RQI: High Dependency On Interest Rates, Low Margin Of Safety (2024)

Relatively recently, I issued a bullish article on one of the real estate focused Cohen & Steers closed end funds - Cohen & Steers Total Return Realty (NYSE:RFI).

In the article, I outlined how the focus on high quality REITs and their fixed income as well as preferred share securities should warrant a decent upside potential, while providing juicy streams of current income.

Also, in the article I contextualized RFI with a closely related CEF: Cohen & Steers REIT & Preferred Income Fund (NYSE:RNP). RNP effectively carries a very similar exposure to that of RFI, and the only material difference lies in the fact that RNP relies heavily on external leverage to magnify the underlying yield potential. Because of this and the higher for longer backdrop, I decided to downgrade RNP, which has since then lost circa 8% of its share price.

Now, the question is whether the Cohen & Steers Quality Income Realty Fund (NYSE:RQI) exhibits a similar risk profile to RNP that would in turn justify a more conservative stance from the investor side.

Thesis review

My latest piece on RQI was circulated back in December 2023, where the overall message was rather positive due to the duration-loaded factor, which under a scenario of interest rate cuts should lift the stock price significantly higher from the present levels.

It is not a surprise that the Fund has registered unpleasant returns (~ 3% drop) as the consensus pertaining to the number of hikes has clearly changed, assuming a stronger higher for longer scenario.

Interestingly, if we look at the chart below, we can notice that RQI has actually massively underperformed RNP despite having almost identical portfolio allocations.

Moreover, the following chart helps further capture the essence here:

Namely, zooming back to a historical 3-year period, we can observe how tightly correlated both of these names have been and also that there have been multiple instances in which, say, RNP temporarily exceeds RQI and then after a relatively short period the relationship returns to a balance (oftentimes the other Fund taking the lead role in the next moment of deviation).

So, theoretically, one could argue that the YTD return dynamic is a temporary thing that will eventually smoothen out. In my opinion, there is a definitely an element of truth in this, but if we peel back the onion a bit and take a more careful look at RQI's asset allocation mix, we quickly understand why RQI has been at least to some extent punished correctly by the market.

The key difference is really the portion of assets that have been placed into fixed income like securities, where in RQI's case the share amounts to 19% of the NAV, while for RNP the relevant segment consumes 48% of the portfolio.

In the context of higher for longer and the looming recessionary risks, the market has clearly favored allocations and income streams, which exhibit stronger defensive characteristics and carry a limited risk of registering a reduction in distributions.

Yet, the key issue with RQI is identical to RNP's situation, where the risks that are associated with the external leverage render the vehicle overly speculative and dependent on a timely reduction in the interest rates.

The table above shows how RQI is currently benefiting from a sound hedging strategy and the reliance on fixed rate borrowings. In other words, as of now, RQI has 81% of its total leverage stipulated against fixed rate financing, which sits at 1.6%, while the market-level rate is closer to 6% as we can infer it from the above reflected variable rate financing rate. This is a notable advantage, allowing RQI to capitalize on spreads between the cost of financing and portfolio yield levels that have risen as the interest rates have gone up.

However, this table also indicates a risk that will eventually materialize once RQI is forced to refinance or roll over the hedges on its 1.6% fixed rate component. Granted, the interest rates might go down by the time the debt maturity wall kick in, but it is highly unlikely that RQI will manage to keep the interest rate so depressed as it is now.

In fact, looking at FOMC dot plot, the consensus indicates that in ~ 2 years from now (which largely corresponds to the time RQI would have to refinance) the SOFR will revolve around 3.1%. In RQI's case we have to add some credit risk premium on top of this, which leads to at least doubling of the prevailing fixed rate financing rate.

With that being said, investors have to be cognizant of the possibility that the interest rates stay this high for longer than what is baked into the FOMC projections.

The bottom line

All in all, I still remain bullish on the underlying fundamentals of RQI just as for RNP and RFI, where, in my opinion, an exposure to high quality equity REITs will eventually generate outsized returns as the interest rates begin to fall a bit.

However, the risk that stems from RQI's leverage profile introduces just too much of a dependence on the interest rate path, which is inherently impossible to predict, especially if we look back at the revisions (and deviations from consensus) in the past couple of quarters. In case the interest rates stay this high for the ensuing 2-3 years, RQI's cost of financing would skyrocket, which, given the fact that ~30% of the AuM is accommodated by debt, would not only shrink the cash generation, but also force the Fund to even revisit its current dividend in my opinion.

Because of this, I am downgrading the Cohen & Steers Quality Income Realty Fund (RQI) to hold.

Roberts Berzins, CFA