- After trading flat for almost three years, REITs are cheap with relatively low FFO multiples, discounts to NAV, and high dividend yields.
- Irrational fears of interest rate hikes have affected share prices while fundamentals remain very solid. Expect FFO to keep on growing, and dividends to continue to increase.
- With the U.S. economy continuing to fire on all cylinders, there are many reasons to be bullish on the sector.
- Most importantly valuations are very appealing relative to other asset classes.
- If you are looking for high yield without the associated work from managing a diversified portfolio, you may want to consider investing in this best-in-class high-yield REIT closed-end fund.
- Members of my private investing community, High Dividend Opportunities, can follow this idea, as well as my other top picks with access to my model portfolio. Start your free trial today >>
This report has been produced together with High Dividend Opportunities author Jussi Askola.
Property REITs are one of the safest asset classes to be invested in simply because they invest in real estate. Historically, this is a lower volatility sector which has outperformed almost all asset classes over the long term. Today, Property REITs are still very cheap, offering a great buying opportunity to achieve high yields in addition to long-term capital gains.
REITs: Big Dividends Sold on the Cheap
Who is happy with a 1.78% dividend yield? Certainly not income seekers. This is why at High Dividend Opportunities, we put a greater emphasis on investing in sectors which we believe to have a significantly higher dividend yields relative to their risk profile, growth potential, and valuations. Today, as we enter the second half of 2018, we remain very bullish on the REIT sector which appears to be one of the sectors that has much more to offer than the broader equity markets over the next few years.
- REITs own a diversified portfolio of real estate properties - generating steady and growing income from long rental contracts. The risk profile is thus lower than average, and shares have historically been less volatile.
- The average dividend yield of REITs (VNQ) is more than 200% higher than the S&P 500 (SPY) at 4.3%. That said, we have been able to identify many interesting opportunities with yields well above 6% in the recent months.
- While several equities (notably technology stocks) sell at historically elevated valuation multiples, REITs are relatively inexpensive with moderate multiples and even discounts to NAV. This is largely due to interest rate fears which are mostly unwarranted based on the current macroeconomic environment.
- Fundamentals of REITs are overwhelmingly positive with rents, net operating income ("NOI"), funds from operations ("FFO") and dividends growing. The recent tax reforms are expected to provide an additional boost, and yet the valuations remain opportunistic after three years of massive underperformance:
Now after experiencing such an under-performance in 2015, 2016 and even 2017, we have started to see a reversal in trend that we believe is set to continue for many years. First, the earnings reports of most Property REITs during the year 2018 has been nothing but stellar. Higher interest rates did not only have little effect on profitability, but growth in earnings and "funds from operations" are clearly there. After all, REITs have historically been strong outperformers, especially during periods of economic growth such as today - generating an average annual return of 12% during the last 40 years.
Current Low Valuations = Opportunity
The recent underperformance puts REIT valuations at up to a 7% discount to NAV compared to a 2-3% historical premium - a strong signal that REITs are now cheap and set to outperform in the subsequent periods.
Source: Lazard Real Estate
But why are REITs priced so cheaply in the first place? The REIT market fears interest rate hikes… But is Mr. Market right?
Fears are Overblown
Despite having historically performed very well during times of rising interest rates, investors today stubbornly claim that REITs cannot prosper in such conditions. Because of this perception, Property REITs have sold off each time there's talk about potential interest rate hikes.
We always find it intriguing at how investors pay so much attention to such small macro events. Is a 25 basis point rate hike really going to have a material long-term impact on your investment?
Studies from NAREIT have demonstrated that share prices of listed equity REITs have more often increased than decreased during times of rising interest rates. In the 16 periods since 1995, when interest rates rose significantly, equity REITs generated positive returns in 12 of them.
The reason for that outperformance is due to the fact that the performance of REITs have more to do with the state of the U.S. economy, and less to do with interest rates. Therefore, when interest rates rise as a reflection to changes in the level of economic activity to a stronger one, Property REITs tend to prosper. The reason is that a better economy results in a higher occupancy, rent growth and overall superior business fundamentals for REITs. Therefore, a conservatively financed REIT with low levels of variable interest rates is set to just outperform over time, regardless of small changes in interest rates.
This does not mean that REITs will never suffer from interest rate increases. If interest rates are increased sharply and at a fast pace, it could cause an economic recession. This would certainly harm REITs as demand for real estate during recessions fall and rents stagnate or even decrease. But this is not a REIT-specific risk. All income-producing assets, including stocks, are affected by recessions and higher interest rates.
