WELL - Earn +8% From The Highest Quality REITs: RQI

2023-06-21 07:35:00 ET

Summary

• Being a landowner is a historical form of wealth generation.
• Managing many properties can be a lot of hard work.
• We present a solution to get income through real estate without all of that effort.

Co-authored with Treading Softly.

While the U.S. stock market has been one of the greatest generators of wealth that the world has ever seen, it has only existed for a couple of centuries. An even older form of traditional wealth generation has been to be a landowner or one who owns real estate. Going back to feudalistic systems, or even monarchies, the person who owns the land controls the land. Those who live on the land either have to pay rent or serve the landowner. Those people are then generating wealth upwards, not outwards.

Within the United States, those who own large empires of real estate also usually have a large net worth. Over time, buying land or homes has become harder and harder, as there are more people and there's no more land. Historically, the demand for housing has remained strong and has outpaced inflation, creating value over the long run. For most investors or retirees going out and building a land empire of rental homes or properties is not practical or plausible, but that does not mean you don't have the ability to leverage real estate as a means of generating strong income.

Real Estate Investment Trusts (REITs) provide an opportunity to invest in real estate along with other investors and pool your money together. These investments require that the REIT pay out 90% of its taxable earnings to investors to avoid taxation. What this means is that often you get large dividends from these companies, unlike you would from regular companies. You can compound this by using Closed-End Funds ("CEFs") with professional portfolio managers who carefully pick the best companies to invest in and then pass on distributions to you as required.

Prologis ( PLD ), American Tower ( AMT ), Welltower ( WELL ), and Realty Income ( O ): what do all of these names have in common? If your answer was "blue chip REITs" or "a bevy of SWANs," you are right. These are some of the most prestigious REITs that have earned great returns for investors over the decades.

They also make up the four largest positions in Cohen & Steers Quality Income Realty Fund ( RQI ), a CEF that focuses on high-quality REITs and yields 8.3%.

RQI 's top 10 holdings are the "who's who" of REITs. Source .

Accounting for approximately half of RQI's portfolio, you aren't getting REITs that are "diamonds in the rough" or are hard to find. You are getting REITs that have proven themselves to be the best in their business.

So why would you invest using RQI instead of just buying these REITs?

1) You have the opportunity to buy at a discount. RQI is currently trading at over a 7% discount to NAV. In other words, if you invest $1,000 into RQI, it would cost you about $1075 to buy the exact same stocks that RQI has.

2) RQI converts capital gains to income. Many high-quality REITs have a yield of 3-5% these days. As income investors, 3% just doesn't meet our goals. As a CEF, RQI is required to pay out both its income and realized capital gains. RQI does this by paying a "managed distribution" of $0.08/month. In years where realized capital gains are higher than the dividend, like in 2022, RQI pays out a special dividend at year-end. CEFs can be a great vehicle to gain exposure to sectors that you want to own but don't have high-yielding options.

3) 2.7%. That is the weighted average interest rate that RQI pays on its leverage. RQI utilizes leverage at around 30% of assets. Leverage helps provide higher income, though it also amplifies volatility. Leveraged funds will tend to decline more and rise more than unleveraged funds. So when there is a large sell-off, leveraged funds will underperform. When there is a rally, they outperform.

Here is a look at RQI compared to sister fund Cohen & Steers Total Return Realty Fund ( RFI ), which holds substantially similar assets but without leverage.

Note that RQI outperformed over the past 10 years because the market has rallied more than it has fallen.

With interest rates rising, RQI has a further advantage in the current environment. It has used interest rate swaps to fix 81% of its debt at an average interest rate of just 2.0% for an average of over three years.

So, when you buy $1,000 of RQI, you are getting $1,075 in net asset value, but that only represents 70% of assets net of leverage. The actual assets being managed for your benefit are worth $1,535.

So for you to replicate RQI's portfolio, you would need $1,075, plus take out a $460 loan and buy $1,535 to have the same assets. How much interest would you pay on that loan? I'd bet a good bit more than 2.7%!

But what about the expenses?

One of the most frequently asked questions I get when talking about CEFs is the expenses. Investors' eyes gloss over if you talk about executive salaries and stock options and G&A expenses, but when they see a 2.33% "expense ratio," they panic.

How much is 2.33%? Well, if you recreate RQI's portfolio and invest $1,535, using $1,075 of your cash and $460 in debt, you would "save" yourself that 2.33% expense ratio... right?

Not so fast. A 2.33% expense ratio would cost $35.76/year, which includes interest. Just because you are investing yourself does not mean you avoid all expenses. You borrowed $460; you have to pay interest on that! How much would you have to pay? $35.76 would equate to a 7.7% interest rate on the debt. For many of you, the interest on the leverage alone would be more than all of the expenses RQI pays, which includes interest. Surprisingly, a fund with billions of dollars in assets is able to get better deals on borrowings than we can! This is one of the big reasons why I don't get up in arms over expense ratios with CEFs. Note that the CEF's distributions paid to shareholders are net of expenses – the expenses are not subtracted from RQI's 8.3% yield.

The bottom line is that if you were to try to recreate RQI's portfolio from scratch, you would have to pay $1,075, take out a $406 loan that is recourse to you, and would probably pay similar if not higher annual expenses to get the same economic result you would get with a $1,000 investment in RQI. I would argue that it is often worth a premium to not have to actively manage an investment portfolio in a sector when you can get it at a discount with a quality manager; seize the opportunity!

If you want to own premium blue-chip REITs, and I certainly do, why wouldn't you use RQI as a vehicle?

Conclusion

We've spent a lot of time today discussing why RQI is an excellent investment for income. While you could take the time to recreate their portfolio and get similar leverage, if you're able to get similar costs as they can, the question is, is it worth the effort? I would argue that the quality of the portfolio managers alone makes it not worth the extra time and effort to try and recreate what they do.

The biggest headache of being a landowner is having to manage your properties or finding someone to pay to manage them. If you own rentals, you have to collect rent, fix repairs, and manage tenants. If you own commercial properties, again, you still have tenants to take care of and rent to collect. By being able to own real estate through a passive investment vehicle like RQI, you can get many of the benefits without many of the headaches, all while still being paid a strong stream of income.

When it comes to retirement, do you want to be fixing leaking faucets or improperly functioning toilets, or would you rather enjoy your hobbies and spend time travelling? I want a retirement that is paid for by the stock market through dividends. This way, I can spend my time doing whatever I want. I want capable portfolio managers or company executive management teams to take care of the day-to-day work to generate the income that they pay me.

That's the beauty of my Income Method. That's the beauty of income investing.

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