For the decade following the financial crisis, REITs capitalized on an environment of persistently low interest rates to fuel the commercial real estate engine. Declining yields and capitalization rates supported rising REIT valuations and property values. REIT excelled during this period. The situation changed dramatically after the pandemic era. Many perceived the Federal Reserve’s low interest rate policy as permanent.
The sea changed in 2023 as many of these tail winds evaporated during a condensed period. REITs suffered due to rising interest rates and a flight to alternatives such as bonds, Treasuries and, to the surprise of many, technology. Rising borrowing and capital costs slowed purchases and new development across real estate.
Again, the tide is beginning to turn. The Federal Reserve has hinted at near-term rate cuts, which will be critical to short-term REIT performance. MArKet has taken note and REITs across the space have recovered from their October lows. Today, we’re going to dive back into one of the best closed-end funds in the real estate space. we have previously covered RQI, but feel now is an appropriate opportunity given the changes in the market. In previous coverage, we noted that RQI’s portfolio could benefit from several long-term growth drivers, including rising rents and inflation. That said, future interest rate risk was substantial.
Summary of the Fund
Cohen & Steers Quality Income Real Estate Fund (NYSE:RQI) is a closed-end fund that invests in high-quality REITs. Cohen & Steers (CNS) specializes in real estate, infrastructure and preferred stock investments through a selection of vehicles such as managed accounts, CEFs and traditional mutual funds. While CNS offers many real estate iterations, RQI is a pure play, REIT fund. A alternative to RQI is Cohen & Steers REIT & Preferred Income Fund (RNP), another real estate CEF that combines REITs and preferences for a slightly higher internal yield and distribution rate.
RQI’s portfolio is built from best-in-class companies across the real estate sector. RQI invests in a wide variety of public owners, each with a common area of focus. Sectors are diverse with Telecom (13%), Industrial (9%) and Healthcare (8%) leading the largest allocations. The majority of the portfolio is dedicated to common stock in equity REITs with a smaller portion invested in debt equity REITs.
The RQI portfolio is a call to best-in-class owners. The first five positions in the portfolio are American Tower Corporation (AMT), Prologis (PLD), well tower (GOOD), Simon Property Group (SPG), and Guest Houses (INVH). American Tower is one of the largest global REITs with a portfolio of approximately 225,000 cell tower and communications sites and additional data center facilities in the US. PLD is a global leader in logistics real estate that owns and operates approximately 1.2 billion square feet (115 million square meters) of industrial real estate in 19 countries. Welltower invests in senior housing properties throughout the United States, Canada and the United Kingdom. SPG is one of the world’s largest retail REITs owning a quality portfolio of shopping centers across North America, Europe and Asia. Finally, INVH owns a massive portfolio of single family homes spread throughout the United States.
Anticipated rate cuts
As mentioned in the introduction, the Federal Reserve has begun to hint at raising interest rates. Although a March cut was taken off the table, Powell did all but certain that there will be a reduction in rates by the end of the year. This interest rate speculation has generated spectacular REIT activity over the past four months.
The market has begun to price in these cuts as REIT share prices rise, valuations expand and capitalization rates are projected to fall. The result has been a booming market.
When all thoughts tend to converge, we get into trouble. With a consensus appearing to be forming, investors agree that a short-term rate cut is certain. The economy is reflected in REIT prices. For REITs, these cuts may not just be a certainty … they may be a necessity. Cracks in large-scale commercial real estate continue to develop. Most recently, Janet Yellen expressed “concern” on the state of commercial real estate, seeing the massive wave of loans coming due this year. We recently covered the implications of these maturities in our coverage of Ares Commercial Real Estate (ACRE).
Having priced in our precious rate cuts, can we determine if there is value left in RQI.
REITs and closed-end funds have different methodologies for evaluating and evaluating their performance. A simple barometer of the relative risk of an income-producing asset is comparing the yield against the current ten-year Treasury. Typically, investors view the ten-year Treasury as a relative risk hedge. Described as the “risk-free rate,” the ten-year Treasury sets the benchmark yield for everything from coupon rates to discount rates.
In general, the RQI yield tends to follow ten-year movements. When yields rise systematically, RQI’s share price must fall to compensate. As ten years go up, risk-free assets become more attractive on a relative basis. Investors will sell RQI to buy Treasuries until the spread adjusts to a suitable level. That said, determining an appropriate spread is easier said than done.
Comparing the year-end yield of the ten-year Treasury to the year-end distribution yield of the RQI provides a point of comparison. Over the past ten years, RQI’s yield has averaged 5.23% over the ten-year Treasury at year-end. The minimum spread was in 2021 at 3.75% and the maximum spread was 2020 at 6.81%. If we assume that 5.23% is the market spread for RQI over the ten-year Treasury, we can set up a fair value matrix.
Currently, the ten-year Treasury rate is 4.09%. Therefore, if we add our 5.23% spread to the current Treasury rate, this implies a fair value price of $10.41 per share for RQI. Compared to RQI’s current share price of $11.75, the fund is overvalued on a relative risk basis. The current ten-year spread is 4.05%, near the bottom of the historical range. The stock price would need to fall by 11.4% to narrow the average spread.
RQI is currently trading at a discount to net asset value of nearly 5%. While share prices trade independently of the underlying assets, RQI shares may be valued at a premium or discount to NAV. A decline in NAV could represent a buying opportunity for RQI. Opportunities where RQI trades at a discount to NAV and a yield premium to the ten-year Treasury generally indicate the strongest buying opportunities for a fund like RQI.
Quite simply, RQI is one of our favorite closed-end funds. As revealed, we hold long positions in CEF, initially buying at deep discounts during the pandemic. The above methodology has provided a general guide to opportunities to add to the position. Over time, RQI has been able to consistently outperform indexed competitors. The management team is best-in-class, the portfolio is strong, and there are tailwinds that could continue to power the REIT’s performance in 2024. While overvalued, RQI is in the “never sell” category given the consistent performance of index. Let the tailwinds blow and be patient to strike while the iron is hot.