WPC - Real Estate Passive Income: Forget RQI Buy These High Yielders Instead

2023-05-29 08:00:00 ET

Summary

• RQI is a wildly popular high-yield REIT fund.
• However, we believe that investors are setting themselves up for long-term disappointment with this fund.
• Instead, we share some high-yielding real estate alternatives that we think will provide much better returns for passive income investors.

The Cohen & Steers Quality Income Realty Fund ( RQI ) is a wildly popular high yield REIT fund. Much of its legend stems from its track record of outperforming the REIT sector ( VNQ ) over a long-period of time:

However, we believe that this track record is misleading investors, setting them up for long-term disappointment by investing in RQI. In this article, we discuss why RQI is bound to lead to disappointing results for most if not all shareholders and then offer some alternative high yielding real estate picks that will likely deliver more satisfactory results.

Why RQI Is Poised To Disappoint

One reason why we think that RQI is bound to disappoint investors over the long-term is simply because its long-term track record is not nearly as good as it looks in the chart we just shared with you. First of all, if you look at the periods where REITs got pummeled, you will notice that RQI significantly underperformed VNQ each time. The reason for this is simple: RQI - as a closed end fund - uses quite a bit of leverage. As a result, when REIT prices go up, it generally outperforms the broader REIT sector. When REIT prices fall, it generally underperforms the broader REIT sector.

The amplifying effect of leverage is further enhanced by the fact that CEFs are free to trade at deep discounts and large premiums to their underlying NAV. As a result, when REITs are in favor, RQI's share price generally trades at a higher ratio relative to its NAV, whereas when REITs are out of favor, RQI's share price generally trades at a wider discount to its NAV. Ultimately, this means that RQI is a pretty volatile instrument, negating much of the supposed diversification benefits that come from holding a large fund like RQI or VNQ for REIT exposure.

Moreover, research has shown that most retail investors tend to vastly underperform the broader market for one simple reason: they become victims of their emotions and tend to sell during volatile market crashes, thereby locking in steep losses and oftentimes missing out on some of the strongest upward moving days that the market experiences. As a result, by investing in leveraged, volatile products like RQI, chances are you are setting yourself up for long-term underperformance. In other words: retail investor beware, buy RQI at your own risk and make certain that you can continue to hold it even during violent market crashes while it is underperforming the broader REIT sector.

Another reason why we believe RQI is poised to disappoint investors moving forward is summed up in the wisdom of Warren Buffett :

Performance comes, performance goes. Fees never falter.

While RQI may like to trumpet its period of outperformance, the fact of the matter is that with interest rates having risen and likely to remain higher for longer at the same time that commercial real estate is being disrupted like seldom before , the fund is going to have an increasingly challenging time delivering attractive returns for shareholders. This will prove even more to be the case when you take into account that it charges 1.34% in fees and expenses to shareholders on top of the interest expense for its leverage.

Last, but not least, while RQI's current distribution yield of 8.75% looks attractive, it is important to keep in mind that it has been cut numerous times in the past and may not prove to be sustainable during a recession in which some of its underlying holdings may have to cut their dividends. The high leverage ratio on the fund may exacerbate the impacts of these potential cuts by even more.

Three Real Estate High Yielders To Buy Instead

Instead of investing in RQI, we believe investors would be better served by purchasing the following high-yield blue chip REITs:

• EPR Properties ( EPR ) - an entertainment focused triple net lease REIT that boasts a high and well-covered yield, trades at a steep discount to NAV, and has pretty solid long-term growth potential, all backed by an investment grade balance sheet with plenty of liquidity.
• Alexandria Real Estate Equities ( ARE ) - a very high quality life science lab space landlord that has a tremendous track record of delivering market-crushing total returns, robust dividend growth every year, and has one of the strongest balance sheets in the REIT space. It is currently priced at a deep discount to NAV and should deliver double-digit returns alongside a low risk profile.
• Simon Property Group ( SPG ) - the leading mall and outlet center landlord that owns a well-diversified and high quality portfolio of properties. Property level fundamentals are booming and the dividend is growing. Meanwhile, the balance sheet is one of the strongest in the REIT space and earns an A- credit rating from S&P. Despite all of this, the stock price is heavily discounted relative to historic averages and the dividend yield has soared to ~7.25%.
• STAG Industrial ( STAG ) - an industrial REIT with a strong balance sheet and robust growth rates that is priced at a discount to NAV. For a REIT in an in-favor sector like this that also enjoys some defensive qualities ahead of a recession, we think this is one of the most no-brainer buys in the REIT space today.
• W.P. Carey ( WPC ) - last but not least, WPC offers one of the best all-around risk-adjusted high yields in the market today, combining a very safe and growing 6.3% dividend yield with a very defensive portfolio that is increasingly focused on mission-critical triple net lease industrial properties. Moreover, it derives most of its rent from leases with inflation-linked contractual rent escalators, and its BBB+ credit rating gives it an attractive cost of capital.

Investor Takeaway

RQI certainly has an alluring investment case: a track record of outperforming VNQ over the long-term, a high monthly distribution, and the promise of security that comes from a well-diversified portfolio managed by a reputable fund manager.

That said, investors need to keep in mind that RQI's management fees are quite high and that the high yield and periods of outperformance are largely due to the very high leverage ratio that the company has assumed. While this has served RQI well in the past during periods of low interest rates and economic prosperity, we are now in a high interest rate and declining economic environment. As a result, investors are setting themselves up for a potentially wild roller coaster ride in RQI and the research suggests this will lead most retail investors to underperform over time as they allow their emotions to get the best of them during market crashes.

As a result, we would caution retail investors to do some thorough self-examination before buying RQI to ensure that you have the psychological makeup to hold it through volatile periods. Moreover, we think investors will do just as well - if not better - over the long-term by forgoing the high fees and risky leverage of RQI and simply build themselves a portfolio of blue chip REITs like those mentioned in this article. That is what we have done at High Yield Investor, and it has served us very well .

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