When it comes to property, one of the key issues is location, location, location. On that front, Preferred Apartment Communities (NYSE: APTS) is in the right regions of the United States, with a focus on the Sun Belt states. However, it runs afoul of another important rule: Keep it simple. That said, some recent moves prove that it's working on simplifying its business, which is great, but there's still a lot more work to be done.
What's in a name?
One of my biggest gripes about Preferred Apartment Communities is that its name is highly misleading. You would think the real estate investment trust (REIT) owned a collection of what it believed were desirable ("preferred") apartment buildings. But that wouldn't be the case. It actually owns apartments, shopping centers, and office properties. And, up until November of pandemic-hit 2020, it also owned student housing.
It wouldn't be unreasonable to wonder why the word "apartment" is even in the company's name, given that it would be best described as a diversified REIT. The late 2020 sale of the student housing properties, however, may have marked an important shift, because in early 2021, the company also inked a deal to sell its office properties. Management described the most recent move as transformational, which seems a bit dramatic, but it definitely helps to simplify the portfolio.
Simplification shouldn't be undersold here. I think Preferred Apartment Communities is definitely moving in the right direction. That said, given its name, it could do with jettisoning its shopping centers, too, which would make it an exclusive apartment REIT. But management is calling the retail assets complementary to its apartments, so I'm not holding my breath on that front. (A name change would be an agreeable alternative to selling the shopping centers.)
The bigger issue
The thing is, there's one more problem with Preferred Apartment Communities. The word "preferred" refers to the way in which the company has historically funded its business: by selling preferred shares (it has nothing to do with the quality of its properties). Selling preferred stock is an interesting option that allows the company to sidestep the bond market and equity markets. But it's a more complex approach than investors may want to be involved with.
Notably, the company's preferred shareholders redeemed shares early in the coronavirus pandemic. That basically forced Preferred Apartment Communities to issue stock at what was a pretty terrible time. Meanwhile, preferred stock ranks higher than common stock in the capital structure, so the preferred holders' dividends will be paid before common dividends. On this front, Preferred Apartment Communities cut its common dividend by roughly 33% in 2020.
Although the fourth-quarter 2020 adjusted funds from operations (FFO) payout ratio was a solid 70%, given the dividend cut, it wouldn't be shocking if the sale of the office assets had a negative impact on the dividend. That said, the plan is to use the proceeds from the office sale to buy back preferred shares, so the reduction in preferred dividend payments may be enough to offset the impact from the drop in rents and allow the REIT to maintain the common dividend. At the very least, investors should probably expect the payout ratio to rise.
But the bigger risk here is still the use of preferred stock, even though Preferred Apartment Communities is moving to simply its business in other ways. While you can argue about whether it's a good or bad approach, the question I always fall back on is: If making such a heavy use of preferreds is such a great approach, why aren't more publicly traded REITs doing it? And the fact is that Preferred Apartment Communities is pretty unique in this way, but that doesn't mean anything about the model is really preferential.
On the sidelines
When I get attracted to unique business models like this, I always remind myself to keep it simple. One too many times I've been burned by what ends up amounting to a high-risk approach (note the dividend cut here in 2020) that I would have been better off avoiding. Until Preferred Apartment Communities has changed the way it funds its business, I'm just not willing to jump aboard its "preferred" approach.