2023-12-31 09:00:00 ET
Summary
- REITs and BDCs both offer big dividend yields, although BDC dividends are generally bigger and REIT prices are currently more contrarian (we share updated data on over 40 of each).
- As an alternative, we review a REIT-focused CEF offering the attractive contrarian pricing of a REIT and the bigger yield of a BDC (plus a nice discount to NAV).
- After reviewing RQI (strategy, distribution, leverage, price, risks) we conclude with an important takeaway about how we're incorporating it (and REITs, BDCs and CEFs) into our High Income NOW Portfolio.
Introduction:
If you are trying to build a monster-yield portfolio (i.e. 8% to 10% aggregate yield), you've likely considered many different categories, including real estate investment trusts ("REITs") and business development companies ("BDCs"). Both groups offer big yields (although BDC yields are typically higher) and both groups offer long-term price appreciation (however REITs seem a bit more "contrarian" right now). In this report, we review a particularly attractive REIT closed-end fund (the Cohen & Steers Quality Income Realty Fund ( RQI )) that offers the compelling contrarian opportunity of a REIT, but also the higher yield of a BDC. After diving into RQI in detail (i.e. strategy, distribution, leverage, price and risks), we conclude with information on how we are incorporating it into our own "High Income NOW" portfolio, plus our opinion on how others may want to consider REITs versus BDCs and CEFs, especially at this point in the market cycle.
REITs Versus BDCs:
REITs and BDCs are fundamentally different business models. For starters, most REITs own real estate that they lease to tenants, while most BDCs make loans to small businesses. However, both REITs and BDC often capture the attention of income-focused investors because they pay big dividends (this is because both vehicles can avoid paying corporate income taxes if they pass through most of their profits to investors in the form of dividends).
Also worth mentioning, both groups have been dramatically affected by rising interest rates, but in different ways. Rising rates slow the economy making it more difficult for many REIT tenants to pay the rent, and making it more difficult for many BDC loan recipients to pay back their loans.
To get some additional flavor on the two groups, here is data on top individual REITs and BDCs, including dividend yields, price performance, valuation metrics and more.
40+ Big Yield BDCs:
Data as of 12/28/23 (StockRover) Data as of 12/28/23 (StockRover)
( OBDC ) ( FSK ) ( BXSL ) ( MAIN ) ( HTGC ) ( OCSL ) ( CSWC ) ( CCAP ) ( SAR )
100+ Big Yield REITs:
Data as of 12/28/23 (StockRover) Data as of 12/28/23 (StockRover) Data as of 12/28/23 (StockRover)
( VICI ) ( WPC ) ( OHI ) ( PSA ) ( MPW ) ( STAG ) ( NLY ) ( AGNC ) ( SPG ) ( O ) ( CCI ) ( DLR )
You'll probably notice at least a few of your favorite REITs and BDCs in the tables above. You may also notice yields tend to be higher for BDCs, but REITs may currently offer a more attractive contrarian opportunity (i.e. the 2-year return numbers for most BDCs have been solid, while many REITs have been weak).
Specifically, a lot of REITs were hurt badly by rising interest rates over the last two years combined with secular changes (such as work-from-home and shopping online). But considering interest rates are now stabilizing and may even reverse lower (knock on wood), yet many REITs are still very hated by the market, select attractive big-yield contrarian opportunities are emerging.
One interesting way to play the REIT space, while still capturing a higher yield (the type of big yield that is more typically in the BDC space) is through a REIT-focused CEF, such as the one we consider below.
Cohen & Steers
Cohen & Steers Quality Income Realty Fund
( RQI ), Yield: 8.1%
The Cohen & Steers Quality Income Realty Fund ( RQI ) is a blue-chip REIT closed-end fund ("CEF") that offers a large distribution yield (currently 8.1%) and trades at a significant discount to net asset value ("NAV"). In the following paragraphs, we review its strategy, distribution characteristics, leverage, price and risks.
RQI Overview:
The primary investment objective of RQI is high current income through investment in real estate securities (the secondary investment objective is capital appreciation). And the fund seeks to accomplish its objectives by investing mainly in public equity REITs, as well as some bonds (recently around 12% of the fund is invested in corporate bonds) and preferred stocks (recently around 8.6% of the fund was invested in preferred stocks).
For your reference, here is a look at the fund's recent top 10 holdings, which consists of REITs, many of which you are likely familiar with (and these REITs are included in our earlier data table too).
( AMT ) ( PLD ) ( WELL ) ( SPG ) ( DLR ) ( O ) ( CCI ) ( EQIX )
And here is a look at the fund's top sector exposures (as of the most recent quarter end, 9/30/23).
As you can see, corporate bonds are the second largest at 11.58% and preferreds are the fifth largest at 8.48%.
Recent Real Estate Performance
As mentioned, the real estate sector has underperformed the market recently, as you can see in the following chart.
