PFFR: REIT Preferred Shares ETF, strong dividend yield of 6.3% (NYSEARCA: PFFR)

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Author’s note: This article was released to members of the CEF/ETF Income Laboratory on January 25, 2022.

The InfraCap REIT Preferred ETF (PFFR) is exactly what it says on the tin: a REIT preferred stock index ETF. PFFR offers investors a strong, fully hedged dividend yield of 6.3%, moderately higher than most preferred stock ETFs. PFFR’s holdings are also more concentrated, less diversified than average, which increases risk and volatility. PFFR’s strong, stable and fully hedged 6.3% dividend yield makes the fund a buy, but the fund’s niche holdings mean position sizes need to be kept at relatively low levels.

Basic Principles of RSTP

  • Investment Manager: Infrastructure Capital Advisors
  • Underlying index: Indxx REIT Preferred Stock Index,
  • Dividend yield: 6.26%
  • Expense ratio: 0.45%
  • CAGR of total returns (creation): 5.08%

Presentation of PFFR

PFFR is a REIT preferred stock index ETF. Preferred stocks are mostly similar to high-yield corporate bonds, offering investors strong but risky returns but little opportunity for substantial capital gains. Preferred shares are suitable investments for most income investors and retirees, although the risks may be unacceptable for more conservative, risk-averse investors.

PFFR itself tracks the Indxx REIT Preferred Stock Index, an index of these same securities. It is a relatively simple index, investing in all preferred stocks of US REITs that meet a basic set of criteria of size, volatility, etc. The index only includes securities with a yield greater than 3.0%. It is a market capitalization weighted index, with certain rules to ensure a minimum of diversification, which is particularly important given the index’s niche holdings. PFFR’s underlying index looks good enough, with no issues or significant negatives.

PFFR’s preferred REIT holdings are a niche within a niche. Preferred shares are a relatively small asset class, and REIT preferred shares are a small sub-segment. The result is a relatively concentrated and undiversified fund. PFFR invests in just 45 stocks, with the top ten representing 43% of its total value.

PFFR Holdings

PFFR corporate website

PFFR has some diversification within the REIT industry itself, although I don’t find that very important: the concentration is still high.

PFFR Industry Exhibitions

PFFR corporate website

By comparison, the industry benchmark iShares Preferred and Income Securities ETF (PFF) invests in 501 different stocks, with the fund’s top ten holdings accounting for just 15% of its value. PFF is the most diversified and secure fund. PFFR’s concentrated and undiversified holdings increase portfolio risk and volatility and expose fund investors to idiosyncratic risk. Expect significant losses and underperformance if the fund’s larger holdings, including Vornado Realty Trust (VNO) and Diversified Healthcare Trust (DHC), underperform. For example, these two holdings significantly underperformed in the first quarter of 2020, at the start of the coronavirus pandemic.

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Data by YCharts

PFFR also underperformed, as expected.

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Data by YCharts

Importantly, and notwithstanding the foregoing, excessive concentration does not not necessarily lead to higher losses during downturns. If, for whatever reason, PFFR’s largest holdings outperform during downturns, the fund should also outperform. For example, VNO and DHC have both outperformed since the beginning of the year.

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Data by YCharts

PFFR also outperformed, as expected.

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Data by YCharts

PFFR’s excessive concentration means that the fund’s share price and dividends are highly dependent on the performance of its larger holdings. As mentioned earlier, this increases volatility and risk, but does not necessarily lead to underperformance during downturns. Still, I believe the situation calls for limited position sizes in PFFR, to avoid the possibility of significant underperformance due to idiosyncratic factors. I wouldn’t go above 5%.

PFFR Dividend Analysis

PFFR’s basic investment thesis is based on the fund’s 6.3% dividend yield. This is a reasonably high return on an absolute basis, and somewhat higher than that of most relevant asset classes, including the broader preferred stock universe.

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Data by YCharts

PFFR’s dividend is also fully covered by the underlying revenue generation, although the situation looks a bit complicated. By my calculations, the fund’s underlying holdings generate around 6.3% of income per year, which effectively equals the fund’s dividend yield, indicating fully covered dividends. At the same time, the fund currently has an SEC yield of 6.3%, a short-term normalized measure of a fund’s underlying income generation. On the other hand, the fund’s latest tax documents indicate a return on distributed capital estimated at 37.5%. From what I’ve seen, it appears the discrepancy is due to differences between accounting standards and federal income tax regulations. Certain industries, including REITs and MLPs, enjoy favorable tax treatment, of which these return of capital distributions are an example. It looks like PFFR shareholders are getting the best of both worlds: a fully covered dividend and the favorable tax treatment of return of capital distributions. This is a solid combination, and a benefit for the fund and its shareholders. Keep in mind that the return on capital amount is an estimate and is subject to change.

Finally, PFFR’s dividend growth track record is also reasonably good. The fund has mostly paid the same annual dividend of $1.44 since inception, although there has been some volatility, mostly in 2019 when the fund moved from quarterly to monthly dividends. There were no real dividend cuts or hikes, aside from the aforementioned volatility.

PFFR dividend grade

Looking for Alpha

PFFR’s stable dividend is also indicative of reasonably good quality holdings. If the fund’s holdings were excessively risky, the fund’s dividend would not have fared very well in 2020, as the coronavirus pandemic has led to an increase in corporate bankruptcies and defaults. No dividend cut means no default, which was obviously good news for the fund and its shareholders.

PFFR’s strong, stable and fully covered dividend yield of 6.3% is a significant benefit to the fund and its shareholders, and its fundamental investment thesis. This is an income vehicle, which you buy for performance.

PFFR – Performance Analysis

Finally, a small point on the performance of PFFR.

PFFR has slightly underperformed its benchmark since its inception, exclusively due to small capital losses for the same.

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Data by YCharts

From what I’ve seen, PFFR’s small capital losses were due to widening credit spreads in the fund’s holdings relative to those of its benchmark. This widening of credit spreads was, in turn, caused by the financial weakness of the parent company. For example, VNO and DHC, the issues of the fund’s two largest holdings, have experienced significant price losses in recent years. Preferred shares are higher in the capital stack, and therefore see inferior capital losses than shareholders, but lower does not mean zero: they still fall, due to fears of bankruptcy or default, and this negatively impacts investors, including PFFR.

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Data by YCharts

Although PFFR’s past underperformance has been negative for the fund’s former shareholders, it presents an opportunity for future investors. Lower stock prices mean higher dividend yields, with the PFFR yielding around 1.6% more than its benchmark so far. The difference has rarely been higher.

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Data by YCharts

At the same time, PFFR’s long-term underperformance is reversing, with the fund moderately outperforming its benchmark year-to-date as investors turn to battered value stocks and more.

Conclusion – Buy

PFFR’s strong, stable and fully hedged dividend yield of 6.3% makes the fund a buy.

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