If you are looking for a compelling, out-of-the-box way to play the strengthening real estate sector, this closed-end fund (“CEF”) is worth considering. It offers a healthy 7.2% yield (paid monthly), it trades at a discounted price (versus its NAV), and it has a growing track record of success. Plus the real estate sector is currently attractive (we’ll explain). In this report, we review the fund strategy, holdings, leverage, expense ratio, pricing/valuation, and why we believe the opportunity is particularly compelling if you are a long-term income-focused investor.
What is a CEF?
Before getting into the details of this particular fund, it’s worth reviewing the concept of a closed-end fund. Like a mutual fund or exchange traded fund (“ETF”), closed-end funds own a portfolio of assets so investors can simply buy the fund instead of each of the underlying assets. However, closed-end funds are different because they can trade at significant premiums and/or discounts to the value of the underlying portfolio assets (this differs from mutual funds and ETFs because there are mechanisms in place to keep the price of those funds close to their net asset values “NAVs”). As such, current premiums/discounts is one of multiple highly important factors investors should consider when investing in CEF.
Overview: Cohen & Steers Quality Income Realty Fund (RQI), Yield: 7.2% (paid monthly)
Overview:
The CEF we are referring to is the Cohen & Steer Quality income Realty Fund (RQI). The primary objective of RQI is high current income through investment in real estate securities. The secondary investment objective is capital appreciation. In the case of this fund, Real estate securities include 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.
For perspective, here is a look at the recent top 10 holdings of RQI (it includes a variety of popular REITs that you may have be familiar with).
We appreciate the well-diversified nature of this fund (within the real estate sector), and you can view more detail about the current holding here.
Price versus NAV:
As mentioned, one of the most important considerations when investing in CEFs is the current premium or discount versus NAV. And in the case of RQI, it currently trades at a discount (~-2.95%, currently), as you can see in the following chart.
We greatly prefer to buy attractive funds as a discount (no a premium) because it mean we are getting access to all of the underlying holdings (and the dividends they pay)—at a discount. In some sense, it’s like buying something on sale. An in this case we can see the product (RQI) is actually quite attractive.
Use of Leverage
Another critically important factor when investing in close-end funds is whether or not they use leverage (or borrowed money). Leverage can magnify returns in the good times, but magnify price declines in the bad times. And in the case of RQI, the fund’s current leverage ratio is 25.35%. This is significant, but in the case attractive. By rule, equity CEFs are generally limited to a maximum leverage ratio of 30%. Again, this leverage can magnify price returns, and it also magnifies the income payments you receive (i.e. each dollar you invest in the fund buys you about $1.25 worth of real estate securities). We are comfortable with RQI’s use of leverage.
Fund Expenses
Fund expense ratios are another important consideration when investing in CEFs. And in the case of RQI, we are comfortable with 2.22% annual expense ratio. This ratio may seem high to some investors, but understand that the cost of borrowing (recall the fund uses leverage) is baked into this ratio, so RQI’s expense ration will likely seem high as compared to funds that use no leverage. For perspective, here is a look at a recent breakdown of the fund’s recent expenses (and as you can see “interest expense” (i.e. the cost of borrowing/leverage) makes up a significant portion of the total expenses).
Distribution History
Distribution payments to investors is one of the main reasons people own CEFs (i.e. they like the big regular distribution payments). And in the case of RQI, the current distribution is a healthy 7.2% and it’s paid monthly. You may be wondering how RQI is able to pay this large of a distribution (considering most of the underlying REITs it owns don’t pay this large of dividends), the answer is mainly the leverage. Recall, that buy borrowing money, RQI is able to magnifiy returns and distributions.
We also like this fund because historically, the majority of the distribution payments have been generated by income produced by the underlying holdings (i.e. dividend payments). This is often preferable to returning some of you own capital (“ROC”) that some funds use regularly to generate distributions (RQI uses ROC infrequently, and we are comfortable with that). From a tax standpoint, distribution types can be treated somewhat differently (for example, ROC can work to reduce your cost basis, so when you do ultimately sell you could end up with larger capital gain that expected. However, for perspective, here is a look at historical distribution breakdowns for RQI, per data from CEF Connect.
Why Real Estate? Why Now?
Some investors may be wondering, why invest in real estate and why now? Generally speaking, real estate investments are known for providing the steady income payments that many investors want, and as we saw earlier, RQI’s holding are attractive. Addititionally, some investors may be concerned about the threat of higher interest rates (because REITs rely on borrowing to fund their real estate investments). However, rates remain low and are unlikely to go dramatically higher in the years ahead. Additionally, if rates are rising that is a sign the economy is stronger—which is a good thing for businesses—including REITs. Further, REITs are one of the sectors that has not yet recovered following the onset of the pandemic. However, as re-openings and vaccine distribution continues, there are healthy opportunities ahead for REITs, this can means the price of RQI has upside from increases in the value of its underlying holdings (as well as from the possibility of a discount to NAV narrowing or even becoming a premium as investors increasingly move into strong opportunities).
Risks
Of course there are risks to investing in RQI. One such risk is simply that the discount to NAV could get wider. This would likely result in some short-term price compression, but would have little impact on the big distributions (which are quite high and quite healthy). Another risk is simply that the Real Estate sector may not perform well. There are popular narratives that all real estate businesses are dying as everything moves on line. However, this is simply not entirely true, and there will continue to be a strong need for real estate for many many many years into the future. And even though RQI is actively managed and well diversified among real estate opportunities, it is still concentrated in the real estate sector.
Conclusion
If you are looking for some big attractive monthly income payments, and investment in RQI is worth considering. We like its discounted price, prudent use of leverage, big monthly distribution payments and the real estate sector in general. We do not currently owns shares of RQI, but it is attractive and high on our watchlist.