- Rental properties are commonly viewed as the best investments you can make.
- However, most rental investors overestimate returns and underestimate the risk involved.
- We explain why investing in property REITs is a much better investment and carries less risk.
- A great way to invest in property REITs is through a CEF - the Cohen & Steers Quality Income Realty Fund.
- RQI trades at a 3% discount and yields 7.4%.
- Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Get started today »
Co-produced with Beyond Saving
In our report today, we will highlight one of the best listed "Property REIT Closed End Funds": Cohen & Steers Quality Income Realty Fund (NYSE:RQI), and why investing in RQI beats direct "real estate" investments. RQI currently trades at a 3% discount and yields 7.4%
Why REITs Are More Attractive Than Real Estate
It's everyone's dream to have passive income - it could be getting a monthly payment from your tenant that's renting your apartment, garage, or even your warehouse. The prices of real estate increase with time as they are biased to rise with inflation, meaning that the return on the investment is stable.
However, owning real estate can be viewed as an investment opportunity and an income generator for the wealthy. Buying real estate is a big commitment that requires a substantial amount of capital that could throw you into debt. The big barrier to entry is that buying real estate is often expensive, especially prime properties. Most of us don't have the millions needed to invest in a portfolio of industrial or luxury residential properties. Furthermore, owning rental properties comes with costs and hidden fees which are the vacancies, capital expenses, and the time-value of your work.
Fortunately, you don't have to be a billionaire to be a part owner in thousands of the best real estate properties around. You can invest in Real Estate Investment Trusts (or "Property REITs") and enjoy the major benefits of being a landlord - consistent income and long-term capital gains. You also get to avoid the major downside of being a landlord, which is holding a less liquid asset.
Many property REITs are listed on public stock exchanges, making them readily accessible and quickly bought or sold. In most cases, each REIT specializes in a specific sub-sector of the real estate industry. Some specialize in residential real estate, some to healthcare and medical centers, others to industrial properties, among others.
Buying real estate through REITs provides one of the best options for retail investors. You can invest as much as you can afford. They are easily traded and require less effort than managing a rental property. REITs reward investors with dividends that are much higher than average, while also being extremely liquid with publicly-traded shares that can be easily and quickly be sold, if liquidity is needed.
Another important factor to take into account is that when buying into a Property REIT, you also are buying the management of the properties. This removes one of the biggest hassles of directly owning real estate. No tenant headaches, no chasing after your rental check, no maintenance and renovations. And you avoid all the related stress and anxiety.
Property REITs have legal distribution requirements that they have to pay in order to maintain their REIT status. REITs are required to distribute most of their taxable income, so as they expand, these REITs will have to raise their dividends. This is why property REITs offer investors the best of both worlds, high income and long-term capital appreciation.
Investing in Real Estate through a Closed-End Fund
Real estate is a very large sector with many sub sectors as discussed above. In order to maximize your returns, diversification can play an important role. One great way to do this is through a closed-end fund. CEFs provide immediate diversification in the sector and are usually actively managed, meaning that managers will find for you the best opportunities in the space to add to your holdings, and thus maximizing your returns.
This leads us to our report today about Cohen & Steers Quality Income Realty Fund ('RQI') one of the best Property REIT CEFs, and also one of our favorites. RQI currently yields 7.4%.
Sector Diversification Through High-Quality Companies
RQI provides exposure to many real estate sectors, including healthcare and infrastructure which are among the fastest growing industries.
Source: Cohen & Steers Quality Income Realty Fund - RQI
- Allocation to "Healthcare REITs": (15% allocation to this sector). Healthcare is one of the fast-growing and safest sectors to be invested in if you are a landlord. The sector has numerous tailwinds including a rapidly-aging population. The last people who will not be paying their rent are doctors and hospitals.
- Allocation to "infrastructure REITs": (13% allocation). The infrastructure sector provides basic necessities that tend to perform well in both good and bad times. RQI is invested in REITs that provide the infrastructure for mobile data. This sector is set to be a big winner with the conversion to 5G underway.
- Allocation to "industrial REITs": (8% allocation) Industrial REITs remained in high demand throughout the pandemic. The fundamentals remain incredibly strong as e-commerce takes on a more central role in our lives.
