DGI Adventure 05-23-16 - Sold Puts: VER July 15 2016 $9.00 strike @ $0.25/share
Even though I took my leap of faith over a week ago, some of the funds from my Beneficiary IRA transfer have only now hit my Interactive Brokers account. Since IB doesn’t support most of the mutual funds I held, the rest of the funds are going to take a few more days, which means I only have $25K in cash at the moment. Maybe I should have waited for the rest of the funds to transfer? IDK I figured I’d go ahead and get some income going.
First order of business is to get the REIT shares out of the taxable account. I have 400 shares of VER, and 26.6757 shares of HCP in my taxable brokerage account. Dividends from these REITs are unqualified, meaning they’re taxed as regular income rather than capital gains. That is a major hindrance to the real yield they produce. I like the investments and the income, I’m just holding them in the wrong type of account.
This is kind of like my Gilead switcheroo except in reverse. My goal is to buy an equivalent number of REIT shares in tax protected accounts because of the relatively large amount of dividend income they produce. Unlike the Gilead switcheroo, I don’t want to sell the original shares for a gain, since I would have to pay taxes on that gain. Fortunately? (yeah..fortunately for the purposes of this scheme)...my VER investment only recently got close to break even range and HCP is down about 17%. So as long as I wait long enough to avoid wash rule issues, I can do a little tax loss harvesting, and transfer the dividend income to a protected account.
My theory is that the REIT share prices might drop in June if the FOMC decides to push another rate hike through at their next meeting. So I don’t want to just buy shares now, or try to gaff fish with a limit order. Instead, I’ve decided to sell put options at a strike price that would effectively lower my cost basis. Meanwhile I collect the option premium as income and if the share prices fall, I can make my switcheroo at a lower cost basis.
Take this trade with VER as an example. My current cost basis is $9.40. By selling July 15 puts for $0.25/share with a strike price of $9.00 I earn a 19.13% annualized gain (2.78% actual gain over 53 days) with the premium. If I get assigned, I will lower my cost basis by $0.40/share, and hold the shares in a tax advantaged account. If I don’t get assigned, I keep my premium and do it again. VER has been down the past couple of days, so the prices of put options were up. I’m waiting for HCP to have a couple down days before I try a similar maneuver. I’m especially interested in the HCP $30.00 strike right now.
I sold 4 put contracts at $0.25/share, which netted me $99.88 in premium (including commissions...IB is awesome!). Meanwhile, I’m expecting a $55.00 dividend distribution from the 400 shares I own outright.
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I’m not wildly enthusiastic about the prospects for the broader stock market over the remainder of 2015. But I do think that REITs offer a pocket of value. I don’t see bond yields rising much in today’s market. If the Fed is too timid to raise rates, that tells you that there are enough macro risks out there to keep bond yields low. But if and when the Fed finally does get motivated to raise rates, I don’t see that translating to higher long-term bond yields, or at least not for a while. A higher Fed funds rate is disinflationary, which is good for bond prices.
So for the time being, we seem to be in a sweet spot for bonds where, irrespective of what the Fed does, bond yields should stay lower-than-normal for a while. And as long as bond yields stay low, REITs should outperform the broader market.
Source: Nasdaq
But there is one more reason to believe that REITs are due to continue their rally. Several of the names I follow are very heavily shorted right now. Short sellers have been punishing the sector for months in the view that higher interest rates would wreck the sector. But here’s the thing about heavily-shorted stocks. When you short a stock, you are obligated to buy it back. So when you see a heavily-shorted stock, you know that there is a lot of buying that must happen… eventually. And if too many short sellers try to close their positions at the same time, you get a short squeeze that can send the stock price sharply higher. To toss out a few examples from the list above, Realty Income has a short interest currently equal to more than 11 days’ worth of daily volume. VEREIT has a short ratio of 9 days to cover. And Digital Realty has an almost ridiculously high short ratio of 20 days to cover.
Short sellers have had a great six months shorting the REIT sector. It’s been a profitable trade for them. But with REITs showing modest strength right now in the face of broad market weakness, I expect those short sellers to start bailing… and soon.
Even though they generally have a low correlation to the broader market, REITs are still stocks. And if we have another volatile rough patch like August, you can expect them to fall alongside the rest of the market, at least temporarily. But I still expect REITs to massively outperform the broader market for the remainder of 2015, particularly if the shorts get squeezed.
Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.
