RQI - RQI: Rising Rates And A Weakening Economy Could Mean Underperformance

2023-10-18 16:00:17 ET

Summary

• Cohen & Steers Quality Income Realty Fund has been hit hard in the current rate cycle due to multiple factors.
• The CEF has consistently underperformed the S&P 500 and broader indexes over the last decade.
• Rising rates, inflation, and leverage make the CEF poorly positioned in the current economic environment.

Few types of investments have been harder hit by the current rate cycle we are in than REITs. While real estate investment trusts have done well at times in the past when interest rates have been rising, that has not been the case this time for multiple reasons.

One fairly well-known REIT fund that has been hit hard over the last 2 years has been the Cohen & Steers Quality Income Realty Fund (RQI). I last wrote about this closed-ended fund in April. I rated this fund a sell because of the deteriorating economic environment for REITs and because of how expensive the significant leverage this CEF uses has become. This fund's total returns have been negative 10.86% since I started covering this investment. Today I am updating my coverage of the Cohen & Steers Quality Income Realty Fund to strong sell. This fund is very poorly positioned in the current economic environment. Energy prices and overall inflation rates have begun to rise again, the economy continues to slow, and this CEF is still using significant leverage. This REIT's leverage ratio remains high at 32.5%.

This closed-ended fund has performed fairly well since the CEF's inception, but this REIT has also consistently underperformed the S&P 500 and most of the broader indexes over the last decade.

The S&P 500 has offered investors total returns of 197.33% since 2013, while this REIT has offered investors total returns of 110.98%. This fund has performed predictably poorly during the current inflationary period and rate cycle.

This fund's total return is negative 6.58% since price increases began to accelerate in March of 2021.

The Cohen & Steers Quality Income Realty Fund is invested 100% in real estate, 19.63% in corporate bonds, 2.62% in government bonds, and .5% in cash and equivalents. This fund uses leverage, which is why the fund has invested holdings that exceed 100% of stated capital. The current leverage ratio is 32.5%. The yield is 9.66%, the current funds under management are $1.47 billion, and the expense ratio is 2.21%. The expense ratio without including the cost interest costs related to the leverage this uses is 1.15%. This fund pays monthly distributions.

The top 10 holdings of this CEF comprise 50% of the overall investments. The largest 3 investments of this fund are the American Tower Corp ( AMT ), Prologis ( PLD ), and Welltower ( WELL ), which make up a combined 22% of the closed-ended fund. The fund holds several different types of real estate.

The fund's distributions have remained steady, but these payouts also haven't grown much in the last several years. This REIT's dividend growth rate over the last 5 years is just 4.51%.

Rising rates hurt REITS in multiple ways, and this fund in particular has more exposure to the current rate cycle because of the leverage this CEF uses. Real Estate Investment trusts tend to carry higher levels of debt, and rising rates make refinancing this debt more expensive. Increasing interest rates also make fixed-income investments that are lower risk more appealing as well. While REITs have outperformed historically in some rate cycles where interest rates are rising, those periods of time have been when the economy was much stronger than what we are seeing in the US and abroad right now. Rising rates also hurt most residential REITS since the cost to finance mortgages is higher. This rate cycle has also made the cost of the significant leverage this CEF is using more expensive too, since 19% of the financing of the leverage is at variable rates.

There are multiple signs that the economy is continuing to slow and that the current rate of inflation will likely continue to rise, rates should remain elevated for some time. The price of oil is up over 20% since June, and the conflict in the Middle East combined with the continued war between Russia and Ukraine show no signs of ending. The current conflict between Israel and Hamas also has a significant risk of becoming a regional war, which would likely cause the cost of oil to increase dramatically. Supply chain and labor shortage issues remain and are continuing to create inflationary pressures as well. Inflation rates have risen or remained constant for three consecutive months after falling for 12 straight months prior to July of this year. The Fed is likely to remain unwilling to lower rates since Powell's stated goal of 2% inflation remains well below the current rate of 3.7%.

Economic growth estimates also continue to fall as well. Fitch recently revised global growth estimates for growth in 2024, citing weakness in China's property sector and the stalling economic recovery in Europe. Rising rates have also made the cost of credit significantly more expensive, and there is a significant risk of credit defaults in sectors like commercial real estate, and the industrial real estate sector should face challenges as well. This fund has 11% of the assets invested in commercial and residential real estate, and many of the REIT's industrial holdings, such as American Tower, have also struggled as well. American Tower is this fund's largest holding, comprising 8.70% of the CEF, and this investment is down 30% using total returns just over the last year.

REITs have performed well during past rate cycles when the economy remained strong despite inflationary pressures, but that is not the current investing environment we are seeing today. With the rate of price increases falling for 12 straight months, there was some hope the current rate cycle would end sooner than many bullish on the real estate sector expected, but the recent inflation data and the new conflict in the Middle East will likely make the Fed more cautious to lower rates any time soon. While the REITs outperformed the S&P 500 and most of the broader indexes for much of the last 20 years, these investments are likely to continue to significantly underperform for some time in my opinion, and especially in the current economic environment.

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