In our CEF Spotlight series, we take a look under the hood of some of the most popular Real Estate Closed-End Funds (CEFs) and highlight the strengths and idiosyncrasies of these funds. We discuss eight of the most popular real estate CEFs, analyzing the critical metrics including dividend yields, performance, expense ratios, and underlying portfolio characteristics and offer conclusions on the best potential investment options in the segment.
Last week, we analyzed High Yield Real Estate ETFs. In a world of perpetually low interest rates, investors have piled into yield-oriented equity sectors to quench their voracious appetite for income under a "give me yield or give me death" mantra. High-yield real estate ETFs are especially popular, which offer juicy dividend yields of 5-9% compared to their broad-based real estate ETF counterparts yielding below 4%. We examined six ETFs including the Invesco KBW Premium Yield Equity REIT ETF (KBWY) and the Global X SuperDividend REIT ETF (SRET) and the IQ U.S. Real Estate Small-Cap ETF (ROOF).
This week, based on reader requests, we applied the same analysis to the Real Estate Closed-End Fund (CEFs) universe. Like their open-end peers (ETFs and traditional mutual funds), CEFs are pooled investment vehicles that offer instant diversification, and like ETFs, are traded intraday on an exchange, but that's largely where the similarities end. While CEFs are generally significantly more expensive and less tax-efficient than their ETF counterparts, the CEF structure does enable the fund to use leverage to amplify returns - both on the upside and the downside - which can be appropriate for investments in naturally less-volatile asset classes like bonds and real estate. Below, we outline the primary differences between these three fund structures.
On Wall Street, there's certainly no free lunch. We discussed last week how high-yield REIT ETFs typically include a collection of misfits, outcasts, small-caps, and recent underachievers. In our recent report, The REIT Paradox: Cheap REITs Stay Cheap, we discussed our study that showed that lower-yielding REITs in faster-growing property sectors with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding counterparts. While higher-yielding "diamonds in the rough" certainly do exist, the evidence suggests that systematically overweighting these highly-levered and "inexpensive" names may be a losing strategy over the long term.
Unlike High Yield REIT ETFs that typically invest in riskier or troubled companies to achieve their sky-high yields, CEFs can achieve comparable yields by levering-up a relatively higher-quality underlying portfolio. While we believe ETFs are the more suitable option for the vast majority of investors, CEFs can make sense for certain investors seeking high income, active management, and are willing to pay a steep expense premium for it.
We introduce and analyze eight of the most popular real estate closed-end funds that offer dividend yields ranging from 6% to 9% and compare these CEFs to the Vanguard Real Estate ETF (VNQ). Led by the Cohen & Steers (CNS) suite of CEFs, these eight CEFs have a combined $6 billion in assets under management. These eight CEFs charge an average expense ratio of over 2.0% - well above the ETF average of less than 0.5% - but interest costs explain some of the fee premium. Excluding interest costs, these CEFs have an average expense ratio of roughly 1.4%, still steep but not terribly out of line with other actively managed mutual funds. Below, we note the dividend yields, leverage factors, and expense ratios of these funds.
While the creation-redemption process of ETFs - and its inherent tax and trading efficiencies - are one of the most investor-friendly financial innovations of the past century, the "open-end" structure of ETFs does have potential drawbacks for income-hungry investors. Because of the "capital stability" inherent with closed-end structure of the fund, funds can issue debt or preferred shares to achieve a target leverage factor. The CEF structure is also relatively more conducive to investments in relatively less liquid (and potentially higher-yielding) securities which may expand an active manager's potential investment universe. As a result, Real Estate CEFs typically hold a broader range of securities than ETFs including preferreds, convertibles, and bonds. Below, we note the portfolio characteristics of these eight funds.
In our analysis of High Yield REIT ETFs, we noted that all six high-yield real estate ETFs underperformed the more growth-oriented VNQ on a total return basis over most recent measurement periods. Consistent with the findings of our factor analysis study, over the past five years, high-yield REIT ETFs that systematically overweight lower-quality but higher-yielding equity REITs have underperformed the broad-based "core" REIT portfolios, and have certainly underperformed real estate ETFs with a focus on higher-growth (but lower-yielding) real estate sectors like the Data & Infrastructure Real Estate ETF (SRVR) and the Industrial Real Estate ETF (INDS). (Note that return figures in the below chart are cumulative total returns.)
As noted above, unlike High Yield REIT ETFs that typically invest in riskier or troubled companies to achieve their premium yields, CEFs can achieve comparable yields by levering-up a relatively higher-quality underlying portfolio, which would be more consistent with optimizing the findings of our factor analysis study. As noted below, aided by the longest bull market in history, these eight CEFs have generally outperformed the un-levered Vanguard Real Estate ETF and their high-yield real estate ETF cousins over most recent measurement periods, led by consistently strong performance by the Cohen & Steers REIT & Preferred Income Fund (RNP). (Note that return figures in the below chart are annualized total returns.)
This performance, however, comes with critical caveats. Utilizing leverage seems judicious in hindsight when the underlying benchmark has trended higher, but can make one look foolish in times of market turmoil. From peak to trough during the financial crisis, these CEFs plunged by an average of 90% compared to a relatively more reasonable - but still painful - 50-70% from their un-levered real estate ETF cousins. While beyond the scope of this report, a yield-seeking investor looking to utilize a similar strategy of "levering-up" a relatively higher-quality REIT portfolio may have more efficient do-it-yourself options to achieve similar results - like applying a margin factor to a lower-cost ETF - without the hefty additional management fees.
While we believe ETFs are the more suitable option for the vast majority of investors, Real Estate CEFs can make sense for certain investors seeking high income, access to leverage, active management, and are willing to pay a steep expense premium for it. Underscoring the increased complexity of CEFs, we only made light mention of the CEF NAV premium/discount effects, which can add another potential twist to a CEF investment strategy.
We again stress that there are no shortcuts in REIT investing and our research shows that focusing on total return and long-term dividend growth can "tilt the playing field" in one's favor. While it's easier said than done, we encourage investors to focus on more than dividend yield alone and understand REITs to be "living and breathing" organisms with an underappreciated track record of long-term growth.
For investors who absolutely need the 6-7% yield from their real estate allocation, we like the Cohen & Steers suite of levered CEFs: RQI and RNP and believe that these may indeed be slightly better options for sophisticated investors than the high-yield REIT ETFs covered in the last report, especially for tax-advantaged accounts that wouldn't benefit quite as much from the substantially superior tax efficiencies of ETFs.
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