Co-produced with Beyond Saving
Last October, we wrote an article noting that the REIT sector was getting overvalued. Companies with a REIT tax structure are frequent favorites of ours because they fit in well with our Income Method. There’s a lot to love about REITs because they provide significant amounts of cash flow, and partly through tradition, partly through tax law requirements, the majority of that cash flow is passed along to investors as dividends.
There are many ways to gain exposure to the REIT sector, for individual picks, we have focused on “deep value” like mall REITs where even very high-quality landlords like Macerich (MAC) yield over 12%, REITs trading at a steep discount to NAV like the 7% yielding Cedar Realty Trust (CDR), and core holding like the 7.7% yielding Iron Mountain (IRM), or the 6.3% yielding EPR Properties (EPR).
There are many other REITs that we like, but they have yields that are entirely too low for our objectives. American Tower (AMT), Prologis (PLD), Equinix (EQIX) and others are all very high-quality REITs with fantastic track records, impeccable management, and strong balance sheets. Unfortunately, they also yield a pitiful 1.5%-2.5%. For portfolios geared toward providing significant levels of income, that makes these companies a non-starter.
So how do you gain exposure to these great companies without sacrificing yield? One way is to go with a CEF (closed-end-fund) that invests in these companies. CEFs are actively managed and will provide much higher levels of income.
Best-in-Class Property REIT CEF Yielding 6.7%
There are many advantages in investing into property REIT CEFs and ETFs. Not only they provide instant diversification, but also usually result in lower price volatility than investing into individual stocks. Additionally, the vast majority of property REIT CEFs pay attractive yields on a monthly basis, which is a great solution for those income investors looking for a regular paycheck.
Cohen & Steers is our manager of choice in the REIT space. They have a long history of market-beating returns and have navigated the ups and downs of the REIT sector with great skill. Cohen & Steers Quality Income Realty Fund (RQI) is a long a favorite pick of ours, but in October 2019 we recommended to trim this position and consider its sister fund Cohen & Steers Total Return Realty Fund (RFI) also managed by Cohen & Steers.
The reason we cooled on RQI is because it was trading at a premium to NAV and Property REIT valuations were getting expensive. At the time, swapping out RQI and replacing it with RFI resulted in improved income for the same capital deployed. RFI was yielding 6.3% while RQI only yielding 6% back then.
Around the same time, we also recommended to our investors to get exposure to international REITs through Aberdeen Global Premier Properties Fund (AWP) with a yield of 7%. AWP provides a good exposure to European and Asian REITs which trade at a significant discount to their U.S. counterparts, and set for higher returns in the year 2020.
Our call has worked out nicely as RFI and AWP have had materially better performance.
Opportunity: RQI is Trading Back at a Nice Discount.
Today, RQI is trading at an 8.7% discount to NAV with a yield of 6.7%. When we recommended to trim RQI it was trading at a 3.5% premium and yielding only 6%. For our investors who opted to sell and redeploy into RFI, it’s time to turn the green light back on.
After all, for the past 10 years, RQI has materially outperformed both RFI and AWP.
CEFs are actively managed, this means that the manager is buying and selling positions all the time. That is why we frequently pick our CEFs based on who is managing it. Cohen & Steers has a long and very admirable track record in the REIT space. In our opinion, they are the best CEF manager for REITs.
Why Price/NAV Matters When Buying CEFs
CEFs report their NAV daily, so we have a very accurate read of what the fund would be worth if they simply sold all their shares.
As we predicted, both price and NAV came down in late 2019. However, since January, we have seen NAV increase, but the price kept falling. This means that it’s 8.7% cheaper to buy RQI than it would be to buy the exact same shares they hold.
When we consider that RQI is able to obtain leverage much cheaper than we can, this is a no-brainer. Investors can look forward to having gains not only as the absolute value of RQI’s assets increase, but also as the discount to NAV shrinks.
Here’s a look at RQI’s top 10 holdings.
Source: Cohen & Steers
Every single one of these is indisputably a high-quality REIT. Some might even call them “SWANs” and all of them have the stamp of approval from our REIT expert Beyond Saving. The main reason we don’t invest in them is that they have very low yields.
RQI provides an opportunity to have your cake and eat it too. You can benefit from improving values in these great REITs, collect sizable income, and buy it a discount. RQI is particularly well positioned to benefit from the news that the Sprint (S) and T-Mobile (TMUS) merger was approved. AMT and CCI, two of their largest positions, are up materially and benefit from the news.
To reduce price volatility, RQI allocates 20% of its portfolio to preferred stocks issued by property REITs. This is another added value from RQI.
Reason for This Opportunity: The “Rights Offering”
It is unusual for RQI to be trading at such a large discount relative to its sister fund, RFI. Their holdings are very similar and the main difference between the funds is that RQI uses leverage, while RFI does not.
We believe the big impact for RQI is a rights offering. On Jan. 17, shareholders were granted one right for each share. For every three rights, shareholders will have the option to buy one share of common stock at 95% of the four day average price computed on Feb. 13.
In plain English, shareholders will have the option to buy shares at an additional 5% discount. This means that the number of shares outstanding will increase by 33%. This anticipated dilution has created a temporary headwind on RQI’s share price and has provided us an opportunity to buy back in.
Cohen & Steers has stated that they intend to maintain the current $0.08/month dividend. The funds raised will be deployed, with leverage, and increase their assets under management.
With RQI’s solid history, we are confident that their NAV and price will quickly rebound.
We make our investment decisions taking into account macro economics, the market outlook, and valuations. We made the case that property REITs are getting overpriced, and recommended that income investors trim down their REIT exposure. In addition to selling some individual picks near top, RQI was trading at a high premium. While RQI is one of our favorite CEFs, valuation matters. RQI pulled back due to the “rights offering” and presents income investors a nice entry point.
We expect more opportunities in the REIT space to show up in 2020 as investors and financial institutions shirt away from overvalued assets such as Property REITs to cheaper asset classes. As a result, some nice opportunities will emerge. Smart investors should take advantage of such pullbacks and increase their exposure to the property REIT space, but this may take some time to achieve. Patience and close monitoring is required in order to buy the best ones that come up, and this is what we offer to our members: High yield at attractive valuations.
RQI is managed by one of the best active managers in the REIT investment space. Cohen & Steers is a true specialist and pioneer with a track record of market outperformance. C&S has a long history of value creation.
Today, income investors have the opportunity to buy the best-in-class property REIT CEF with a nice 8.7% discount to NAV and a yield approaching 7%. The dividend is paid on a monthly basis. This pullback is a great opportunity to buy or add a position in RQI. The sale for this high yielder is unlikely to last for long.
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Disclosure: I am/we are long RQI, CDR AWP, MAC, IRM, EPR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.