- NRO invests in a portfolio of real estate securities that generate income for investors.
- The fund appears to be following a contrarian strategy, which has merit but could pose problems if things do not return to normal quickly.
- Real estate offers an excellent way for investors to protect their wealth against inflation and even grow it.
- The fund had to cut the distribution earlier this year in response to fairly hefty capital losses that it took in 2020.
- The fund appears reasonably valued but a better entry point may become available.
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One asset class that every investor should have a degree of exposure to is real estate. This serves two purposes. First, it serves as a store of value in the face of inflation, which may become important later this year if the U.S. government continues with its current spending ambitions. Secondly, real estate companies tend to offer higher yields than many other things in the market, which is quite attractive to retirees or others that are depending on their portfolios for income. Unfortunately, the current low interest rate environment has caused the market to bid up the stock prices of real estate trusts so that their yields are no longer as attractive as they once were. There is a way around this however and that is to invest in real estate securities through the use of a closed-end fund. These funds are able to utilize a variety of strategies to increase their yields that other types of fund cannot. In this article, we will have a look at one such fund, the Neuberger Berman Real Estate Securities Income Fund (NYSE:NRO), which yields an attractive 8.12% at the current share price. I have discussed this fund before but it has been over a year now and naturally a lot has changed so we will put extra emphasis on the changes as well as providing an update on the fund’s finances and how well it weathered the events of 2020.
About The Fund
According to the fund’s web page, the Neuberger Berman Real Estate Securities Income Fund has the stated objective of delivering a high level of current income to its investors. The fund also has a secondary objective of delivering capital appreciation. This is not at all unusual as most closed-end funds have very similar objectives. What makes this fund a bit different from other closed-end funds is the strategy that the fund uses to achieve its objective. As the name of the fund implies, the Neuberger Berman Real Estate Securities Income Fund invests in a portfolio of securities issued by real estate investment trusts. Admittedly, the web page does not state exactly what securities are eligible but at look at the fund’s actual holdings reveals both common and preferred stock. Presumably, the fund could also invest in debt securities (there is no stated restriction on this) but it does not currently have any in its portfolio. Thus, as might be expected, it looks like an easy way for an investor to get access to the real estate sector.
There are several different types of real estate, each with somewhat different fundamentals. For example, an apartment building is very different from a shopping mall or a datacenter. This fund invests in all of them and appears to be reasonably well diversified between the various types:
Source: Neuberger Berman
The recent pandemic had a very significant negative impact on certain real estate sectors and a negligible impact on others. Most notably, the shopping mall sector was devastated as various COVID restrictions limited the ability of people to go shopping and thus pushed some of their tenants into bankruptcy. Things such as datacenters were not impacted at all and in fact may have benefited as numerous firms attempted to establish their infrastructure to allow employees to work from home. This could also pose problems for the office sector as there have already been some companies that have stated that now that their employees are established to work from home that they will not be returning to a traditional office environment. Thus, that sector may soon find itself oversupplied with office space, which could prove troubling. It is curious that the fund has a much lower weighting to the sectors that are showing strength (like datacenters) and is overexposed to weak sectors (resorts and shopping malls) compared to its benchmark index. It appears that management is attempting to follow a contrarian strategy here, which could have merit but I do not have the same confidence that they do. If it takes longer for people to return to their pre-pandemic lives than management expects then this strategy could easily result in underperformance compared to the index. In addition, now that people have gotten used to working and shopping from home, it is quite possible that they will never return to their pre-pandemic lives. The risks here are somewhat concerning.
Real estate investment trusts are among the more prominent issuers of preferred securities in the market. These securities serve as a form of leverage, allowing them to boost the returns that are delivered to the common equity beyond what could be achieved with a traditional bank mortgage. From an income investor’s perspective, these securities typically offer higher yields than the common equity along with typically a bit more stability. Thus, they may be appealing to a conservative investor even though they do not have the same upside potential. The fund invests in both types of security, although it is a bit more heavily weighted towards common equities:
Source: Neuberger Berman
This is something that is rather nice to see as it serves to offer the best of both worlds. The common equity in the fund offers more potential upside and a degree of inflation protection while the preferreds lower the volatility of the portfolio and serve to boost the yield of the overall portfolio. This is exactly what we want in an income fund.
