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Are Real Estate CEFs Worthy of Consideration?

While they may not be for every investor, real estate CEFs can fulfill some niches at current valuations.

Steven Pikelny, 09/06/2013

With interest-rate concerns taking center stage for many investors, several closed-end fund categories have sold off in recent months. Among them, interest-rate-sensitive municipal funds, high-yield funds, and emerging-markets debt funds have gotten the most attention. Real estate CEFs have also seen their discounts widen substantially. Investors who view the sector itself as oversold, or are looking to rebalance the real estate allocation of their portfolios, might consider discounted CEFs as good instruments. But as we frequently point out, a large absolute discount does not necessarily mean that a CEF is attractively valued. Many investors will find that ETFs are the best way to gain cheap exposure to the sector. Nevertheless, some CEFs satisfy more specific investment needs, so they might still be worth considering.

U.S. Real Estate CEFs
Vanguard REIT Index ETF VNQ is hard to beat when it comes to expenses. The ETF charges a mere 0.10% for operating expenses. In comparison, Cohen & Steers Quality Income Realty RQI (the largest real estate CEF by net assets) charged a total expense ratio of 1.96% for the first half of fiscal 2013. To be fair, the fund’s expenses are higher--in part--because it has a leverage ratio (total assets/net assets) of 1.40. This means that the quoted number is inclusive of expenses directly associated with the leverage. Because 85% of its leverage is fixed-rate, these expenses are higher than they would be if they were floating. The increase in total assets also means that management expenses increase, hence the 1.30% adjusted expense ratio (which strips out direct interest expenses) for the same period.

The bottom line is that investors who are not specifically looking for leverage would likely do better with the low-cost option. After all, the two portfolios show significant overlap. And, while RQI has exhibited higher total returns than VNQ over the past three years, this is likely due primarily to the use of leverage in an up market. (RQI’s R2 with respect to VNQ was 0.99 over the period.) In any case, individual investors specifically looking for leveraged exposure to the U.S. REIT market would be hard-pressed to find a cheaper non-CEF option. Despite the high expenses, RQI passes along the costs of lower, institutionally priced leverage to shareholders. Replicating this leveraged exposure by buying VNQ on margin would likely be much more expensive.

RQI's 7.5% discount appears somewhat attractive but ultimately does not add much value for shareholders. Considering the 6.3% three-year average discount, history does not suggest that the current pricing is unusual on a relative basis. The discount does increase the distribution rate to 7.50% at share price from 6.90% at net asset value, but investors should take this extra 60 basis points with a grain of salt: The portfolio does not typically generate enough net investment income to cover this distribution and has realized substantial capital gains in the portfolio for six of its last seven distribution payments. The fund has seen its balance of unrealized capital gains increase for most of this period (aside from the last four months), so this can largely be interpreted as an actual return, rather than an accounting trick. However, this also means that the stability of the distribution is predicated on the portfolio’s ability to continue appreciating in value.

Most other U.S. real estate CEFs are in the same ball park in terms of distributions, expenses, and leverage, but investors willing to accept a modified investment allocation might want to consider Cohen & Steers REIT & Preferred Shares RNP as well. The fund invests roughly half of its assets in corporate preferred shares, with the other half devoted to REITs, but has a more attractive valuation than does RQI, in our opinion. The two funds have identical leverage ratios, though RNP charged a total expense ratio of only 1.79% for the first half of fiscal 2013. In addition, the fund’s 14.6% discount increases its distribution rate to 7.93% at share price from 6.76% at NAV. Even though the two latest distributions included substantial return of capital (which is somewhat accretive considering the large discount), its earnings rate increases to 5.45% at NAV from 4.64% at share price. The discount does not offset enough of the expense ratio to make it competitive with VNQ, but it certainly helps. The discount also makes the fund attractive on an historical basis. (Shares have traded at an average discount of 7.4% over the past three years.)

 

Global Real Estate CEFs
Investors looking for more of a global focus might also be interested in one of the three global real estate CEFs trading at large discounts. Because individual investors don’t have any super-cheap ETF options to gain exposure to a broad global real estate portfolio, CEFs in this sector can actually be cost-competitive. SPDR Dow Jones Global Real Estate RWO is the cheapest ETF with a broad global portfolio and charges an expense ratio of 0.50%. Meanwhile, the cheapest CEF in the space, CBRE Clarion Global Real Estate IGR, charges a 1.02% total expense ratio and trades at an 11.6% discount.

IGR pays a 6.13% distribution rate at NAV, but Clarion estimates that the portfolio does not currently generate enough income to cover the distribution in full. Rather, the firm estimates that the fund has either returned capital or dipped into its balance of undistributed net investment income in recent months. Considering that the portfolio holds various derivative contracts for hedging purposes, however, this muddles the picture. The fund could potentially reclassify the return of capital as income at year end. With this in mind, let’s use a conservative estimate, and focus on the fund’s 4.16% earnings rate at NAV (i.e. the amount of income the portfolio has actually generated on an annualized basis according to the last filing). The discount brings the earning rate up to 4.72% at share price. In all, the extra 56 basis points offsets a significant portion of the expense ratio.

Nevertheless, investors should still note the fundamental non-expense differences between IGR and RWO. For example, investors worried about the Australian real estate market might want to lean towards RWO, which only has a 7% weighting there (compared to IGR’s 14% weighting). Moreover, IGR uses a small degree of leverage, which should add more volatility to its returns. 

Click here for data and commentary on individual closed-end funds.

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Steven Pikelny is a closed-end fund analyst at Morningstar.
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