reduction from the heady pre-COVID TINA era. In contrast, 10Y T-Notes were yielding 4.43% and 1Y T-Bills were yielding 5.17%. The yield curve is still inverted, but relatively less so. S&P Capital IQ Source: S&P Global Capital IQ In hopeful theory, if the Fed ultimately does lower rates, it could lubricate the real estate transactions machine. Funds might be more available to refinance maturing loans and more affordably capitalize property purchases and sales. This new liquidity might disperse the clouds that have hung over commercial real estate these last few years. Maybe REIT share prices can rise again. But it’s different this time. TINA is dead. Jerome Powell killed TINA. Alternatives abound. An important consideration is that the Fed controls interest rates at the short end. While the 5.33% Fed Funds rate listed above will be reduced when the Fed starts cutting and the 1Y and 2Y Notes may follow suit, there is no assurance that the yield curve will not un-invert with the 5Y and 10Y Note yields staying stubbornly high. If that is the case, O’s 5.91% yield might not provide a sufficient risk premium over longer term, riskless, treasuries. An Alternative for Capture of Lower Rate Induced Gains Though they are equities, in the markets preferred stocks behave a lot like bonds. When interest rates rise, preferred stock share prices are likely to fall. When interest rates fall, preferred stock share prices may rise, but call/redemption provisions typically put an upper limit near par value on market price. ARMOUR Residential REIT 7% Series C Cumulative Redeemable Preferred Stock has a $25.00 par value. It pays a $1.75/share annual dividend (7% against par) in monthly installments (like Realty Income). It is an $86,000,000 issue that sits just senior to ARMOUR Residential’s common equity. ARR.PR.C is callable on or after 01/28/2025. Portfolio Income Solutions Since preferred stocks demonstrate bond trading behavior, significantly lower interest rates may make it trade up to that $ 25.00 par limit, as it has in the past. If that were to happen, shares may appreciate more than 20% from their June 7 closing price of $20.78. Yahoo Finance Source: Yahoo Finance If interest rates don’t decline significantly, it might make sense to run an apples-to-apples comparison to alternative investments, such as Realty Income common stock. Dividend Aristocrat vs. Discounted, Fixed-Coupon Preferred Realty Income’s long history of dividend growth has earned it legions of followers. In recent investor presentations, O management describes that since its IPO, Realty Income has grown its dividend at a CAGR of 4.3%. We think this higher interest rate environment might make that rate of dividend growth more difficult to achieve, but for this comparison we will give them the benefit of the doubt. ARR.PR.C has a fixed 7.0% coupon, so, if it remains outstanding, it will be paying the same dividend 10 years from now as it does today. So, while we wait for interest rates to drop, which of these investments might deliver a better return? Below is a compressed spreadsheet that compares the cumulative income streams produced by $10,000 investments in O, ARR-C, and 10Y Treasury Notes. The yields were determined by Friday, June 7th’s closing prices. The comparison ends when O’s dividend equals that of ARR-C. 2MCAC Source: 2MCAC Assuming that O continues to grow its dividend at a 4.3% CAGR, in July of 2032, 8 years and 1 month into the process, Realty Income’s monthly payment will equal that of ARR-C’s. Beyond that, O would begin to pull away. In the interim, ARR-C will have paid almost $1,110 more in dividends (18.78% more) than O. We included the 10Y Treasury as the riskless alternative. If interest rates do decline, it is possible that O shares will trade at sharply higher prices, like they did in the TINA era. Lower interest rates might make ARR-C trade higher, but likely only up to its $25 par limit. Today, unlike the TINA era, there are thousands of liquid high-yield alternatives. ARR-C is not the same as O, but it is one of dozens of steeply discounted preferreds that offer potential capital appreciation. To realize that appreciation, ARR-C only has to trade towards par. O doesn’t have a par value, but instead must rely on FFO multiple expansion to deliver gains. Investors are not presently enamored of commercial real estate, and we may never see TINA era multiples again. In Conclusion In 2008 and again in March of 2020, the world faced dire existential macroeconomic threats; drastic measures in the form of slashing interest rates to zero (and less than zero in Europe and Japan) were necessary. Today, as the Fed tries to wind up its inflation fighting campaign, we have a robust economy and employment market that make cutting rates an intricate, careful operation. This time, we won’t see the dramatic decline in rates that brought about the extreme overvaluations of the TINA era. Value and entry prices remain important. If interest rates decline, REIT’s will find their fair values (not overvalues) and discounted preferreds may trade up to par, but no higher.