To sum up, we believe that the interest rate fears are overblown because:
- Increasing interest rates is a sign of a strong and expanding economy - which results in NOI growth for REITs.
- Equity REITs have on average a debt ratio of "only" 31% with the rest being equity capital. This is a pretty low debt level for this sector in general.
- The great majority of REITs' debt is fixed-rate long term debt - so any rate hike may not have a direct impact on the interest cost.
- History has proven that REITs can perform strongly in times of increasing interest rates.
If you are still not convinced, perhaps the following example may help you: From July 2004 until June 2006, the Federal Reserve hiked interest rates from 1.25% to 5.25%. Anyone would agree that this was a very material increase that we are unlikely to see today. According to the consensus belief, this should have been a horrible time for REIT investors, yet REITs significantly outperformed the broad equity market:
This is proof that REITs can not only "survive" interest rate increases but also even prosper and outperform in these periods. While investors were "panicking," REITs returned more than 48% over that time period while the S&P 500 only generated 18%. This is because REITs are NOT bonds. REITs are real estate, and as such, they are able to generate profit growth that often more than compensate for the increased interest expense.
Based on our long experience in this market, we expect REITs to outperform in the long run, and we plan to benefit from it.
High Yields from REITs with Closed-End Funds
We have in the recent quarters been actively presenting many individual REIT opportunities at High Dividend Opportunities. A few examples include Iron Mountain (IRM), Lexington Property (LXP), and Ventas (VTR). We do however realize that many retail investors have no interest in trying to manage a 20-plus REIT position which can be time consuming and stressful. Yet, many income investors want high yields through diversified funds, so we are here to present alternatives within the REIT "closed-end fund" ("CEF") space.
REIT CEFs are attractive to income investors because they provide instant diversification and lower price volatility than investing into individual stocks. Additionally, the vast majority of equity REIT CEFs pay attractive yields on a monthly basis, providing a timely solution for those looking for a regular paycheck. There are many metrics to look at when assessing a property REIT CEF, some of the main ones include:
- The fund's strategy and holdings
- Leverage level and other key risks
- Valuation and current yield
- Track record and management fees
- Allocation to preferred shares
One of our latest top picks among REIT CEFs was published exactly one year ago, and the results already have been satisfying:
Our pick, Aberdeen Global Premier Property (AWP) - with a yield of 9.4% - outperformed the passive Property REIT Index (VNQ) by 2 basis points on a total return basis - while paying higher dividends and providing valuable diversification to international markets. AWP is unique in a sense that it provides good exposure to real estate in international developed markets including Japan, Germany and the United Kingdom. AWP allocates about 50% of its holdings to non-U.S. REITs. We think that AWP remains a good pick for REIT investors seeking high monthly income from a diversified CEF with global exposure.
Today we seek to highlight another low-risk property REIT CEF that complements AWP and which is very opportunistic and suited for conservative income investors. It is the Cohen & Steers Quality Income Realty Fund (NYSE:RQI) - yield 7.6% - and we believe that it's set to outperform.
Best-in-Class Property REIT CEF Yielding 7.6%
Cohen & Steers Quality Income Realty Fund is a REIT CEF just like AWP, but instead of investing in international REITs, it solely focuses on the U.S. market. Given the recent underperformance of U.S. REITs, we like to maximize our exposure to this particular market to benefit the most from any reversal in market sentiment.
We also note that, more generally, RQI is a higher-quality REIT simply because of its management team. Cohen & Steers (CNS) is a true pioneer in REIT investing and was one of the very first active asset managers to specialize in this particular asset class. It has historically proven to be able to add value and develop strategies that can and had outperformed passive REIT indexes. Furthermore, the outlook of U.S. Property REITs is very solid as many properties of these REITs today still trade at their lowest valuations in years.
Cohen & Steers, just like any other active manager, may suffer from periods of underperformance, but overall its track record has been very favorable with its premier fund outperforming passive indexes since 1991.
Source: Institutional Investor
Cohen & Steers Quality Income Realty Fund follows a slightly different strategy, but the potential value added in active stock picking remains there. This specific CEF has for a primary objective to generate high current income and to secondarily seek capital appreciation by investing in the higher-quality spectrum of REITs and other real estate securities.
We like this strategy because:
- Despite mostly investing in more conservative REITs and using moderate leverage, the CEF is currently able to pay out a monthly 7.6% dividend yield.
