VNQ - RFI And IGR: Updating REIT CEFs Outlook

2023-03-20 11:31:49 ET

Summary

• We had sell ratings on both RFI and IGR on our last coverage.
• The funds have seen modest improvements in their pricing.
• We think we are halfway there to a potential buy point, but we are upgrading one of these two today.

Closed end funds focusing on REITs have generally been on our "naughty" list. Generally, there is a lot that is wrong with them and while we make tactical buy decisions, they have been good funds to heap a ton of sell ratings. We talk about the macro setup today alongside two funds that we previously covered.

CBRE Global Real Estate Income Fund ( IGR ) got a sell rating from us in September 2022 as we highlighted the big risks facing this fund.

Investors rushing in here could get the double whammy of a falling price and rising discount. If IGR tries reducing leverage in that environment or cutting its distribution (which it really needs to do), things could get uglier. We would stay out of this one.

Source: A Risky Choice For The 10% Yield

The fund did get caught up in the February euphoria, but got rapidly reacquainted with gravity. It lagged the Vanguard Real Estate ETF ( VNQ ) by almost 10% since that article was written.

Cohen & Steers Total Return Realty Fund ( RFI )'s critique and sell rating two months back got a lot more protests.

And here we are with a 12.46% premium. The Z-score also looks scary. If we see the fund trade at a 5% discount to NAV (which it often has), alongside a 15% drop in the index, we could see a 30% decline dead ahead. Buyer beware. We rate the fund a Sell.

Source: A Sell Setup

RFI double timed into an identical outcome.

Both calls were successful as the funds dropped far harder than the market or benchmarks.

The Macro

The big picture here is that the Fed tightening is finally having the desired impact. That desired impact is to slow the growth of credit. The delay is of course due to the lag with which all monetary policies work. There are a few different ways to plot this data and they involve looking at changes in the Fed Funds rate, yield curve or credit spreads over time. We are showing one below which examines banks willingness to lend with a six-quarter lag. This is plotted against the 2-10 year yield curve.

While the relationship is not perfect and global policy moves can sometimes blunt the cycle, we think it will hold in the months ahead.

One additional factor that we had not considered in our initial analysis was the impact of the regional banking crisis.

Smaller banks are the lifeblood of the commercial real estate market and they have their hands full with deposits running into Treasures. According to Apollo Global Management, the regional banking crisis just added 150 basis points to the Fed Funds rate.

They are going to tighten far higher than the averages and you will see it in real estate pricing. In summary there is a lot more cap rate expansion real estate and lot more multiple compression for REITs ahead.

IGR-Setup & Verdict

The IGR bear thesis rested on a few different legs. The first was that the leveraged fund would be hit with a huge increase in leverage costs. This is playing out. Here are the annual expense ratios from 2021.

Here are the ones for 2022.

The fund still maintains huge leverage for this stage of the cycle.

Note that the leverage is always shown on CEF Connect as a percentage of total assets. We prefer to see this as a percentage of net assets. That gets us to 47%. That is 4700 basis points higher than what we think one should have here. In 2023 annual expense ratios should go whizzing past 3%. This is easy to visualize when you see that the fund is paying about 75 basis points over the risk free rate. So a fund with $100 in net assets and $147 in gross assets will pay about 5% interest on $47 for the year. That is $2.35 or 2.35% on the $100 of net assets. Adding in other expenses gets you near the 3.5% mark. With VNQ generating close to 4% in yield, IGR will really, really struggle to generate its 11.5% yield on NAV after expenses. Of course the idea is we need capital appreciation, but that won't come and you will have depleted a lot of NAV to pay that hefty distribution.

We are hence moving up the risk on our proprietary Kenny Loggins scale

A "Call Kenny Loggins" rating signifies a 75%-90% probability of a distribution cut in the next 12 months.

The fund has one thing going for it though. The discount has widened materially since the September article.

But the setup still remains poor and we are maintaining this at a Sell until they actually cut the distribution.

RFI-Setup & Verdict

The biggest thing RFI has going for it is the unleveraged structure.

The fund has done phenomenally well over long periods, but it still is subject to the same forces of gravity coming for the real estate sector. As we had mentioned, we were looking for a solid NAV drop alongside a 5% NAV discount. That would get us to a buy point and a 30% decline from the last article. At this point, we think we will get at least a 10% NAV discount and a further 10% NAV decline. Nonetheless, the NAV premium has gone from 12.43% to just a shade over 2%.

The last time the Z-score was at 2.74 for one year, it showed the fund was incredibly expensive relative to its own history.

We are now in very respectable territory.

A negative number signifies that the fund is cheap relative to its history.

We cannot find strong justification to press the sell rating at this premium, even though we expect negative returns over the next 12 months. We are upgrading RFI to a hold.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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