Using REITs to Generate Monthly Income With Little Downside Risk

Includes: ICF, IYR, KBWY, REK
by: Matt D'Alto

In our current world of sub-1% interest-bearing money market accounts, I find myself increasingly looking for "creative" ways to boost the yield of my investable cash these days. The problem is, shorter-term bonds are generally of little help to this objective. You need to go out to at least 10-year paper today for the incremental yield to matter, and that kind of duration risk right now just doesn't seem palatable to me given I have trouble seeing the future one-year out, much less 10 years. Treasuries and corporate bonds, especially those with longer-term maturities, broadly seem somewhat overpriced to me in the shorter-term and make me nervous about investing new capital at current levels.

Certainly this thirst for yield has created some of the recent demand for higher-yielding equities. Many of higher-yield alternatives, such as REITs, have attracted investors and thus have seen yields come down over the past 18 months or so. Still, the yield spread on a typical REIT relative to a money fund remains meaningfully wide.

For the most part, I have been unwilling to be long REITs because of some of the risks I still foresee in the real estate market, which I believe the market has largely ignored because of the Federal Reserve's current easy-money policy. But until Helicopter Ben decides it is time to tighten policy, the downside risks will continue to be masked.

Even with the risk of rising rates sometime in the future, I believe I have devised a relatively low-risk strategy for investing in REITs that will allow investors to take advantage of their current higher-yielding cash flow characteristics, while protecting your downside investment risk in the event of a correction in REIT prices. And you do not need a lot of capital or knowledge about individual REITs to execute this strategy.

Review of PowerShares KBW Premium Yield Equity REIT Portfolio (NASDAQ:KBWY)

In recent months, Keefe, Bruyette & Woods and Invesco PowerShares have partnered and come to market with a new ETF called the PowerShares KBW Premium Yield Equity REIT Portfolio (KBWY). What makes this particular REIT ETF unique is that it is the only REIT ETF (at least that I am aware of) that pays its dividends on a monthly rather than a quarterly or semi-annual basis. To some, this may not be that big a deal, but personally I like the idea of earning a more frequent income stream wherever possible (something about present value that I learned in business school).

According to the KBWY prospectus,

The Fund will normally invest at least 80% of its total assets in equity securities of real estate investment trusts.

Thus, while the fund currently holds a mix of 30 smaller-cap REIT names and is not forced to be a market-cap weighted REIT index, the fund should nevertheless be relatively highly correlated with the performance of most major cap-weighted REIT indexes over time.

Based on its last monthly dividend, the annualized dividend yield of KBWY is 4.96%. This yield compares favorably with those of other popular cap-weighted REIT ETFs like the Cohen & Steers Realty Majors Index Fund (NYSEARCA:ICF), whose distribution yield is currently 3.37%, or the Dow Jones U.S. Real Estate Index Fund (NYSEARCA:IYR) whose comparable yield is 4.39%. To reiterate, both of the latter ETFs pay distributions only on a quarterly basis, making KBWY a potentially more attractive alternative investment from a cash-flow standpoint.

To be fair, the potential risk to investing in KBWY (other than the risk of investing in REITs generally) is that it is still a very new and fairly illiquid ETF. Since the beginning of 2011, this ETF has traded about 4,700 shares per day. So this ETF obviously will not be a viable alternative for traders with significant capital to put to work. But smaller investors, for example, only need to buy 200 shares of KBWY to make a $5,000 investment, given its current market price over $25/share.

I would also expect the liquidity of this product to grow with time, since it has only been a public offering since late 2010. The KBW name brand and distribution muscle behind it also gives me confidence in the product's longer-term liquidity growth and viability.

Hedge KBWY with REK

As I mentioned before, my objective is to capture the monthly cash flow stream from this REIT investment, not to bet on the upside of REITs as an asset class.

To accomplish this objective, I would pair up a long of KBWY with a long of the ProShares Short Real Estate ETF (NYSEARCA:REK). This fund's objective is to seek returns inversely correlated with the Dow Jones U.S. Real Estate Index, which is a market-cap weighted REIT index. Note that REK is not a leveraged ultra-short fund – it is "only" 100% inversely correlated, which is perfect for this essentially market-neutral income strategy.

Why go long REK, and not just pair up with a short of another REIT ETF instead? Well, you could do that. The problem with shorting any REIT ETF, however, is that you have to "pay" the fund's quarterly dividend if you are short on the ex-dividend date of that ETF. You could try to time this by getting in and out of your short before the ex-dividend date, but the commission costs of doing so may defeat the objective here, which is to earn a higher and more frequent yield on your cash. By simply going long REK, you gain an inversely-correlated hedge to your KBWY position.

In addition, REK has not had any recent distribution events associated with it, so again it protects the downside of your REIT investment, but doesn't offset any of the monthly income stream associated with being long KBWY. Finally, using a "long-long" strategy allows you to execute this pair trade in an IRA, where your monthly income can be earned on a tax-deferred basis (remember, you cannot short any securities in an IRA due to regulations against borrowing in such accounts).

Another alternative to REK is to go long a traditional open-end mutual fund called The Short Real Estate ProFund (SRPIX). This fund should largely mirror the performance of REK. The benefit to choosing SRPIX over REK is that you can buy SRPIX commission-free through many broker mutual fund distribution platforms (like Schwab OneSource). REK, however, would provide you with greater control over taking advantage of intra-day price volatility, as SRPIX is priced only once a day, at the close of the market. Either way, it's really just a question of personal preference.

Ideally, this hedged income strategy would be even better if either KBWY or REK traded options. In this way, you could enhance your income stream by writing call options against your long positions (to learn more about covered call writing, see my blog entry on the basics of this option strategy). Unfortunately, neither ETF offers option trading at this point in time.

This strategy isn't for everyone, and it doesn't provide a perfect hedge against a downturn in REITs since the holdings in KBWY and REK are not identical. But the two securities should be oppositely correlated enough to be roughly REIT-market neutral; and in the meantime, you can collect a monthly cash flow stream that currently is at least 400 basis points higher than what you can earn in your money market fund.

If any of my followers or readers have feedback or alternatives to the strategies listed above (particularly related to optionable ETFs for such a strategy), please write in your comments below – I'd love to hear them!

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in KBWY, REK over the next 72 hours.

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