FOR INVESTMENT PROFESSIONAL USE ONLY 1 Preferred Stocks A Hybrid Investment Creates Opportunities A Continuing Education Course Sponsored by FOR INVESTMENT PROFESSIONAL USE ONLY V-18-60 | CE ID: 249138 FOR INVESTMENT PROFESSIONAL USE ONLY 2 About Preferred Stock § Preferred stocks have been around for a long time. The earliest issue was in 1836 in Maryland and gained greater popularity in the 1990s § A preferred stock is a class of ownership in a corporation that has a higher claim on its assets and earnings than common stock § Dividends must be paid out before dividends to common shareholders § Shares usually do not carry voting rights FOR INVESTMENT PROFESSIONAL USE ONLY 3 Sample Capital Stack FOR INVESTMENT PROFESSIONAL USE ONLY 4 A Hybrid Investment Preferred stock is a hybrid form of financing, combining features of debt (bonds) and common stock § Like Common Stock § they represent a class of ownership in a company § can include the potential to appreciate in price § Generally trade on an exchange (unless non-traded) § Do not have voting rights § Like Bonds § Companies must pay on a regular basis a set amount of interest § Possess a par value § Dividend must be paid before dividends can be paid on the common stock, § Dividends are typically taxed at ordinary income or “qualified” tax rates § Traded preferred stocks can be very interest rate sensitive § Pricing also impacted by call features and sinking fund provisions (if any) § Most call features provide for a minimum period after the date of issue § Sinking funds create implied maturity date § Like Debt § Pays a fixed or adjustable-rate dividend The details of each preferred stock depends on the issuance. FOR INVESTMENT PROFESSIONAL USE ONLY 5 Types of Preferred Stock § Traditional Preferred Stocks § Fixed Dividends § Adjustable-rate (or Floating Rate) Preferred Stocks (sample: banks) § Generally indexed to Treasury rates § Can hedge against rising interest rates § Trust Preferred Stocks (sample: bank holding companies) § Pay interest not dividends which impacts taxes § Convertible Preferred Stocks § Conversion to common stocks § Preference (or Prior Preferred) Stocks § Has higher priority in the capital stack than other preferred stocks § Non-traded Preferred Stock (IBDs) FOR INVESTMENT PROFESSIONAL USE ONLY 6 Non-Traded Preferred Stock § May be issued by Public or Private companies § May be part of a continuous (shelf) offering § Generally have sponsor-call and investor-put features § Favorable to FINRA 15-02 account statement requirements if the common stock is bearing the cost of the offering costs (i.e. full stated value on client statement) § Dividends may be non-cumulative or cumulative depending on offering § May include Warrants § Do not have the volatility of daily traded preferred stocks Non-Traded Preferred Stocks vs. FOR INVESTMENT PROFESSIONAL USE ONLY 7 Non-Traded Common Stocks Typical Non-Traded Typical Non-Traded Preferred Stock Common Stock Dividend Coverage Generally covered by Generally covered only operating cashflow / FFO / when portfolio reaches AFFO at onset critical mass Client Account Statement Stated (Par) Value Stated Value less offering expenses Publicly Listed Yes No Call / Put Features Yes Limited Dividends Cumulative Yes No Warrants Sometimes No FOR INVESTMENT PROFESSIONAL USE ONLY 8 Why Companies Issue Preferred Stock Companies issue prefer stock for any number of reasons: § Investors want them § Flexibility: can be redeemed by the issuing company before they are scheduled to mature - like a bond - and this gives the company the ability to use preferred stock for a specific funding purpose § May be easier to access capital than borrowing § Does not count as common, therefore no dilutive impact on Earnings Per Share (EPS) § In cases where the stock can be treated as equity, it does not count as debt § Keeps leverage ratios low § Helps bond ratings because the leverage is lower § Does not absorb the issuers borrowing capacity § Usually does not interfere with bank covenants § May be accretive to issuing common stock if preferred yields are below their common yields (i.e. lower cost of capital) § Preserves voting rights FOR INVESTMENT PROFESSIONAL USE ONLY 9 Use in Corporate Financing Bonds vs. Preferred Stock Tax Considerations Tax-deductible Not tax-deductible Equity Dilution No dilution No dilution; unless converted Control Company Maintains Company Maintains Control Control Cost of Capital Lower Rate Higher than Debt Leverage Increases debt-to- No impact to debt-to- equity ratios equity ratios Maturity Date Fixed Callable FOR INVESTMENT PROFESSIONAL USE ONLY 10 Dividends § Typically, the rate is fixed § Can be paid as a dividend or interest, usually quarterly or semi-annually § Preferred dividends must be paid first or