- Allocation to "preferred stocks": (10% allocation) I like the allocation to preferred stock. It provides a high income with lower price volatility. This is a good hedge that management uses to lower the price volatility of RQI.
The managers of RQI target the highest-quality REITs in each sector, and this is one of the secrets of its success. Today, RQI provides a healthy distribution of $0.08 per month for a 7.4% yield. The distribution is paid monthly which is a great plus for those looking for a regular paycheck.
The End of the Dark Era
You could argue some REITs didn't reach their pre-crash levels yet, why should they reach it anytime soon? The answer is that:
- With the deployment of the vaccine in the US, around 50 million doses have already been given. With hundreds of millions doses available or expected to be soon, the pandemic era will be over soon.
- With trillions of dollars being spent on stimulus plans, and more to be spent on infrastructure, property REITs are set to be some of the biggest beneficiaries. I expect this economy to be running hot soon - factories should be fully operating, offices will re-open and more people will get their usual employment checks back. On this track, REITs are positioned to see a full recovery at the end of 2021 and set to thrive once again.
- We need to add to the above the current low interest rate environment that's very favorable to REITs. These companies can use low borrowing rates to acquire attractive properties. This dynamic will boost the performance of the REITs as we are set to see hyper growth in this sector. We already have seen several quality REITs raising capital to fund new acquisitions.
REITs: Strongly Outperformed All Asset Classes
Real estate has been one of the greatest wealth generators of all time. The same can be said about property REITs. Over the long term, property REITs have outperformed almost all asset classes.
As we can see from the chart above, since the year 1989, property REITs have returned 1895%, outperforming both the S&P 500 index (SPY) and the Russel small cap Index (IWM). If you are a long-term investor looking to maximize your returns, this is one of the best sectors to be invested in.
Valuation of the REIT sector
Property REITs today are one of the cheapest sectors around. Despite the surge of large indexes, investors have been hesitant of this sector due to the continued impact of the pandemic.
However, many of the higher-quality REITs already have their occupancy rates today at pre-pandemic levels, and yet the prices remain depressed. For other REITs, rent collections have been increasing in every industry and it will continue to improve as the wider economy recovers.
When we talk about REITs it's inevitable not to mention the Vanguard Real Estate Index ETF (VNQ). Perhaps the best valuation metric for REITs is to look at their dividend yield relative to the 10-year Treasury rate. When this spread is high, it has historically been a great time to buy REITs. When it's below zero, that has historically been a poor time to buy REITs.
When we look at VNQ's dividend spread compared to the 10-year Treasury, we can see that while it has come down from COVID-19 highs, it's still the highest it has been since July of 2009.
Was July 2009 a good time to buy REITs?
So if you missed the huge post-COVID sale on REITs, history tells us that you are not too late. There's plenty of room for upside and REITs can be expected to dramatically outperform for the next several years.
Overprinted Dollar and Rising Inflation
If you are worried about excess government spending and dollar over-printing, you are right to be so. All this spending will come at a cost and someone will have to foot the bill. I expect that hefty bill will come through inflation, which is indirect tax that we will all have to pay. This is unlikely to materialize over the next two years, but I fully expect to see its impact in the year 2023 and beyond, as the cycle of dollar printing takes its toll. Investing in high-yield REITs is a great way to hedge this risk. Property REITs offer a good hedge against inflation as prices of properties go up as inflation ticks higher. Because real estate is a physical asset with higher barriers to entry and a more limited supply, it's inherently inflation resilient. Rental prices are often directly tied to inflation indices and are raised every 1-3 years to match inflation.
RQI provides another hedge against our beloved overprinted currency. As a global CEF, where more than 16% of their holdings are abroad, diversification plays an important role in the decision you make for an investment - it's wise not to be overexposed to a single currency.
Source: Cohen & Steers Quality Income Realty Fund - RQI
RQI: A Clear Winner based on Performance
RQI is a long-term winner. It has proven itself in the market and its value increases steadily with time while paying out dividends.
RQI also has beaten the returns of the S&P 500 index (SPY) over the long term. Below is a performance chart comparing RQI with SPY since the year 2002.
