2023-04-22 02:59:56 ET
Summary
- RQI is a real estate focused investment fund.
- It pays an attractive 8.3% distribution yield.
- Historically, the RQI fund performs very well during expansionary economic periods, but very poorly during economic weakness.
- As there is a high probability of a recession in the coming months, I recommend investors stay on the sidelines for now on RQI.
The Cohen & Steers Quality Income Realty Fund ( RQI ) aims to provide high current income through investments in REITs and related securities.
With a pending recession on the horizon, I recommend investors stay on the sidelines on this fund. However, if and when economic fundamentals make a turnaround, I believe the RQI fund can perform very well, as it has historically delivered very strong returns during economic expansions.
Fund Overview
The Cohen & Steers Quality Income Realty Fund ("RQI") aims to provide high current income through investments in real estate securities, including bonds, common stock and preferred shares issued by real estate companies including REITs and similar entities.
The RQI fund may use leverage to enhance returns and had 30% effective leverage on $2.4 billion in managed assets as of December 21, 2022. The RQI fund charged a 1.91% expense ratio to common shareholders.
Portfolio Holdings
Figure 1 shows the sector allocation of the RQI fund. Although its holdings are real estate securities, it is broadly diversified amongst the various sub-sectors within real estate. The fund's largest sector exposures are Industrials (11%), Infrastructure (9%), Apartment (8%), Health Care (8%) and Data Centers (8%). The fund also holds 12% in corporate bonds and 8% in preferred shares.
Figure 2 show the top 10 holdings of the fund, which account for 49.0% of the portfolio.
Distribution & Yield
The RQI fund pays a managed distribution currently set at $0.08 / month which annualizes to a 8.3% distribution yield. RQI's distribution is funded from a combination of investment income and long-term capital gains (Figure 3).
Figure 3 - RQI has funded distribution from NII and realized gains (RQI annual report)
Returns
The RQI fund's historical returns are shown in Figure 4. It has 3/5/10/15Yr average annual returns of 14.6%/8.0%/7.9%/6.5% respectively to March 31, 2023.
On an annual basis, the RQI fund had performed well in the past decade, with several eye-popping return years including 36.7% in 2014, 34.9% in 2019, and 47.7% in 2021. Unfortunately, the fund also suffered a notable slip-up in 2022, returning -26.9% (Figure 5).
What Happened In 2022?
Within RQI's portfolio, retail-focused REITs outperformed as consumer discretionary spending remained strong in 2022. However, security selection in both free standing REITs and shopping center REITs detracted from returns. Hotel REITs within RQI's portfolio also outperformed on the re-opening of the economy after the COVID lockdowns.
Health Care REITs, a relatively large weight in the fund, was a positive contributor as improved senior housing occupancies translated into higher rents, however security selection again detracted from returns.
Data center REITs were caught up in the broad technology selloff while industrial REITs also suffered declines. Infrastructure lagged due to higher interest rates, FX headwinds, and churn. Residential properties lagged on concern around softening rental and leasing rates.
Reading through the fund's 2022 commentary, the two unifying themes on RQI's poor performance was a rise in interest rates due to the Fed's fight against inflation and a slowing economy dragging down lease/rate expectations.
What Is The Outlook For Real Estate For The Rest Of 2023?
With a calendar quarter now completed for 2023, has economic prospects improved and is the RQI fund now a buy?
Unfortunately, I believe the answer to the above question is a solid no. Not only has economic prospects for real estate companies not improved, they have in fact gotten worse.
First, on interest rates, the Fed has continued raising interest rates in 2023, albeit at a slower pace of 25 bps per meeting so far in February and March (Figure 6).
Figure 6 - Fed has raised at 25bps cadence in 2023 (federalreserve.gov)
However, looking forward, market participants widely believe the Fed will raise interest rates just once more in either May or June (Figure 7).
Before investors rejoice, the reason market participants believe a Fed pause and rate cuts are imminent is because they foresee the U.S. economy falling into a recession in the coming months.
For example, the Conference Board , a global non-profit think tank, estimates the probability of a U.S. recession at 99%, a near certainty (Figure 8).
Figure 8 - U.S. recession probability at 99% (Conference Board)
Although other economists are more conservative, there is a wide consensus that the probability of a U.S. recession in the coming months is very high. Even the Fed's own staff economists are projecting "a mild recession starting later this year, with a recovery over the subsequent two years," as they wrote in the latest FOMC Minutes.
Signs Of Economic Slowdown Abound
Looking through the economic fundamentals, it is not hard to see early signs of a pending recession. For example, the latest U.S. retail sales released on April 14th showed retail sales fell 1.0% in March, following a 0.2% decline in February. Historically, back-to-back declines in retail sales are rare and typically associated recessions (2000/2001,2008/2009, 2020). In fact, U.S. retail sales declined in 4 of the past 5 months and 6 of the past 9 despite high inflation that should have boosted nominal sales figures (Figure 9).
Figure 9 - Retail sales show worrying trend (Census.gov)
Weak retail sales may act as a headwind for retail-REITs like Simon Property Group ( SPG ) and Realty Income Corp ( O ) that have suffered modest declines YTD (Figure 10).
Figure 10 - Retail REITs have suffered declines YTD (Seeking Alpha)
Furthermore, U.S. manufacturing activity has been in contraction since late 2022, as evidenced by the ISM Manufacturing PMI (Figure 11).
Figure 11 - U.S. manufacturing activity in contraction (ismworld.org)
Weak manufacturing could weigh on industrial REITs, as there may be less demand for industrial buildings like warehouses and factories.
Finally, with companies announcing mass layoffs seemingly by the day, the hardest hit real estate sector continues to be Office, as evidenced by the steep double digit declines in YTD performance by Vornado ( VNO ) and its Office REIT peers (Figure 12).
Figure 12 - Office REITs hit especially hard (Seeking Alpha)
Fortunately, Office REITs is not a big weight in the RQI fund, however, it does speak to the weakness in economic fundamentals.
RQI vs. IYR
One thing I like to do when analyzing investment funds is to compare active funds like the RQI against passive ETFs to see if a given fund's strategy delivers any active alpha.
Comparing the RQI fund against a passive ETF like the iShares U.S. Real Estate ETF ( IYR ) using Portfolio Visualizer, we can see that the RQI fund has delivered a higher CAGR return of 9.1% vs. 8.0% for IYR (Figure 13) since RQI's inception in March 2002.
Figure 13 - RQI vs. IYR (Author created using Portfolio Visualizer)
However, investors should note that the RQI fund has more risk, with a volatility of 34.6% compared to 20.9% for IYR. Furthermore, the RQI fund suffered a mind boggling 88% drawdown during the Great Financial Crisis, which should give investors some pause.
Overall, I think the RQI fund is a high beta real estate investment vehicle that 'swing for the fences'. When economic prospects are good, investors are rewarded with superb returns like 34.9% in 2019, and 47.7% in 2021. However, when economic prospects are poor, the RQI fund can also do incredibly poorly.
Conclusion
At the current juncture, I believe the downside risk outweigh the upside risk to the RQI fund, so I recommend investors stay on the sidelines. However, if and when economic fundamentals make a turnaround, I believe the RQI fund can be a solid contributor to a well-diversified portfolio, as it has historically performed very well during expansionary economic periods.
For further details see:
RQI: Patience Required For This 'Swing For The Fences' Fund