VNQ - Bargain Alert: I Am Buying The Dip In REITs

2023-07-25 07:35:00 ET

Summary

• REITs are primed for a recovery.
• Today, we look at my favorite fund for when the sector as a whole is expected to climb.
• Great income for today, amazing total returns for tomorrow.

Co-authored with Treading Softly

A common mistake of a novice investor is thinking that when a sector is out of favor, it is a terrible time to invest in that sector. Unless you're trying to be a swing trader or a momentum trader, this most likely isn't the case, especially if you espouse the doctrine of buying low and selling high.

2022 has been a hard year for real estate investors – that's an undeniable fact. The Vanguard Real Estate ETF ( VNQ ) fund has largely lagged behind the market, and its 1-year returns are in the negative single digits.

What is important to remember is that real estate values during this time have not fallen to the same degree. A major factor in the decline in the value of publicly traded real estate investment trusts is their use of leverage. Many of these trusts rely on high levels of leverage to then turn around and pay out strong dividends. When the price of leverage goes up, their ability to continue to grow and pay out dividends goes down.

The goal, therefore, becomes identifying the REITs which use the lowest cost leverage and have the strongest dividend coverage.

Another option is to move into Closed-End Funds ('CEFs').

CEFs tend to be more sensitive to macro storylines than individual companies. With a CEF, you have two components, the "market price", which is the price that investors are willing to pay for the fund, and the "net asset value", which is the current value of the fund's holdings. With a fund that buys common stocks that are easily valued, a person might assume that the market price and NAV would be the same – that person would assume wrong. When market sentiment is negative, CEFs tend to fall more, and when the sentiment is positive, they rise more.

The Cohen & Steers CEFs: RQI and RNP

Cohen & Steers is an excellent portfolio manager of multiple top-notch REIT CEFs. We hold many of their funds in our Model Portfolio, yielding 10% on average, like their REIT and Preferred Income Fund ( RNP ), which we've highlighted recently . Today we want to look at the second excellent option.

RQI – Yield 8%

Consider Cohen & Steers Quality Income Realty Fund, Inc ( RQI ), which, following the big selloff in Property REITs, now yields 8%. In 2021 and 2022, NAV and market price were within spitting distance, and the market was full of optimism. Today, you can buy $12.89 of NAV for $11.97.

Interestingly, this is a very similar position to where it was three years ago in 2020 when you could buy $11.96 in NAV for $10.81. Those who snapped up that deal were certainly happy with the results in 2021!

REITs started a recovery this year, bolstered by strong Q1 earnings, but RQI's market price is still in October. This provides an opportunity to buy RQI at a higher-than-typical discount.

RQI has a long history as a REIT CEF that has been through the end of the world for REITs, which was the Great Financial Crisis. RQI went through "the end of the world" and came out the other side strong.

Today, RQI is in a very unique position, having locked in very low financing costs. RQI, along with sister fund RNP, used interest rate swaps to lock in low-interest rates, fixing 81% of RQI's leverage at a 1.8% interest rate for several years. Source

RQI then utilizes those funds to hold top-quality REITs. RQI's top 10 holdings are filled with REITs that are undeniably "blue chips" in their respective sectors.

If the market is willing to sell the highest quality REITs at a 7% discount, are we going to turn that down? Well, I can't speak for you, but I'm not going to!

Conclusion

When it comes to getting paid great income from the market, you need to be aware of the leverage or the debt that your investments have.

Leverage is a valuable tool, especially when the economy is great and things are on the climb; you can see greater than normal returns using less initial money invested. The issue is that when you flip the coin over on the way down, leverage will cut you and bite you harder than anything else can in the market. This is one of the reasons why we repeatedly encourage investors not to leverage their personal portfolio with margin. Margin is a tool that can be used effectively, but when relied on heavily can destroy a retirement.

Currently, we see real estate investment trusts being near the bottom of our expected prices for them. Thus, now is a great time to invest in a fund like our RQI that uses leverage to help bolster those returns as they shoot higher. If you continue to worry about the downside risk, an investor could instead choose to use Cohen & Steers Total Return Realty ( RFI ), a fund that uses no leverage at all but also invests in REITs. One is great for the way down, and the other is great for the way up.

At the end of the day, the goal of a professional income investor is simple. We want a retirement that's paid for by dividends, and we're willing to leverage various tools provided by the market to receive that excellent income. In a situation like this, where we expect a sector-wide recovery, we may elect to use a closed-end fund that is currently trading at a discount to its value. It also uses a modest amount of leverage so that when the upside arrives, we can enjoy even stronger gains and excellent income since the fund itself holds some of the best real estate investment trusts available in the market today.

Let the portfolio managers do the work so you can enjoy the benefits. That way, you can have financial security and financial independence without being shackled to your phone or computer and needing to babysit your portfolio.

That is the beauty of my Income Method. That is the beauty of income investing.

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