Real Estate As Wealth Preservation
One of the biggest challenges facing retirees today is the threat of inflation. Economists define inflation as a broad-based increase in prices throughout an economy and generally consider it to be a natural occurrence. In fact, it is caused when the money supply increases faster than the production of goods and services in the economy. This is because such a situation essentially results in more money available to purchase each unit of economic production. This has certainly been the case in the United States over the past year. We can see this quite clearly by looking at the M3 money supply, which is the most comprehensive measure of the nation’s money supply. Back in January, M3 sat at $19.3946 trillion, an increase of $3.9782 trillion (25.80%) over the $15.4164 trillion that existed back in January 2020:
Source: Federal Reserve Bank of St. Louis
This is unlikely to be a surprise. At the end of March 2020, the United States Congress passed the Coronavirus Aid, Relief, and Economic Security Act. With a price tag of $2.2 trillion, it was the largest spending package in American history. As I pointed out in a previous article, this package was financed by the Federal Reserve simply printing new money and using it to purchase the Treasury securities that the government issued to pay for the stimulus. The Federal Reserve itself also instituted a few programs that were intended to support the bond markets and these were also undertaken with newly printed money. Finally, we also saw two more large spending packages pass in December and March 2021. These two latter packages are too recent to be presented in the chart above so we can assume that the money supply is even larger by now. There are even further large spending packages in the pipeline that have been proposed but not yet passed. These would likely swell the deficit and increase the money supply further over the coming year or two.
The economy has not kept up with this growth in the money supply. The most recent figure available for the United States gross domestic product comes from the fourth quarter of 2020 when it stood at $21.494731 trillion. This is in fact a decline over the $21.747394 trillion that the country had back in the fourth quarter of 2019:
Source: Federal Reserve Bank of St. Louis
Clearly then, we can see that the money supply has grown substantially faster than the economy over the past year. However, the problem has been going on for far longer than that. In the fourth quarter of 2010, U.S. GDP sat at $15.240843 trillion so it has grown by 41.03% over the trailing ten-year period:
Source: Federal Reserve Bank of St. Louis
In January 2011, the M3 money supply was $8.8387 trillion so it has increased by 119.43% over the trailing ten-year period:
Source: Federal Reserve Bank of St. Louis
Thus, we can clearly see that the money supply has been growing much faster than the economy as a whole. This is a recipe for inflation. At this point, there may be some readers that point out that we have not seen inflation yet in the United States over the past ten years but in fact all we have to do is look at the housing market to see that we have been experiencing inflation. The inflation thus far has been confined to the securities and other asset markets (like real estate) but the new stimulus packages put money directly in the hands of people that are likely to spend it once the economy reopens. This could certainly result in inflation during the second half of this year.
Real estate protects wealth against inflation because it has some of the same qualities that other items do that rise in price in such an environment. In short, real estate is in limited supply and the central bank cannot just print more out of thin air. In addition, real estate is a necessary good since it can be used to grow food or provide shelter, both of which are necessities. Thus, people will always want to obtain it. In an inflationary environment, a growing amount of money will be available to purchase every piece of real estate, driving up values. Thus, real estate helps preserve your wealth and even grow it since it can be rented out to someone else. Therefore, every investor should have real estate or a real estate fund in their portfolios.
As I mentioned in the introduction, there are a few strategies that a closed-end fund can use to boost its yield over those of comparable open-end or exchange-traded funds. One of these strategies is the use of leverage. Basically, the fund borrows money and uses that borrowed money to purchase securities. As long as the yield on the securities that the fund purchases is higher than the interest rate that it pays on the debt then this strategy will work quite well to increase the yield of the overall portfolio. When we consider how low interest rates today and the fact that the fund can borrow at institutional rates that is generally going to be the case. Unfortunately, leverage is a double-edged sword since it amplifies both gains and losses. Thus, we want to make sure that the fund is not using too much leverage so that it strikes an appropriate balance between risk and reward. As I discussed in a previous article, I like to see this ratio under about a third as a percentage of assets for this reason. Fortunately, the Neuberger Berman Real Estate Securities Income Fund meets this requirement as its leverage ratio is 17.6% of the fund’s total assets. Thus, it does not appear that the fund is exposing its investors to too much risk with its leverages. In fact, it has room to increase leverage as opportunities present themselves.
