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
- Foreign company's shares are deposited with a U.S. bank (depositary)
- Bank issues receipts (ADRs) representing those shares
- ADRs trade on U.S. exchanges or OTC in U.S. dollars
- Dividends are converted to U.S. dollars and paid to ADR holders
ADR Structure
| Component | Description |
|---|---|
| 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.
| Feature | Sponsored ADR |
|---|---|
| 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.
| Feature | Unsponsored ADR |
|---|---|
| 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 | Where It Trades | SEC Registration | Capital Raising | Use Case |
|---|---|---|---|---|
| Level I | OTC (Pink Sheets) | Form F-6 only | No | Basic U.S. presence |
| Level II | NYSE, NASDAQ, AMEX | Full SEC reporting | No | Major exchange listing |
| Level III | NYSE, NASDAQ, AMEX | Full SEC reporting | Yes—can issue new shares | 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
| Risk | Description |
|---|---|
| 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 Nestlé ADRs to gain exposure to the Swiss company. Even if Nestlé'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 liquidity.
REIT Qualification Requirements
To qualify as a REIT and avoid corporate-level taxation, a company must meet several tests:
| Requirement | Test |
|---|---|
| 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)
| Characteristic | Description |
|---|---|
| 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)
| Characteristic | Description |
|---|---|
| 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
| Dividend Type | Tax Treatment |
|---|---|
| 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 × 32% = $320 tax
- With 199A: ($1,000 - $200) × 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
| Feature | Description |
|---|---|
| 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
| Feature | Rights | Warrants |
|---|---|---|
| Time to expiration | Weeks | Years |
| Exercise price | Below market | Above market (at issuance) |
| Issued to | Existing shareholders | Often with bonds or preferred |
| Purpose | Prevent dilution | Sweeten bond or preferred offerings |
| Risk level | Lower | 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
An investor holding ADRs of a German company would be exposed to:
To qualify as a REIT, a company must distribute what percentage of taxable income to shareholders annually?
Warrants differ from stock rights in that warrants typically:
6.1 Mutual Funds
Chapter 6: Pooled Investments