- The fund utilizes a 24.5% leverage ratio which, not surprisingly, may result in underperformance when Property REITs are out of favor, but also outperformance if and when the market sentiment improves (which we expect to happen sooner or later).
- The allocation to preferred shares and fixed income is limited at 17%. It results in a safer and more predictable income sources which may result in a more conservative dividend to the shareholders of the fund. Moreover, when considering the low cost of leverage (2.5% interest rate) to the fund, the allocation to safer income sources allows for significant spreads.
- The underlying assets and income sources are well diversified with well over 100 positions and no excessively large concentration on any specific property type or mortgage REITs.
A Closer Look at the Assets
Being macro and micro analysts with a strong focus on the high-yield space, we not only analyze CEFs at the fund-level, but also the individual holdings themselves.
Below is a list of all positions representing at least 1% of the fund's assets:
Source: Fund Complete Holdings
Here, we are pleased to see many names among the largest positions which we are bullish on. This includes Simon (SPG), Healthcare Trust (HTA), Host Hotels (HST), Sabra (SBRA), Extra Space (EXR) and to a lesser extent Equinix (EQIX) to just name a few. On the other hand, we only identify a limited number of REITs which we have a bearish stance on. This includes Prologis (PLD), Public Storage (PSA) and Boston Properties (BXP), and although we do not favor these individual REITs due to relative pricing, we do recognize the benefits of having them as part of a widely diversified portfolio.
Source: C&S Factsheet
The largest property type exposure is apartments, followed by offices and retail. Apartments fit well within the conservative investment approach as these assets tend to be relatively resilient to crises. Moreover, we like the higher weight on retail which trades today at very low average FFO multiples relative to other REIT sectors. The average expected 2019 FFO multiple of regional malls stands today at about 10, and shopping centers at ~12.6 which compares very favorably to the average of REITs as a whole at about 18.
- Cohen & Steers Quality Income Realty Fund is being managed by one of the best active managers in the REIT investment space. Cohen & Steers is a true specialist and pioneer with a track record of market outperformance. While most CEF active managers end up underperforming, C&S has a long history of value creation.
- The portfolio is fully concentrated on the U.S. market which may be set for future outperformance after substantial underperformance in the last three years. Moreover, the portfolio positions appear attractive with a solid exposure to some of the best REITs in the sector.
- The leverage is modest and the allocation to preferred and fixed income investments is strategic.
- The yield is nonetheless very significant at 7.6% and payable monthly!
So, this all sounds very nice, but at what price?
Currently, the fund sells at an 8% discount to NAV. This is about the same discount as AWP. Coming from a best-in-class management team with a solid investment strategy, we believe that this pricing is favorable for new investors. Trading far from its highs, and a historically low price/NAV, we consider this an attractive pick to play our contrarian conviction on REITs.
Given that REITs as a whole are priced at a 7% discount, and that this fund is priced at an additional 8% discount to an already discounted NAV, you are essentially getting a double discount on an attractive asset class paying off high and consistent income.
Conclusion: Undervalued sector + attractive strategy + solid management team + 7.6% yield backed by real estate + discount to NAV = Favorable risk-to-reward outcome for investors seeking high income from a diversified CEF with less volatility than individual REITs.
Markets can be moody. In this sense, REITs are today suffering from a pessimistic market sentiment that's unlikely to last. This is how opportunities are created.
Seeking high yields in oversold sectors with a constructive outlook is our specialty at High Dividend Opportunities. We consider the monthly pay of 7.6% yield to be very generous and sustainable. Property REITs tend to outperform during periods of economic growth and the economic situation today is no different. Considering that the sector is still very attractively priced, we are confident that RQI, with the double discount it provides, is set to result in both high income (yield of 7.6%) and long-term capital gains.
A note about diversification
To achieve an overall yield of +9% and optimal level of diversification, at High Dividend Opportunities, we recommend a maximum allocation of 2-3% of the portfolio to individual high-yield stocks and a maximum of 5% allocation to high-yield exchange traded products (such as ETFs, ETNs and CEFs) such as RQI. For investors who depend on the income, diversification usually results in more stable dividends, mitigates downside risk, and reduces the overall volatility of their portfolio.
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This article was written by
Rida Morwa is a former investment and commercial Banker, with over 35 years of experience. He has been advising individual and institutional clients on high-yield investment strategies since 1991.Rida Morwa leads the investing group Learn More.
Analyst’s Disclosure: I am/we are long RQI, IRM, VTR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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