Top Manager in the Field
The managers of RQI are Cohen & Steers, the best management in this sector. They actively manage RQI's portfolio which maximizes your returns. By actively managing means that RQI consistently select the highest-quality REITs and have the flexibility to overweight specific stocks when there is an unjustified pullback, or reduce exposure to a stock that became expensive or has seen a deteriorating outlook. This is why before investing in any CEF, it's very important to assess the quality of its management. Decision making, in this case, is critical.
This management have proven their ability to outperform in both good and bad times, and to deliver market-beating results.
The Importance of Leverage in a Bull market
Another important point to add is that RQI is 22% leveraged, as we know leverage can cut both ways, negatively and positively, meaning that RQI share price falls faster on the way down and rises faster on the way up. As we noted earlier, we are at the end of the dark era; we expect a strong bull market in the Property REIT sector. RQI offers a great way to maximize your returns.
To shed the light on the fee structure, the average CEF fee typically ranges from 1.2% to 1.3% whereas the fee of RQI is at 1.1% (lower than the average). RQI carries interest expense of 0.89% for its leverage which is not part of the management fee. This is a low borrowing cost that individual investors cannot replicate through their brokers. This is not much to pay for the active work that RQI management provides and given their long term performance. Note that all the returns shown in the charts above are "net of management fees," meaning that RQI has outperformed the S&P 500 index and also VNQ (the passive Property REIT CEF), after taking into account the management fees.
A Discounted Purchase
Comparing the NAV to RQI share price, we can see that RQI is undervalued. The CEF is trading at a 2.7% discount to NAV - investing now will save you around 2.7% of upfront cost compared to buying all RQI's holding individually.
Going forward, I expect that NAV will see significant growth as REIT prices recover, and this should translate into much better performance for RQI in terms of capital gains for the years 2021 and 2022. This is on top of the monthly dividends that investors are cashing in.
Why Direct Investment in Rental Properties Carries a Higher Risk
Today, it's estimated that the "net return" on rental properties after paying taxes, mortgage expense, and maintenance is between 2% to 5% depending on the quality of the property and its geographic area. However, as we have seen during the pandemic, you could pass by many streets and see rental advertisements that could be hanging for several months.
Every month missed on your rental will hit hard as you are dependent on the monthly income of your tenant. If you lose just two months due to vacancy, this means that you are losing 16% of your gross revenues, translating into negative "net returns" for the year.
Having a vacant property for a few months can happen anytime, and not only in an extreme situation as seen in the pandemic. Therefore directly investing in real estate could be risky, especially for retirees who are dependent on rental income to meet their expenses.
Investing in listed REITs instead, you can still collect your regular income because these REITs are in general highly diversified and do not derive their rent from a single tenant. A loss of income from a few tenants will not impact their ability to pay you your dividends, as we have seen for the vast majority of REITs during the pandemic.
Historically, even before the existence of stock exchanges, real estate has proven to be one of the most reliable and profitable investments ever. Real estate wealth has been transferred from generation to generation, because it carries an income generation power, and can be preserved without the need to sell it. Furthermore, it is also a good hedge against the risks of higher inflation as discussed above.
One of the best ways to invest in Real Estate is through the closed-end fund RQI:
- RQI has one of the best track records among all Property REIT CEFs.
- It provides instant diversification to the highest quality REITs.
- It has outperformed the S&P 500 index over the long term, since the year 2002.
- It generates a recurrent and reliable monthly payment through its distribution.
- The yield is generous today at 7.4%, and RQI still trades at a discount to NAV.
- The distributions are paid on a monthly basis.
- Investing in RQI today, you are getting exposure to one of the most undervalued sectors in the markets: the Property REIT sector.
In effect, with RQI, you are getting a double discount. The first one relates to the property REIT sector that is one of the cheapest sectors on the market today. The second discount is that RQI trades at a discount to NAV. RQI is one of my largest holdings in my own retirement portfolio. I expect it to be one of the biggest winners in the coming years!
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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 High Dividend Opportunities where he teams up with some of Seeking Alpha's top income investing analysts. The service focuses on sustainable income through a variety of high yield investments with a targeted safe +9% yield. Features include: model portfolio with buy/sell alerts, preferred and baby bond portfolios for more conservative investors, vibrant and active chat with access to the service’s leaders, dividend and portfolio trackers, and regular market updates. The service philosophy focuses on community, education, and the belief that nobody should invest alone. Lean More.
Analyst’s Disclosure: I am/we are long RQI. 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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