2023-10-31 16:35:38 ET
Summary
- REIT investments have been impacted by higher interest rates, creating buying opportunities for investors.
- Cohen & Steers Quality Income Realty Fund and Hoya Capital High Dividend Yield ETF are two funds that offer diversified exposure to the REIT market.
- RQI is a closed-end fund that trades at a discount and employs leverage, while RIET is a non-leveraged, passively managed ETF that tracks a high dividend yield index.
Written by Nick Ackerman, co-produced by Stanford Chemist.
There is no doubt that real estate and real estate investment trust ("REIT") investments have been getting pounded by higher interest rates. However, as prices move down, the yields get "sweeter" like a Halloween treat for adults while waiting for an eventual recovery.
Today, I wanted to highlight two funds that can be a way to play this in a diversified way. That would be the Cohen & Steers Quality Income Realty Fund ( RQI ), a closed-end fund ("CEF") that allows investors to pick up shares currently traded at a deep discount. Additionally, I wanted to give Hoya Capital High Dividend Yield ETF ( RIET ) an updated look as a non-leveraged, passively managed exchange-traded fund ("ETF") way to play the REIT game.
RQI Basics
- 1-Year Z-score: -1.70
- Discount: -9.03%
- Distribution Yield: 10.14%
- Expense Ratio: 1.39%
- Leverage: 32.44%
- Managed Assets: $2.19 billion
- Structure: Perpetual.
RQI's investment objective is to provide a "high current income." They also have a secondary investment objective of "capital appreciation." They will invest in "real estate securities including common stocks, preferred stocks and other equity securities of any market capitalization issued by real estate companies, including real estate investment trusts (REITs) and similar REIT-like entities."
As the fund employs leverage, that is something to consider before investing as it also increases the total expenses of the fund. With those expenses included, we see the total expense ratio go up to 3.79%. Fortunately, the fund is hedged with interest rate swaps. So, those higher rates are being offset for the next few years. This gives the fund some time to wait for rates to come down rather than look for financing at these levels.
RIET Basics
- Dividend Frequency: Monthly
- Dividend Yield: 10.48% (SEC yield 9.99%)
- Expense Ratio: 0.50%
- Leverage: N/A
- Managed Assets: $38.51 million
- Structure: Passive ETF.
RIET's investment objective :
"is to track the performance, before fees and expenses of the Hoya Capital High Dividend Yield Index, a rules-based index designed to provide diversified exposure to 100 U.S.-list that's estate-related securities that collectively provide income through high dividend yields."
Several key features of RIET include;
- access to 100 select real estate securities paying high dividend yields
- "smooth" monthly distributions for shareholders
- real estate specialist Hoya Capital Real Estate is behind the fund
- an inflation hedge, which we all know is essential at this time.
Performance And Portfolios
Despite being a leveraged vs. non-leveraged fund, both funds have been hit equally as hard in terms of total NAV returns since the Fed began to raise rates in early 2022. This is the performance comparison between the two from the beginning of 2022 to today, which encompasses primarily when rates were moving higher.
One thing to note is that RIET isn't all that old, with only being launched at the end of 2021. While it's easy to say that this fund is "terrible" or "flawed," I'd say it has more to do with the unfortunate timing of the launch rather than it being a bad fund.
With that being said, these funds hold quite a different portfolio of REITs, with RIETs exposure being particularly poor heading into the current environment.
Since RIET screens for higher-yielding REITs during its semi- annual reconstitution and rebalance that takes place in June and December, they can often go to out-of-favor sectors. One of those places is the office space, which is currently present in the fund's top holdings. The exposure to office REITs wasn't as prevalent when the fund first launched but has increased since.
With that being said, there is a bit of a quality part of the screening that takes out highly leveraged REITs for RIET.
