RQI: Real Estate Exposure At A Discount (NYSE:RQI)

Richard DruryOverview With the rise of interest rates, the real estate sector has continued to deliver underwhelming returns for investors due to their heavy reliance on access to cheap debt. However, I believe that this presents an opportunity for long-term investors to buy in at lower valuations. With so many options out there within the real estate sector, it can be challenging to determine the best approach to these times of uncertainty. This is where the Cohen & Steers Quality Income Realty Fund (NYSE:RQI) comes in. We can see that the total return of RQI closely aligns to the real estate sector (XLRE) and Vanguard’s Real Estate ETF (VNQ) for reference. Data by YChartsFor context, RQI is unique because it operates as a closed end fund that has a primary objective to provide a high current income by maintaining exposure to real estate securities. The secondary objective is to provide some capital appreciation through increased valuations of its holdings. RQI is an established closed end fund with over two decades of history since the inception dates back to 2022. The fund currently has a value of about $2.26B with a management fee of 1.45%. I believe that this is an ideal time to start accumulating a position in this real estate fund due to the discounted valuation and high dividend yield. The current dividend yield sits at about 8.3% and distributions are paid out on a monthly basis, which makes it an appealing choice for income investors. This monthly distribution can also be appealing for investors that are retired and depend on reliable and consistent income from their portfolio. RQI has maintained its current distribution rate since 2015, despite what macroeconomic conditions look like. Additionally, the fund sits at an attractive valuation and trades at a higher discount to net asset value than normally. Based on outlook for the rest of the year, I do not believe this discount will get much larger, if at all. Instead, I actually think RQI has a few catalysts that may boost the price going forward. Before we get into those details, let’s discuss the fund’s strategy and holding exposure. Strategy & Holdings Part of the fund’s strategy is the effective use of leverage to amplify the dividend yield it can provide. As long as the returns generated from the leverage is beyond the cost of borrowing, this can be a solid strategy. However, it may potentially increase risk when conditions are not ideal. I mention this because I think that the current high interest rate environment is a more risky time to use this level of leverage, within a sector that already heavily relies on debt financing. According to the latest factsheet, RQI uses a leverage at the rate of 29.4% of the total managed assets within the fund. The use of leverage typically has the ability to contribute to additional capital appreciation during bull markets but also equally contributes to any downside experienced. To RQI’s credit, the leverage used is mostly taken out on a fixed rate financing basis. Approximately 81% of the fund’s leverage is on this fixed rate basis. The remaining 19% of leverage is on a variable rate basis, which means that this portion of the leverage is likely more expensive to maintain through higher interest payments since the Federal Funds rate still remains at a decade high. However, the weighted average cost of financing only sits at 2.4%. RQI’s strategy is to maintain a diverse range of exposure across different sub sectors of real estate. This focus on diversity helps mitigate any concentration risk. For example, RQI’s diversity helped this CEF fare quite well during the pandemic drop, which was accompanied by office REITs taking a beating due to the shifting norm and acceptance of remote work. We can see that the largest exposure sits within the infrastructure space, accounting for 13.1% of assets. This is closely followed by a 9.7% exposure to industrials. These two sub sectors are typically considered less volatile as they typically have long-term tenant commitment and operate in space that provides essential services such as energy and utilities. RQI 2023 Annual ReportRQI currently has approximately 189 individual holdings related to real estate that span across different sectors. The current top holding is in American Tower Corporation (AMT), an independent operator of over 224k communication sits which may include data centers, cell phone towers, and other infrastructure related real estate. This is closely followed by exposure to Prologis (PLD) and Welltower (WELL), accounting for both 6.7% and 6.3% respectively. RQI FactsheetAdditionally, RQI implements an option writing strategy to help with generating extra income to fund its distribution. The use of options is also used as a way to reduce overall volatility by selling call options on assets that the fund already owns. The fund may also utilize put options as a way to either offset volatility or collect a premium on the option as a contributor to income generation. Dividends As of the latest declared monthly dividend of $0.08 per share, the current dividend yield sits at 8.3%. While the dividend doesn’t have a strong increase history, the fund has performed very reliably over the last decade. The dividend payout rate has remained the same since its last increase in 2015. This reliability shows the fund’s strength and prioritization in maintaining the current distribution rate. Therefore, I believe RQI to be a great addition to an investor’s portfolio that values long-term income consistency. Even though the growth has been lacking in terms of dividend raises, you still have the ability to essentially create your own income growth with continued reinvestment and contributions. In order to visualize this concept, I ran a back test using Portfolio Visualizer to see how an initial investment of $10,000 would have played out over the last decade. This calculation assumes that you made an initial investment in 2015 and reinvested every single dividend received. In addition, it also assumes that you contributed a fixed amount of $500 per month consistently throughout the entire holding period. With these assumptions, we can effectively see the value of a long-term outlook and the compounding effect that happens when the distribution remains at a consistent rate. Portfolio VisualizerIn 2015, your dividend income for the year would have totaled only $1,083. Fast forwarding to 2023, we can see that your dividend income would have grown to $7,480 while your position value would have grown to approximately $104,000. However, it should also be mentioned that there were times where the distribution was not able to be entirely covered by net investment income and net realized gains. This doesn’t necessarily indicate anything wrong with the fund but rather a result of poor performance within the real estate sector. Something