NRO: This Real Estate CEF Is Positioned For A Recession

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About: Neuberger Berman Real Estate Securities Income Fund (NRO)
by: Power Hedge
Summary

NRO boasts a very high 9.6% distribution yield and trades at an appealing 9% discount to NAV.

The fund appears to be well positioned for a coming economic slowdown as its largest weightings are in things that will be recession-resistant.

NRO has a much higher allocation to preferreds than most real estate funds.

This cost it dearly during the Fed's interest rate hiking cycle last year.

Real estate as an asset class is a good way to preserve your wealth and generate an income.

As many of my regular readers likely know, one of my favorite asset classes to invest in is real estate. This is due both to its wealth protection and inflation-resistant qualities as well as the fact that one can derive a fairly high level of income from it by leasing it out. While there are a variety of real estate investment trusts that one can invest in to get exposure to the sector and liquidity at the same time, I personally find closed-end funds to be an even better way to play the sector. This is because these entities give you access to a diversified portfolio of real estate investment trusts and usually boast higher yields than any of the trusts do. One of the best real estate-focused closed-end funds is the Neuberger Berman Real Estate Securities Income Fund (NRO), which will be the topic of the remainder of this article.

About The Fund

According to the fund's web page, the Neuberger Berman Real Estate Securities Income Fund has the primary objective of generating a high level of current income with a secondary objective of delivering capital appreciation. The fund looks to achieve this goal by investing in securities issued by real estate investment trusts. The fund's management defines this as being exclusively equity securities such as common and preferred stock. This definition is similar to that of other real estate funds, such as Cohen & Steers Total Return Realty Fund (NYSE:RFI), although NRO has a much higher percentage of its portfolio allocated to preferred stock than the 15% that RFI has:

Source: NRO Fund Fact Sheet

At first glance, the 35.7% weighting that NRO gives to preferred stock seems a bit high. However, there are a few advantages to this. The first is that because preferred stock pays a fixed dividend, it is somewhat more resistant to an economic slowdown than common stock. This is due to the fact that real estate companies might be forced to cut their common stock dividends in a severe economic contraction but will be less likely to cut the dividend on their preferred stock. In addition, because preferred stock does not usually have the same potential for capital gains that common stock does, it usually carries a higher dividend yield. This is just the kind of thing that would appeal to a fund focused primarily on income.

We also see something of a defensive stance across the fund's entire portfolio. This is most obvious by looking at the weightings that the fund has allocated to each of the different real estate sectors:

Source: NRO Fund Fact Sheet

As we can see here, the fund's largest allocation is to infrastructure REITs, a category that includes things like cellular tower REITs. In fact, the fund's two largest holdings are Crown Castle International (CCI) and American Tower (AMT). These companies are likely to be fairly recession resistant since it does not seem likely that people will stop using cellular devices (and by extension cellular towers) should the economy slow down. Thus, it seems likely that these companies will see limited impact from an economic slowdown.

The same comments also apply to hospitals and apartment REITs, the other two largest sectors in which the fund is invested. This should be quite obvious in the case of hospitals as people do not stop needing medical care just because the economy slows down. In addition, most hospitals have very long-term leases with their landlords that are unlikely to expire during any economic slowdown.

It may be a bit harder to see how an apartment REIT would be resistant to recessions until we consider the fact that people will always be in need of a roof over their heads and a place to live. In lean times, people will generally do everything that they can to ensure that they pay the rent. There are many other luxuries that will be cut back on first. In addition, during hard economic times, we may also see people leaving rental houses and moving into apartments to save money. These factors mean that an owner of an apartment building will be much less exposed to the effects of an economic slowdown than the owner of shopping malls, for example.

Thus, it certainly looks as though NRO has positioned itself in order to ride through any potential economic problems on the horizon. This fits in with the management's concerns that slowing global growth, turmoil in Washington, and trade tensions between the United States and China could derail the strong U.S. economy. We certainly saw the early effects of the escalating trade tensions on Monday of this week. Should this problem get worse, NRO may be better positioned to protect its investors than some other real estate funds.

Why Invest In Real Estate?

A few weeks ago, I published an article to this site recommending that all investors have at least some exposure to gold (PHYS) as a way to protect their wealth. This view comes about due to the near certainty that the U.S. government or Federal Reserve will need to engage in some form of money printing to cover the expected permanent government deficits along with the looming unfunded liabilities from the major entitlement programs (along with any new ones). This would cause inflation as ever larger amounts of money is chasing after a finite quantity of goods and services produced by the economy. Gold would also benefit from this due to the fact that there would be a growing amount of money buying it.

Real estate would also benefit from this. Like gold, there is only a finite quantity of land available so it too should see its value increase due to the increasing supply of money chasing after it. Real estate also has an advantage over gold too in that it can be leased out to other people and so can produce a high level of income. This may make real estate preferable to gold for someone that is both looking to protect their wealth and earn an income from it.

Distributions

As already mentioned, the primary objective of NRO is the generation of current income for its investors. As such, one might expect that the fund would boast a high distribution yield. This is indeed the case. The fund currently pays a distribution of $0.04 per share monthly, which gives it an appealing 9.6% yield at the current price. The fund did pay out $0.045 per share monthly last year so the current distribution is following a cut that it made at the end of the year, but in 2017 and before, it was at the current level or lower.

The reason for the cut was actually the high exposure to preferred stock. As preferred stock typically moves inversely to interest rates and is quite sensitive to interest rates due to its perpetual duration, the fund took hefty losses from the Federal Reserve's interest rate hikes last year. While I am hesitant to predict the central bank's policy, it seems unlikely that we will see further interest rate hikes in the future. This conclusion is drawn from both the comments from the Board of Governors and the fact that the bank likely wants to avoid more market carnage like we saw in the fourth quarter. In fact, should the economy soften, interest rate cuts become more likely. Thus, the fund will probably be able to avoid another distribution cut caused by another scenario like this.

Valuation

As is always the case, it is critical to ensure that we do not overpay for any asset in our portfolio. This is because overpaying for any asset is a surefire way to ensure that we generate sub-optimal returns from that asset. In the case of a closed-end fund like NRO, the usual way to value it is by using a metric known as net asset value. Simply put, a fund's net asset value is the present market value of all of the assets in the fund minus any outstanding debt. It is therefore the amount that an investor would receive if the fund was immediately shut down and liquidated.

Ideally, we want to purchase shares of a fund when they are trading at a price that is below net asset value. Fortunately, that is the case right now. As of May 13, 2019 (the latest date for which data was available), NRO had a net asset value of $5.49 per share. This compares to its current market price of $5.00 per share, which gives it an appealing discount of 8.93% to net asset value. Thus, an investor buying the fund at today's price is essentially acquiring the fund's assets for quite a bit less than they are actually worth, which is always nice.

Conclusion

In conclusion, real estate has a place in the portfolio of any investor that is looking to protect their wealth and produce an income. The Neuberger Berman Real Estate Securities Income Fund is a good way to do this, even though it was forced to cut its distribution last year. The fund appears to be well positioned to weather any coming economic weakness, which could prove to be a good thing. Finally, it boasts a very appealing yield and trades at quite a reasonable distribution. It therefore might be worth considering.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.