As noted earlier, the primary objective of the Neuberger Berman Real Estate Securities Income Fund is to provide a high level of current income to its investors. As is the case with many such funds, it accomplishes this by paying out a monthly distribution to its investors. The fund currently pays out a distribution of $0.0312 per share monthly ($0.3744 per share annually), which gives it an 8.12% yield at the current price. This distribution has not been consistent over the years, which is unfortunate. The fund had to cut its distribution back at the start of the year:
This is undoubtedly discouraging, especially for income investors as they are generally seeking steady to growing income. Another thing that may be concerning is that a relatively high proportion of the fund’s distributions are classified as return of capital:
Source: Fidelity Investments
The reason why this could be concerning is that a return of capital distribution can be a sign that the fund is returning the investors’ own money back to them. Obviously, this scenario would not be sustainable over any kind of extended period. There are other things that can cause a distribution to be classified as return of capital though such as the distribution of unrealized capital gains. Thus, we should investigate to determine how exactly the fund is financing these distributions and whether or not they are sustainable.
Unfortunately, the most recent report of the fund’s financial performance is for the full-year period ended October 31, 2020. This will tell us how the fund weathered the worst of the pandemic but will unfortunately not provide any real insight into its recent performance or the distribution cut back in January. It is still worth investigating though as the fund’s ability to weather through the worst of the COVID-19 crisis does provide a lot of insight. During that period, the fund brought in a total of $9,799,408 in dividends and another $28,653 in interest off of its investments for a total of $9,828,061. The fund paid its expenses out of this amount, which left it with $5,173,162 available for its investors. This was nowhere near enough to cover the $22,761,705 that the fund actually paid out in distributions though. The fund can also get money from other things, such as capital gains, to support the distribution but unfortunately it did not have any capital gains during the period. In fact, the fund realized $16,828,648 in losses and had another $59,814,385 in unrealized losses during the period. Overall, the fund saw the value of its assets decline by $94,227,329 over the full-year period, which certainly explains the distribution cut. We will need to keep an eye on the fund to make sure that the new lower distribution rate solves this problem. Hopefully, the strength that we saw in the market following the election will help somewhat.
As is always the case, it is critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to generate suboptimal returns off of that asset. In the case of a closed-end fund like the Neuberger Berman Real Estate Securities Income Fund, the usual way to value it is by looking at a metric known as the net asset value. The net asset value of a fund is the current market value of all of the fund’s securities minus any outstanding debt. It is therefore the amount that the investors would receive if the fund were immediately shut down and liquidated.
Ideally, we want to purchase a fund when we can obtain it at a price that is less than net asset value. This is because such a scenario implies that we are essentially obtaining the fund’s assets for less than they are actually worth. Fortunately, that is the case right now. As of March 31, 2021 (the most recent date for which data is available as of the time or writing), the Neuberger Berman Real Estate Securities Income Fund had a net asset value of $4.72 per share but the fund only trades hands for $4.61 per share. This gives the fund a 2.33% discount to net asset value. While this is not a horrible price, it is quite a bit worse than the 5.31% discount that the fund has averaged over the past month. It may be a good idea to wait a bit and see if a more attractive discount presents itself.
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This article was written by
Power Hedge has been covering both traditional and renewable energy since 2010. He targets primarily international companies of all sizes that hold a competitive advantage and pay dividends with strong yields.He is the leader of the investing group Energy Profits in Dividends where he focuses on generating income through energy stocks and CEFs while managing risk through options. He also provides micro and macro-analysis of both domestic and international energy companie. Learn more.
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