The Index then identifies the group of ten "Dividend Champions" by starting with the two largest companies by market capitalization in each Property Sector and selecting the one in each Property Sector with the highest dividend yield based on the company's most recent ordinary dividend. From this group of 14 companies (one from each Property Sector), the two companies with the lowest dividend yield and the two companies with the highest debt ratio are set aside, leaving ten "Dividend Champions" that will be included in the Index.
So, despite not employing leverage at the fund level, there is still plenty of leveraged borrowing exposure in these underlying portfolios.
RQI just takes that and puts it on top of the leveraged underlying portfolio. RQI is also actively managed, meaning its portfolio is subject to change at any time. As of their last full holdings list , the fund listed only one office holding at 0.48% of their fund's assets.
Here is a comparison of the performance of each fund's most recently listed top three holdings since the beginning of 2022, when rates started increasing shortly after this. As we can see, the office exposure here has been hit by far the hardest.
I had originally expected that the fund's mortgage REIT, or mREIT, exposure might be to blame for these results. However, when looking at the performance of the top three currently listed for RIET, they've actually held up reasonably well. The worst here was AGNC Investment Corp ( AGNC ) from the beginning of 2022 to date. Despite it being the worst on a total return basis of the three years, it still performed better than all but Welltower ( WELL ) listed above and essentially came in-line with Digital Realty Trust ( DLR ).
Unfortunately, we don't have a long track record to compare both of these funds due to RIET's short history. Going to the max performance metrics only gives us a couple of extra months, but for the most part, performance was still similar on a total NAV return basis.
I suspect that won't be the case over the long term, as these funds take quite different approaches. I believe it is more a function of everything being bad in the REIT space, and RIET's passive rules-based approach caused it to go into more out-of-favor sectors. Therefore, I suspect that going forward, the results of these two funds will be different, and that's why they can be a complement to each other and held at the same time for added diversification.
Given RQI's deep discount currently, that's something to consider as that makes it appealing even as a leveraged fund in this environment. I believe that is one of the main selling points of a CEF over an ETF that often trades at or near NAV on a regular basis.
Distributions
Now, the exciting part about why investors would hold these two positions in the first place is for the dividends. More specifically, it is characterized as distributions as both fund's payouts will be classified as something other than simply income.
This is the case for multiple reasons. One would be because REITs technically pay out distributions as well, despite generally being referred to as dividends.
Here is what Alex Pettee of Hoya Capital Real Estate had to say in our previous coverage when the fund launched:
Question - RIET should provide a smooth monthly distribution for income investors. Are there any set rules on when or how that should be adjusted if needed? With CEFs, they are sometimes based on a target yield but others are just "level" until otherwise adjusted.
We plan to distribute all available REIT income to shareholders - which sounds obvious but not all REIT ETFs do this, as a sizeable percentage of REIT distributions often come in forms that are not "net investment income" by definition. It's complex, but put simply, due to the non-cash impacts of depreciation, even the highest-quality and most profitable REITs will have years with negative taxable income and will have capital gains from property sales, so distributions paid will be classified as return of capital or capital gains. Some REIT ETFs will not distribute this, even though for all intents and purposes, this is part of an "ordinary" REIT dividend in my opinion as REIT analyst.
So, for RIET, we'll still see return of capital or even potential capital gains.
For RQI, that is simply part of the CEF strategy; as they hold more growth-oriented REITs, they'll rely more heavily on capital gains to fund their payout. That does mean that at some point, we need the space to reverse and see growth, or it could be at risk of cutting its payout.
That said, as a CEF, it's likely to pay out a generous distribution yield regardless, even after a cut. Similarly, because RIET focuses on higher yielders, it is also likely to continue to pay a generous distribution yield going forward as well.
Conclusion
RQI and RIET take two different approaches as well as structures, being a closed-end fund and exchange-traded fund, respectively. That said, both are attractive at this time for long-term investors, while the REIT space is ravaged by higher rates. They also both provide regular monthly distributions to investors, providing cash flows while waiting for a recovery.
For further details see:
RQI And RIET: 2 Ways To Play REITs And Get 'Sweet' Yields