Quality Closed-End Real Estate Fund Now Trading At A Discount

Jun.19.14 | About: Cohen&Steers Total (RFI)

Summary

Cohen & Steers Total Return Real Estate Fund is an unleveraged closed-end fund that now trades at a significant discount to its holdings of quality equity REITs.

A merger with another fund seems to have temporarily brought down the price even further below their most recent net asset value.

A dividend increase announced with the merger has brought the annualized yield up to an enticing 7.8%.

Equity REITs have rebounded nicely this year as the Fed continues an orderly taper that is not expected to cause any abrupt rise in interest rates anytime soon, like most investors were worried about last year. The benchmark index, as measured by the Vanguard REIT Index ETF (NYSEARCA:VNQ), has surged some 15% so far this year as yield seeking investors have quickly forgotten the "taper tantrum" they threw last year in dumping higher yielding securities in anticipation of rising rates as the Fed reduced its bond buying program.

So far, this widely-held consensus hasn't panned out, with central banks around the world now seemingly more concerned about possible deflation, with the ECB announcing a negative deposit rate to try to get money moving again, and our own Fed's most recent minutes showing that they're in no hurry to raise rates anytime soon.

Whether or not you agree with this policy or trust that inflation is really running below its 2% target, REITs seem to be in the sweet spot in this environment, still able to borrow cheaply, yet also able to raise rents as the economy improves. Therefore, I don't think it's too late to get in on the move in equity REITs.

However, there's a special situation in a high-quality real estate fund that I think offers a chance to buy in even cheaper. This opportunity is in the Cohen & Steers Total Return Real Estate Fund (NYSE:RFI), an unlevered closed-end fund that shares many of its top holdings with the VNQ index, as illustrated below:

Top Holdings: RFI VNQ
Company Ticker Value (Millions) % Portfolio Value (Billions) % Portfolio
Simon Property Group SPG $9.49 7.57% $3.74 8.70%
Equity Residential EQR $6.56 5.23% $1.52 3.53%
ProLogis PLD $6.26 4.99% $1.51 3.50%
Ventas VTR $5.89 4.70% $1.41 3.27%
Public Storage PSA $5.06 4.04% $1.81 4.20%
Vornado Realty Trust VNO $4.19 3.34% $1.29 3.01%
Click to enlarge

Aside from the obvious order of magnitude difference in sheer size of the fund, it is roughly constituted of similar companies, especially among its top five holdings, where it is within a couple percentage points of most of the index holdings. Therefore, we might expect its performance to closely track that of the index.

While the NAV has indeed kept pace with the benchmark with an increase of just under 15%, the fund's price has lagged dramatically, staying nearly flat on the year. This has resulted in a wider than usual disparity in the fund's price relative to net asset value, with it now trading at around a 9% discount to NAV, up nearly three times its usual average discount over the past 52 weeks.

This is somewhat puzzling for a relatively straightforward, unleveraged real estate fund holding mostly the same large high-quality companies as peers. The only explanation is that the fund finally closed a merger with another of the sponsor's funds, the Cohen & Steers Dividend Majors Fund (NYSE:DVM). This merger had been announced all way back in December of last year, but after only being approved in April, finally went through last Friday.

The terms of the deal were disclosed as follows: an exchange ratio of 1.315505 RFI common shares per DVM common share. While this perhaps could have caused some concern that RFI was diluting existing shareholders by offering discounted shares as currency to acquire possibly overvalued assets from the other fund, this seems unfounded given that the exchange rate was based not on share price, but rather net asset value, meaning RFI got a better bang for its buck by basing it on the $13.40 in NAV per share rather than an average stock price closer to $12.

Therefore, issuing more shares below NAV shouldn't be as big of an issue because they were able to acquire a corresponding amount of assets in return. However, it might inject a bit of uncertainty into the asset mix of RFI, but it shouldn't dramatically change the nature of the fund, given the overlap with the top holdings of the DVM fund.

We can see that the Dividend Majors Fund appeared to be a closet REIT fund, with components very similar to a REIT index, including top holding Simon Property Group (NYSE:SPG) and several other related companies in fairly parallel weighting. Other stalwarts like the two largest, and arguably best, companies in the world, Apple (NASDAQ:AAPL) and Exxon Mobil (NYSE:XOM), round out the top ten and shouldn't cause shareholders to lose any sleep.

Also, we notice that DVM itself had also been trading at a 9% discount to NAV, which should allay any fears that it was somehow overvalued relative to its assets. Cohen & Steers management probably took notice of the discounts and the substantially identical holdings of the two funds and viewed the merger as a possible mechanism to close the gap, as well as also realize some cost savings through synergies that might hopefully result in expenses even lower than the already sub 1% expense ratio of the fund.

This hasn't materialized yet, probably mainly due to the uncertainty surrounding the merger. The discount has actually widened to more closely match that of the old fund, rather than the historic level of the new fund. However, I think this is temporary and should begin to converge closer to NAV once investors realize the minimal effect the merger will have on the asset allocation, with the holdings remaining in solid large-cap companies, mostly REITs, that are poised to continue doing well in a favorable operating environment.

Jittery investors should also take solace in some additional benefits, including a boost in the quarterly payout to 24 cents a share, good for a 7.8% annualized yield based on today's closing price. Together with some ancillary benefits that could come from forming a larger, more diversified fund, this seems like another excellent reason to own this closed-end fund and get exposure to a desirable sector at a discount.

Disclosure: The author is long RFI, AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.