This article was first published on November 7th, 2019.
The Cohen & Steers Quality Income Realty Fund (NYSE:RQI) has been enjoying some incredible returns in 2019 so far. The total market return for the fund is up a whopping 51.98%, with NAV showing a total return of 33.16%. We have seen the discount evaporate in 2019, entering into premium territory. This premium territory is almost unheard of for RQI. This monster performance for 2019 was fueled by a search for yield and being invested in the defensive sector of REITs.
Even with this incredible performance, shares have seemed to turn the other way on us over the past couple of weeks. The market price for RQI peaked for the year at $15.95 per share, with an NAV price of $15.46. This gave RQI a premium of 2.79% on the October 21st peak. At the CEF/ETF Income Laboratory, we have recently just picked up shares of RQI on October 28th in our Income Generator portfolio. (A friendly reminder that our Income Generator portfolio is on absolute fire YTD performance-wise; we are sitting at a 28.42% return at the end of October!) We picked up shares of RQI via a swap opportunity that was presented by selling the Cohen & Steers REIT & Preferred Income Fund (RNP).
In fact, there is still an opportunity here for members to make the swap, even if you haven't done so yet. Although, RNP is quite a solid fund in its own right, so holding on is quite acceptable as well. I have personally held onto my position but added to RQI. Perhaps taking that route of just adding funds to RQI at this time may appeal to some other investors too.
RQI is a sizeable fund with $2.1 billion in total managed assets. Although, 21.72% of those assets are through its leveraged borrowings. This leverage is 85% fixed-rate, with the remaining 15% at a variable rate. The average rate for its financing is 2.9%, with the average term of 2.9 years. This can be seen as positive, as its leverage costs won't move too much for several years. However, this could be a negative, as interest rates have come down a bit since the fund has entered these agreements. RQI charges 1.32% for a baseline expense, and when leverage expense is included, we arrive at a 2.17% total expense ratio.
The fund's primary investment objective is "to seek high current income through investment in real estate securities." It has a secondary objective of "capital appreciation." It includes that "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 trust (REITs) and similar REIT-like entities."
The main focus I wanted to present today was on why we shouldn't be too concerned with the recent rout we have seen in shares of RQI. Indeed, shares did drop from that October 21st high of $15.95 to $14.83, equating to just over a 7% haircut for the shares. However, that still gives us almost 52% on a total YTD return basis. I also don't believe that we are necessarily at a resolution between the U.S.-China trade war. This is even after a "phase one" deal is being touted. In fact, it is reported that they are still working out the final "terms and venue." I do want to remain optimistic that a resolution can be accomplished, but I will believe it when both sides make good on their promises. This makes the REIT sector still an attractive investment. Even with or without a trade deal, REITs can be an attractive place to put money to work, but the defensive nature makes them more appealing during periods of uncertainty. Additionally, RQI is all U.S. domestic-based holdings, making it even more stable.
Lower treasury yields have also sent investors on a search for income - that hasn't gone away either. The 10-year treasury has given some of its gains back recently too, but we are still at 1.83%, according to CNBC at the time of writing. This should be favorable to REITs in general and, in turn, RQI itself.
Looking back at the past 10-year can help confirm this as well. It hasn't been a perfect correlation, but enough to see a general trend between RQI's price and the rate on the 10-year treasury. This close, but not perfect, correlation is about what we should expect as well.
Additionally, we shouldn't expect to see anything different from rates, as we have a long history of declining 10-year treasury rates and a Fed Funds rate that we shouldn't expect to see increased anytime soon. This is why income-producing investments like REITs and CEFs should add appeal to most investors. This could change and we could start trending higher, but from looking at these charts, I wouldn't expect it anytime soon personally.
In the U.S., we have a large wave of baby boomers that are entering retirement as well. Baby boomers are considered those born between 1946 and 1964. The median amount that a baby boomer has saved is $152,000. That is not nearly enough. I believe that we will see investments alternatives such as CEFs become far more utilized when trying to plan for retirement income. Although, even an 8% distribution rate on $152k is only just over $12k/annually. That isn't nearly enough either, but thinking of the comparison to the 10-year treasury yield sub-2% is even worse. To be optimistic, let's calculate it for a 2% yield - we arrive at just $3040.
All these factors lead me to believe that RQI should be a great choice over the short and long term. Cohen & Steers has been a fantastic REIT fund sponsor. This recent pullback in share price is also helpful for those looking to enter the fund, even at these valuation levels. The fund currently sits at a premium of just 0.54%. As the fund has been being pushed to elevated levels, the average discounts have also been rising. We are looking at a 6-month average of -0.67% and a 1-year average discount of 4.48%. This has led the z-score to still be overvalued at current valuations but not off the chart as we have recently seen with the 1-year z-score at 1.10.
