As the commercial real estate doom and gloom continue to circle around us, I had a chance to talk with Jay Hatfield of InfraCap Funds last week. 

Jay is one of the best preferred stock and income investing ETF managers, and he delivers solid returns for income investors in all the funds he manages.

We talked about the current market for preferred stocks, and eventually, the conversation came around to preferred shares issued by real estate investment trusts.

Let me show you what I learned, because it’s something every investor needs to know…

Jay manages the InfraCap REIT Preferred ETF (PFFR) and is doing some hands-on, in-depth research on the industry and the opportunities currently available in REIT preferred shares. He shared with me some of his research and how he and his team approach valuing REIT preferreds.

It occurred to me that I could use his current list of holdings and add my own recent opinions of the REIT market to find some undervalued REIT preferreds that could offer high income and upside potential. So, I essentially used the InfraCap REIT Preferred ETF portfolio as a very skilled, yet completely free (to me), research team.

If you are looking for a broad basket approach to owning REIT preferreds with high income and some capital gains along the way, then you can stop reading and buy the ETF. The shares yield more than 8% at the current price and make a fantastic addition to an alternative income portfolio.

I am digging through the list for a few issues that fit into my own themes and opinions on the current REIT markets that have also passed Jay’s rigorous examination process. One holding that stood out as soon as I looked at the funds is the two Digital Bridge (DBRG) preferred issues the fund holds.

The fund owns the preferred I shares that trade with the symbol DBRG-PI and the J shares that trade as DBRG-PJ. The shares were issued when Digital Bridge was still Colony Capital Northstar, a diversified real estate investment trust with a wide range of holdings.

Digital Bridge has changed its name, sold off the legacy assets, and focused on the real estate and infrastructure required for the digital future. It currently manages $53 billion of digital infrastructure assets and owns cell towers, fiber networks, small cells, and edge infrastructure needed to deliver all the cutting-edge technologies of the future.

The REIT needs to deliver more cash flow to pay a meaningful dividend, as it is still early in the conversion process, but the preferreds are both paying more than 8.5% right now. Both are also trading for less than $21 a share despite being callable at the share’s par value of $25.

As Digital Bridge continues to build its collection of digital assets, the market will slowly revalue the preferred, and the price will move closer to par. If the Federal Reserve does begin to lower rates late this year or early next, that could also cause the preferred shares to trade higher.

Jay Hatfield and his team also own several issues of preferred stock issued by Pebblebrook Hotel Trust (PEB).

Pebblebrook owns 52 upscale resorts and full-service hotels in 15 markets around the United States. About half of its properties target high-end business travelers, and half seek leisure customers searching for a high-class resort experience.

The REIT was recovering from the pandemic when Hurricane Ian caused substantial damage to one of its properties, The LaPlaya, in Naples, Florida. My wife and I felt that one personally, as the LaPlaya was one of our favorite places on the Gulf to stop for drinks or dinner when we headed out for a night on the town.

Pebblebrook is not generating much cash flow right now, while it’s spending to upgrade and repair its properties. As a result, the dividend on the common shares is less than 1%.

The InfraCap ETF’s largest position in Pebblebrook is in the G class of preferred stock that trades with the symbol PEB-PG. The shares trade for less than $19—a substantial discount from the $25 par value—and yield more than 8%.

The volatility in REITs is likely to continue as the economy wrestles with inflation and the possibility of an economic slowdown. And most investors will never think to look higher in the capital structure of REITs and see the opportunity that currently exists in many preferred issues.

Finding out-of-favor issuers that are unlikely to default and trade, well below par value, allows patent-aggressive investors to collect dependable high levels of income along with the possibility of capital gains if and when shares trade closer to par.