5.5 ADRs, REITs & Other Equity Securities

Beyond common and preferred stock, investors have access to specialized equity instruments with unique characteristics. Understanding these securities - particularly ADRs and REITs - is essential for the Series 65 exam.

American Depositary Receipts (ADRs)

ADRs allow U.S. investors to invest in foreign companies without dealing with foreign exchanges, currencies, or settlement procedures.

How ADRs Work

1. Foreign company's shares are deposited with a U.S. bank (depositary)

2. Bank issues receipts (ADRs) representing those shares

3. ADRs trade on U.S. exchanges or OTC in U.S. dollars

4. Dividends are converted to U.S. dollars and paid to ADR holders

ADR Structure

Depositary Bank: U.S. bank holding foreign shares (e.g., JPMorgan, BNY Mellon)

ADR Ratio: Number of foreign shares represented by one ADR

Custodian Bank: Foreign bank holding actual shares in home country

Sponsored vs. Unsponsored ADRs

Sponsored ADRs

Sponsored ADRs are created with the foreign company's cooperation and support.

Company involvement: Yes - formal agreement

SEC registration: Required for Levels II and III

Exchange listing: Can trade on NYSE, NASDAQ

Voting rights: Typically included

Financial disclosure: Translated and available

Unsponsored ADRs

Unsponsored ADRs are created by depositary banks without company involvement.

Company involvement: None

SEC registration: Not required

Exchange listing: OTC only

Voting rights: Rarely included

Financial disclosure: Not translated

On the Exam: Sponsored ADRs have SEC oversight and can trade on major exchanges. Unsponsored ADRs trade OTC with less regulatory protection and no voting rights.

Levels of Sponsored ADRs

Level I: Where It Trades - OTC (Pink Sheets). SEC Registration - Form F-6 only. Capital Raising - No. Use Case: Basic U.S. presence

Level II: Where It Trades - NYSE, NASDAQ, AMEX. SEC Registration - Full SEC reporting. Capital Raising - No. Use Case: Major exchange listing

Level III: Where It Trades - NYSE, NASDAQ, AMEX. SEC Registration - Full SEC reporting. Capital Raising - Yes, can issue new shares. Use Case: Capital raising in U.S.

Level III ADRs have the most stringent requirements but allow the foreign company to raise capital from U.S. investors through new share issuance.

ADR Risks

ADR investors face unique risks beyond typical equity risk.

Currency Risk

Because the underlying asset is a foreign stock, ADR values are affected by exchange rate fluctuations.

Example:

- German company's stock price unchanged

- Euro weakens 10% against dollar

- ADR price falls approximately 10% in dollar terms

Other ADR Risks

Political/Country Risk: Instability in foreign market

Liquidity Risk: Some ADRs thinly traded

Information Risk: Less disclosure than U.S. companies

Tax Complexity: Foreign withholding taxes; potential double taxation

Timing Differences: Foreign markets operate in different time zones

In Practice

An investor buys Nestle ADRs to gain exposure to the Swiss company. Even if Nestle's business performs well, the ADR value will decline if the Swiss franc weakens against the U.S. dollar. Currency hedging can mitigate this risk but adds cost.

Real Estate Investment Trusts (REITs)

REITs allow investors to invest in real estate without directly owning property. They offer diversification, professional management and, for publicly traded REITs, liquidity. Non-traded REITs are illiquid: they cannot be sold readily, and their share redemption programs are limited and can be discontinued.

REIT Qualification Requirements

To qualify as a REIT and avoid corporate-level taxation, a company must meet several tests:

Asset Test: At least 75% of assets in real estate, cash, or government securities

Income Test: At least 75% of gross income from real estate sources

Distribution: Distribute at least 90% of taxable income as dividends

Ownership: At least 100 shareholders

Concentration: No more than 50% owned by 5 or fewer individuals (5/50 rule)

Structure: Must be organized as corporation, trust, or association

The 90% Distribution Requirement

REITs must distribute at least 90% of taxable income to shareholders annually. This requirement results in:

- High dividend yields (often 3-8%)

- Limited retained earnings for growth

- Need for external financing to expand

Types of REITs

Equity REITs (Most Common)

Assets: Own and operate income-producing properties

Income: Primarily from rents

Risk Profile: Tied to property values and occupancy

Examples: Office buildings, shopping centers, apartments

Mortgage REITs (mREITs)

Assets: Invest in mortgages and mortgage-backed securities

Income: Primarily from interest on loans

Risk Profile: Highly sensitive to interest rates

Leverage: Typically use significant leverage

Hybrid REITs

Combine both equity and mortgage strategies - own properties AND invest in mortgages.

On the Exam: Equity REITs are most common and focused on rental income. Mortgage REITs are more interest rate sensitive and typically use more leverage, making them riskier.

REIT Taxation

REIT taxation differs significantly from regular corporations and other investments.

Dividend Taxation

Ordinary income portion: Taxed as ordinary income

Capital gains portion: Taxed at capital gains rates

Return of capital: Tax-deferred; reduces cost basis

Most REIT dividends are taxed as ordinary income, not at qualified dividend rates, because REITs are pass-through entities.

Section 199A Deduction

The Tax Cuts and Jobs Act of 2017 created a 20% deduction for qualified REIT dividends under Section 199A, reducing the effective tax rate.

Example: $1,000 REIT dividend at 32% marginal rate:

- Without 199A: $1,000 x 32% = $320 tax

- With 199A: ($1,000 - $200) x 32% = $256 tax

Stock Rights

Stock rights (also called subscription rights) are short-term instruments allowing existing shareholders to purchase new shares at a discount.

Characteristics of Rights

Duration: Short-term (typically 30-45 days)

Pricing: Below current market price

Purpose: Prevent dilution; raise capital

Transferability: Can be sold on open market

Rights Calculation

Rights Value = (Market Price - Subscription Price) / (Rights Required + 1)

Example: Stock trades at $50, subscription price is $40, need 4 rights per new share:

Rights Value = ($50 - $40) / (4 + 1) = $10 / 5 = $2 per right

Warrants

Warrants are long-term options to purchase stock at a fixed price.

Rights vs. Warrants Comparison

Time to expiration: Rights - Weeks; Warrants - Years

Exercise price: Rights - Below market; Warrants - Above market (at issuance)

Issued to: Rights - Existing shareholders; Warrants - Often with bonds or preferred

Purpose: Rights - Prevent dilution; Warrants - Sweeten bond or preferred offerings

Risk level: Rights - Lower; Warrants - Higher (more speculative)

Warrant Characteristics

- Highly leveraged - small investment controls more shares

- No dividends or voting rights until exercised

- Value derived from time value and potential appreciation

- Can trade on exchanges independently

In Practice

A company issues bonds with attached warrants exercisable at $30 when the stock trades at $25. If the stock rises to $40, warrant holders can exercise at $30, an immediate $10 profit per share. If the stock never exceeds $30, warrants expire worthless.

Key Takeaways

- ADRs allow U.S. investors to invest in foreign companies in dollars; face currency and country risk

- Sponsored ADRs have company involvement and SEC oversight; unsponsored trade OTC only

- Level III ADRs have full SEC registration and can raise capital in the U.S.

- REITs must distribute at least 90% of taxable income to qualify for pass-through tax treatment

- Equity REITs own properties; mortgage REITs invest in mortgages and are more rate-sensitive

- REIT dividends are typically taxed as ordinary income, not qualified dividends (but 199A deduction applies)

- Rights are short-term, priced below market; warrants are long-term, priced above market

- Both rights and warrants are derivative securities with leverage characteristics