made-up in full before common dividends § However, dividends may be suspended or “passed” by the issuer § Most preferred stocks are issued on a cumulative preferred basis (i.e. cumulative dividends) Dividend Coverage Ratio (Core) Funds from Operations (CFFO) + Preferred Dividends Preferred Dividends FOR INVESTMENT PROFESSIONAL USE ONLY 11 Par (or Stated) Value § Preferred shares have a stated par value § In case of liquidation the claim of preferred stock holders is restricted to the par value of the preferred stock § The preferred stockholder’s claim on assets comes after that of creditors but before that of common stockholders § Public preferred stock may trade at a discount or premium to par value = pricing volatility § Non-traded preferred stock are intended to have no pricing volatility = no pricing volatility § Validation by third-party to address FINRA 15-02 FOR INVESTMENT PROFESSIONAL USE ONLY 12 Voting Rights § Preferred stockholders are not typically given a voice in management unless the company is unable to pay preferred stock dividends during a specified period § If such a situation presents itself, the class of preferred stockholders would be entitled to elect a specified number of directors § Any situation in which the company defaults under restrictions in the agreement (similar to bond indenture) may lead to the voting power for preferred shareholders § Preferred shareholders cannot force the immediate repayment of obligations (like debt obligations) New Tax Act Provides Substantial Tax FOR INVESTMENT PROFESSIONAL USE ONLY 13 Savings to REIT Shareholders* § The Tax Cuts and Jobs Act (TCJA) provides substantial tax savings to REIT investors that allows individuals to deduct up to 20% of ordinary REIT dividends, with the remainder of the income taxed at the filer’s marginal rate.* § The effect on REIT investors who paid the top income tax-rate of 39.6% on 2017 distributions will be a drop in taxable rate to 29.6%, producing an after- tax savings of 25.3%. Please check with your individual tax advisor to determine how your individual tax profile is affected. 1Income levels vary between the old and new tax rates. 2Assumes a 6% distribution rate and the maximum tax rate payable. 3The hypothetical does not take into account the 3.8% Medicare tax on net investment income or any applicable state and local taxes. *REIT investments are included in the TCJA definition of qualified business income, with qualified REIT dividends, qualified cooperative dividends and qualified publicly traded partnership income specifically identified.* Section 199A of the Internal Revenue Code provides a deduction for “pass-through” businesses, that allows for a 20% deduction of any qualified REIT dividends against income, resulting in an effective 20% reduction in the tax rate on REITs (where the top 37% tax rate becomes 29.6%. FOR INVESTMENT PROFESSIONAL USE ONLY 14 Acquiring Public, Non-Traded Preferred Stock § Can be purchased in primary offering or secondary market § Possess a CUSIP § Can be purchased thru DTCC for broker-dealer brokerage accounts or “check and app” § Options for a “mini” subscription document FOR INVESTMENT PROFESSIONAL USE ONLY 15 Suitability § No individual state suitability restrictions on income or percentage allocation based liquid net worth requirements § No minimum net worth or gross annual income requirements § Depending on the structure, may be considered a public stock or an alternative investment § Broker-dealers will likely invoke specific suitability requirements specific to certain offerings Covered Security: refers to a class of securities that enjoys federally imposed exemptions from state restrictions and regulations. Most stocks traded in the U.S. are covered securities. FOR INVESTMENT PROFESSIONAL USE ONLY 16 Potential Advantages § Typically, a higher fixed-income payment than bonds or common stock Preferred stocks are § Because preferred stock normally has higher designed to provide a and more regular dividends, it is less volatile than common stock and carries less risk steady income stream through regular interest § A preferred stock with a guaranteed dividend is often considered a fixed-income investment similar to a or dividend payments, bond and their yields tend to be § Lower investment per share compared to bonds higher than those of other traditional fixed income § If a company stops paying a preferred dividend the company must repay all the money it would investments have paid to preferred shareholders before it can pay any dividends to common shareholder § In some cases, preferred holders may have the right to convert that preferred stock into common stock at a pre-arranged price § This is attractive to preferred stock holders because they are entitled to the steady stream