Co-produced with Beyond Saving and PendragonY for High Dividend Opportunities
At High Dividend Opportunities, we have been restructuring our portfolio to prepare for the eventual end of the bull market. Our #1 goal is to find investments that provide a high current income that is capable of enduring a potential bear market.
In our article entitled, "How To Protect Your Income From Falling Interest Rates?", we advocated a "three-legged" strategy for income investors utilizing preferred shares, bonds, and high-dividend common equities.
For the common equity leg, we want high current income, but we are also mindful that nobody can predict exactly when a recession will hit. We want to be prepared for a recession, but we don't want to miss out on potential upside while we are waiting.
As the year goes on, we have found numerous opportunities in all three legs. For the common equity leg, one of the sectors we find to be particularly appealing is REITs. As pass-through corporations, REITs are required to distribute 90% of their taxable income and that leads to a class of equities that have higher than average dividend payments.
Recent recommendations that we have made include Cedar Realty Trust (CDR), Spirit Realty (SRC), Washington Prime Group (WPG), Jernigan Capital (JCAP) and EPR Properties (EPR) among others.
These equities meet our goal of high current yield, and all have the potential for growth, which will help our portfolio's total return. They also make up only a fraction of the potential opportunities in the REIT sector.
We are mindful that there are a lot of great REITs that have great long-term growth prospects and great potential but do not meet our #1 goal of high current income.
REITs like Prologis (PLD), Essex Property Trust (ESS), Ventas (VTR), Digital Realty Trust (DLR), Crown Castle International (CCI), and Simon Property Group (SPG) are among the highest quality REITs in existence. Among their sectors, they are nearly universally recognized as "the best" and have long histories to prove it.
Everyone on the HDO team wants to own the best. Who wouldn't? The problem is that many of the REITs that make the list are REITs with low payout ratios and low yields. When the #1 goal is high current income, it might seem like there is no opportunity to invest in these quality REITs.
If you are a retiree who is seeking regular dividends for income, are these types of REITs closed to you? NO!
High Income From Low Yielders
Cohen & Steers (CNS) are a pioneer in REIT investing. They were one of the first asset managers to specialize in REITs and have proven that they have what it takes to outperform passive REIT indexes.
Cohen&Steers Quality Income Realty Fund (RQI) is an actively managed closed-end fund (CEF). RQI is the best REIT ETF along with its sister fund, Cohen&Steers Total Return Realty Fund (RFI) In their description of RQI, CNS explains their objectives,
"The primary investment objective of the Fund is high current income through investment in real estate securities."
RQI pays a dividend of $0.08/month, which works out to be a yield in excess of 7% at current prices.
Source: CEF Connect
Over time, RQI has consistently outperformed REIT indexes and the S&P 500, routinely producing an annual total return in the double digits. The fund's inception was in February of 2002, so RQI's annualized return since inception includes the significant drawdown from the 2007-2010 recession.
Here is a look at RQI's top 10 holdings,
Source: Cohen & Steers
For those who want to see the entire list of holdings, it is available here. RQI provides exposure to high-quality REIT names that generally would not fit HDO's goal of high current income.
To make things even better, RQI is trading at a 6% discount to NAV, allowing investors to gain exposure to these REITs for less than they could acquire them all individually.
Dividend Sustainability
When discussing CEFs, there are a few considerations that investors need to keep an eye on.
The first is leverage, by utilizing debt, funds can increase their returns and pay a higher dividend than the underlying securities. That can be great in bull markets, but in bear markets, leverage can cut the other direction and lead to larger losses.
In RQI's case, leverage is fairly conservative. They have $460 million in debt and have approximately $2 billion in assets under management for a net leverage of 23.4%. As asset values increase or decrease, that percentage will change, but it is generally in the 20-25% range. We believe that is an appropriate level of leverage that allows liquidity for the fund but does not carry an excessive risk for investors. For those who want to avoid leverage entirely, RFI has substantially similar holdings without any leverage.
The second is whether a fund has a significant "return of capital" or ROC. Funds generally attempt to have stable dividends and will pay out even if they had a bad year, which means that they might pay out more than they made in a given year. If the fund is sitting on large unrealized gains or receiving dividends from investments that are paying ROC and passing that along to shareholders, it is not a concern.
However, if a fund is actually liquidating assets to pay a dividend that is too large, that could be a cause for concern. While such funds can make for profitable investments, an excessive dividend will erode the assets. It is important to understand whether you are investing in a fund that can continue to distribute indefinitely, or if the fund is returning capital to the shareholders with a shrinking pool of assets.
Data by YCharts
This is a look at RQI's NAV since inception and their total return price, which includes dividends and the current market value. Investors in RQI at inception have seen a total return of 392%, the vast majority of which has come in the form of dividends. Meanwhile, NAV dropped only 5% and has substantially recovered from the recession. This leads us to the conclusion that historically, RQI has not paid a dividend that is destructive to NAV.
How The Sausage Is Made
In a recent article "The Income Method: How High Dividend Opportunities Succeeds", we drew an analogy comparing investing to chicken farming. Dividend investing is similar to raising chickens for their eggs, providing a recurring benefit versus those that have to "kill" their chickens for the meat by selling their shares to realize returns.
We prefer the former approach because it provides a consistent stream of long-term income without the need to sell in an unpredictable market. RQI takes the latter approach.
While many of their investments pay dividends, the yields are generally much lower than the yield that RQI pays to their investors. RQI makes up the difference by realizing long-term capital gains from time to time.
Source: Cohen & Steers
We can see this from the tax treatment of their dividends, which historically has primarily been "Long Term Gain". As an actively managed fund, RQI is routinely moving in and out of investments and shifting their focus to sectors they believe are relatively undervalued.
From the investor's standpoint, there is significant stability. For example, when REITs had their major pullback in December, RQI still paid their regular $0.08 dividend. An investor attempting to mimic RQI, but still wanting the income, would have to have sold at an inopportune time. RQI has the ability to pay out the dividend now and sell the position later when that is what market conditions call for.
RQI provides investors with the benefits of exposure to the highest quality REITs while processing that exposure into high current income.
Conclusion
For income investors, REITs provide a very attractive vehicle. Over the long term, real estate outperforms other classes of assets and is capable of producing durable long-term income.
We attempt to find opportunities with a current yield in excess of 6%. While we have found several, many quality REITs have lower yields. RQI provides us an opportunity to gain exposure to a wide variety of high-quality REITs, including those that pay out dividends that are lower than our target.
Since the fund performs the "dirty work" of buying and selling, we can sit back and enjoy the benefits of a steady, reliable, and predictable stream of income. Investors can receive a 7.3% dividend yield with RQI.
As with any fund, RQI has had its bumps and bruises, especially through the recession. Yet their record speaks for itself, over the long term, RQI has provided investors with strong returns, primarily in the form of dividends.
With interest rates declining, we believe that REITs will outperform the market, and RQI offers investors an opportunity to participate in that outperformance. We consider RQI a strong buy anytime it is trading under NAV which is currently $13.84.
Another Property REIT CEF that we like is RQI's sister fund Cohen&Steers Total Return Realty Fun (NYSE:RFI), which is managed also by Cohen & Steers. RFI has substantially similar holdings with zero leverage and slightly higher exposure to preferred equity (15% compared to 14%). RFI yields 7% compared to RQI which yields 7.3%. We consider RFI a buy under NAV, which is currently $13.44.
Both CEFs are managed by the best asset managers in the REIT sector and provide investors with exposure to high-quality REITs while still receiving a high dividend yield. There is no doubt that these two CEFs are the best in class for investors who wish exposure to Property REITs.
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