The main reason I believe we are seeing a drop in shares is mainly the fact that investors are taking profits. Essentially, that is what we did when we sold RNP at the CEF/ETF Income Laboratory. We took our profits in RNP and reinvested them into RQI to grow shares through our "compounding income on steroids" method.
In general, I believe that is what the whole sector is feeling at the moment as some of the air is being let out of this defensive rally we have experienced in 2019. There has been a sharp move into the more cyclical sectors. Mainly we have seen sharp moves higher in the financial sector as represented by the Financial Select Sector SPDR ETF (XLF). I believe the chart below helps to put things into context in a visual way.
The same U.S.-China optimism, I believe, is a driving factor into the more cyclical names and away from the defensive sectors such as REITs as I touched on above. This chart can also help enforce why we constantly go on and on about diversification in one's portfolio (I knew I could find a way to fit in the importance of diversification.)
We can also take a look at the fund's top 10 holdings and see how they have been faring recently as well. Remember, the NAV has also been dropping along with RQI's market price, so we should anticipate quite similar charts when taking a glance.
(Source: RQI website)
The top two holdings are 5G plays, being that they operate as tower REITs: Crown Castle International Corp. (CCI) and American Tower Corporation (AMT). The primary emphasis on these two companies is the 5G that is being deployed around the world, lauded as the next big breakthrough in cellphone technology. This new technology isn't just solely to help lower latency and increase speeds in cellphones though. This may be the tech that we need for autonomous cars and drones to operate safely and en masse. These devices and products will need to make communication in milliseconds to avoid accidents with other devices, buildings and humans.
This important technology has been reflected in CCI and AMT's share prices. Looking at the last 1-year period may not look that spectacular but still beating the S&P 500 SPDR (SPY) 1-year returns of 14.32%. CCI shows a 1-year price return of 33.58% and AMT is giving us a return of 20.63%.
We do see a similar drop in share price like RQI has experienced, as we should have expected. For the reasons I stated above, I believe this decline is only a pause for the sector as a whole.
However, looking at a bit longer-term of a period, we really have seen these two companies reflect expected 5G returns.
The last 10-year period has seen price returns absolutely trounce the returns of the broader market, as represented by SPY.
That's just their price returns too, not including the dividends that these companies have been shelling out and growing.
(Source: Seeking Alpha)
We can see that CCI has been growing its dividend for the past 5 years. The raises have come from the standard annual increases. AMT is a bit more exciting, as its dividend has been rising at a significantly healthier clip, and beyond that, the company has been raising it every quarter for most of that time.
(Source: Seeking Alpha)
Of course, these increased dividends get paid out to RQI and then paid out to us as investors. In general, while these growing dividends are nice, their dividend yield is quite low. CCI comes in with a dividend yield of 3.58%. AMT has a dividend yield of only 1.83%, and that's after increasing it every quarter. The fact is, these two names, in particular, are acting like growth stocks almost and not the defensive REITs that we would traditionally see.
RQI can mainly provide a higher distribution rate of 6.47% by utilizing leverage and capital gains. Although, the NII for RQI seems to have been slightly increased for the most part of the last 4 years. It did dip a bit in 2017, but that is probably a product of portfolio composition. As a CEF, it can be changing its portfolio constantly; RQI had a portfolio turnover rate of 26% in 2018.
(Source: Annual Reports, Author Compiled)
RQI is invested primarily in equities, so we should expect to see that a large portion of the distribution comes in the form of capital gains. As of the fund's latest fact sheet, it shows 83% in common and 17% in preferred & fixed income. There is a risk here that during a downturn that lingers for years, we could see a strain on the distribution. However, I don't personally see a 2008/09 period happening again. If and when we do get a recession, it will more than likely not be such widespread panic.
Overall, we have seen a tremendous performance with RQI for 2019. The recent pullback that RQI is experiencing I believe is temporary, and there is no need to panic. If you purchased shares at the peak on October 21st of this year, then I see no reason to panic at this time. In fact, you may even be able to add shares, as the fund has dropped 7% since that high. RQI is seeing valuations that it hasn't seen in years, but I believe the environment is conducive to the space that RQI is invested in.
The distribution from RQI should be well-supported through continued growth in its underlying holdings, through NII and capital gains. With any equity fund, there is a risk that its distribution may become strained if there is a long period of a slowdown. However, I don't see such a widespread panic as we witnessed in 2008/09.
Should we see continued weakness in the shares of RQI, then I believe that would be further buying opportunity! When I first covered RQI over a year ago, I felt like the fund was "rich" at around a 2% discount. Now, I feel like it is a good buy at a slight premium. My feelings have changed due to the environment and a slight personal shift in investing approach. I'm starting to put more weight in quality CEFs such as RQI in general. This is while still maintaining a diversified portfolio.
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Disclosure: I am/we are long RQI, RNP. 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.