One big reason for the weak performance has been rising interest rates. In particular, as rates rise it becomes more expensive for REIT tenants to borrow money for operations (thereby increasing the potential risk of default).
Another reason for weak real estate performance is secular change. For example, more people shop online now (this is bad for retail real estate), and more people work from home now (this is bad for office real estate).
Worth mentioning, RQI has large exposures to infrastructure and industrial real estate. These are two sub-sectors that we like because they're arguably less impacted by the secular changes mentioned above.
Is RQI Right for You?
Before investing in RQI. it's important to recognize that it is not a REIT, but rather a CEF that own many REITs. For some perspective, here are seven important CEF questions you should always ask yourself before investing, starting with "does the fund meet my investment goals?"
Specifically, should you personally be investing in a real estate CEF? If you are an income-focused contrarian (REITs are relatively out of favor) that likes to invest in things when they trade at a discounted price (RQI trades at a significant discount to NAV, as we will discuss), then RQI might be worth considering for you.
Is the RQI distribution consistent?
RQI has paid consistent monthly distributions of $0.08 per share since 2017 (they switched from quarterly to monthly payments in 2016). Notably (but not surprisingly, the fund did reduce the distribution during the great financial crisis of 2008-2009). Nonetheless, for many investors, the recent dividend consistency is a sign of strength, especially since the distribution can fulfill important individual investor needs.
How are the distributions sourced?
Perhaps more important than distribution consistency is how the distributions are sourced. And in the case of RQI, they are being sourced from income (on the underlying holdings) and long-term capital gains (both are good).
As you can see above, RQI has not been using short-term capital gains or a return of capital ("ROC") to source the distribution payments, and this is a good thing in terms of the fund's health. Funds can get in trouble from a tax standpoint when too much of the distribution is from short-term capital gains (which can be taxed at a higher rate) and when too much of the distribution is sourced from ROC (which can jeopardize a fund's long-term ability to sustain the distribution).
Leverage (Borrowed Money)
Leverage, or borrowed money, is another important consideration when investing in a CEF because it can create risks and opportunities. For example, leverage can magnify the distribution (i.e. make it larger than would be possible without leverage), but it can also magnify losses (when the market goes down, leveraged funds go down more, all else equal).
RQI recently had 29% leverage, which is significant for a "mostly" equity fund, but also prudent (considering the bonds and preferred stocks this fund holds are usually less volatile than equities (stocks) thereby making the leverage somewhat less risky). We are comfortable with this level of leverage in this fund, and believe it makes the investment opportunity more attractive.
RQI Trades at a Discount to NAV
Another interesting characteristic of CEFs is that they can trade at large discounts and premiums to NAV. Specifically, NAV is the aggregate value of all the individual stocks and bonds a fund holds, and in RQI's case, the fund trades in the public markets at a 8.4% discount to its NAV.
Unlike other mutual funds and ETFs, there is no mechanism in place to prevent CEFs from trading at large premiums and or discounts, and this can create significant opportunities and risks. All else equal, we greatly prefer to buy attractive CEFs at a price discount (not a premium).
And as you can see in the chart above, the RQI discount is large by its own historical standards. In our view, this adds to the attractiveness of this contrarian opportunity as REITs have fallen strongly out of favor in the market thereby adding selling pressure and adding to the size of the discount.
Expenses
Expenses are another important factor when investing in CEFs in particular because they are often quite significant. In RQI's case, the total expense ratio was recently 1.91%. Important to note, approximately 1.0% of this amount is due to leverage (i.e. it costs money to borrow money). So without leverage, the approximately 0.91% expense ratio is significant, but not necessarily inappropriate (it is consistent with other funds).
Management Team
Also important to note, the expense ratio (above) includes the costs of the active portfolio management team that is selecting the individual securities and managing this fund.
The portfolio managers (above) are experienced and have the support and resources of Cohen and Steers backing them. For many investors, it makes sense to invest in a fund with an active management team to oversee the leverage, security selection and general operational management of the fund (as opposed to doing this all by yourself).
Conclusion
If you are a contrarian investor attracted to the market's current dislike of REITs (especially with interest rates stabilizing), but also prefer the higher yields offered by BDCs, you might want to consider investing in RQI. It offers both a big yield and an attractive contrarian opportunity.
In fact, we like RQI enough to rank it at #8 in our new report "Top 10 Big Yields." Incidentally, we also ranked a BDC, Ares Capital ( ARCC ), at #6 (read that new report here ).
However at the end of the day, you need to invest only in opportunities that are right for you, based on your own individual situation and goals. We believe that a prudently diversified portfolio, including REITs, BDCs, CEFs (and more) can help income-focused investors achieve their steady high-income goals.
We currently own shares of RQI in our 29-position High Income NOW Portfolio (its aggregate yield is 9.8%), and we look forward to high income and price gains ahead.
For further details see:
RQI: REITs Vs. BDCs And CEFs (Building A Big-Yield Portfolio)