to note is that the distribution from RQI is typically classified as ordinary dividends. Ordinary dividends have more unfavorable tax consequences than qualified dividends. For example, we can see that the distribution for 2023 was entirely funded by NII (net investment income) per share landing at $0.21 and net realized gains totaling $1.54 per share. During years that performance is strong, the fund may retain some of those earnings as a buffer to cover future years that performance may be poor. The 2023 annual report has a great breakdown of the prior year distributions. RQI 2023 Annual ReportWhen the fund doesn’t earn enough to cover the distribution, this may result in the use of ROC (return of capital). The usage of return of capital comes directly from the fund’s assets which means that extended use can cause significant decay in the NAV. However, the silver lining to this is that return of capital is generally taxed at more favorable rates, if at all, since this distribution doesn’t technically count as income that was ‘earned’ and instead reduces the investor’s cost basis. RQI 19a-NoticeI mention this usage of return of capital because it seems like the fund has mostly relied on this to fund the distribution for most of 2024 so far. Referencing the latest 19a-Notice, we can see that 79% of the distributions YTD have been funded throughout ROC while only 20% was funded through NII. While this isn’t inherently bad, it will likely cause NAV to shrink over the year and suppress any price growth potential. Valuation & Outlook Since the main focus for RQI is income generation, we should have realistic expectations in terms of valuation and upside potential. For reference, the fund’s price is down about 23% since the fund’s inception. However, the total return for this same time period exceeds over 530%. This can be attributed to the fund’s reliable history of delivering those distributions. However, I believe that a big piece of capturing the best value in these sorts of closed end funds revolves around the timing of your buy. Data by YChartsSince RQI operates as a closed end fund, the price can trade at a different rate than its actual NAV (net asset value). Therefore, we can reference the history and relationship both the price and NAV to get an idea of when would be an ideal time to start an initial position. While the chart I have provided below shows a ten-year time frame, I will only be referencing a five-year time frame since I believe this serves as a more recent point of reference and the fund’s holdings through this period likely looked similar to the current setup. The price of RQI currently trades at a 6.3% discount to NAV. This is ideal because the current discount remains greater than what is typically considered normal over the last few years. For reference, the price traded at an average discount of only 4.4% over the last three-year period. CEF DataI do not think the discount to NAV will get much larger over the remainder of the year. Just as a reference, even when the stock dropped to lows during the 2020 crash, the price only reached a discount to NAV of 15%. I don’t think the price will trade at a much larger discount due to the fact of interest rate cuts likely on the horizon. It’s no coincidence that RQI’s price fell as rates simultaneously reached their decade highs. We can see the inverse relationship over the years, with the most extreme example happening at the start of 2022 when rates were rapidly hiked. Conversely, the price of RQI started to spike when rates hit near zero levels a few years ago. Data by YChartsInterest rates have a large impact on the price of REITs and the real estate sector as a whole since these businesses are usually reliant on access to cheaper debt in order to fund operations, acquisitions, and different expansion effort. Higher interest rates directly translate to higher interest payments to maintain that debt. As a result, we see a decrease in activity that can drive growth across the sector, as it makes more sense to operate defensively and reduce debt burdens. With inflation starting to cool and unemployment creeping towards 4%, there’s a chance that interest rates get cut in the latter half of 2024. In addition, we have the US Presidential elections on the horizon. Data compiled by JPMorgan shows us that the Fed has more frequently made rate changes during election years over the last 40 years, with the only exception happening in 2012. JPMorganThe cutting of interest rates can potentially serve as a large catalyst for growth going forward. As rates come down, we are likely to see increased growth activity within the sector as debt becomes more affordable and cheaper to maintain. This would likely encourage more growth initiatives to take place once again which can boost valuations and increase business growth through increased consumer spend as well. Lower rates could also mean that any of these businesses that lock in debt at higher rates would be able to effectively refinance at better rates. Risk Profile If we happen to stay in a ‘higher for longer’ rate environment, we would likely continue to see the entire real estate sector struggle to gain any upward momentum. RQI would likely continue to trade sideways or even move downward in price. Even worse, if rates were to get hiked due to the lack of cooling with inflation and continued strength in the labor market, we could see the discount to NAV increase. Businesses within the real estate sector would likely see lower operating profits as debt interest payments rise and lending activity slows. Additionally, the fund’s reliance on using return of capital to fund the distribution would likely continue to contribute toward its decline in NAV. A prolonged period of return of capital will continue to deteriorate the NAV and stunt growth potential. While the fund’s leverage limits its exposure to variable rate debt, a hike in rates could drastically affect how much the fund has to pay out to maintain this debt. Takeaway While RQI may not experience much upside price growth, I believe that it currently sits at a very attractive price point. This is due to the current higher discount to NAV. Additionally, the dividend growth has been lacking over the last decade, but it remains very consistent. This consistency helps deliver a reliable stream of dividend income that can be compounded over time with continued reinvestment. The highly diverse nature of the fund helps mitigate any sort of concentration risk of weaker markets like the office REIT space. I believe that interest rate cuts are on the horizon due to cooling inflation rates and the presidential election upcoming. This can boost the price of RQI and serve as a catalyst moving forward as rate cuts make for better operating conditions for real estate. Therefore, I rate RQI as a buy at these levels.

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