Author: Samuel Smith

The Cohen & Steers Quality Income Realty Fund (NYSE:RQI) is a wildly popular high yield REIT fund. Much of its legend stems from its track record of outperforming the REIT sector (VNQ) over a long-period of time:

However, we believe that this track record is misleading investors, setting them up for long-term disappointment by investing in RQI. In this article, we discuss why RQI is bound to lead to disappointing results for most if not all shareholders and then offer some alternative high yielding real estate picks that will likely deliver more satisfactory results.

Why RQI Is Poised To Disappoint

One reason why we think that RQI is bound to disappoint investors over the long-term is simply because its long-term track record is not nearly as good as it looks in the chart we just shared with you. First of all, if you look at the periods where REITs got pummeled, you will notice that RQI significantly underperformed VNQ each time. The reason for this is simple: RQI – as a closed end fund – uses quite a bit of leverage. As a result, when REIT prices go up, it generally outperforms the broader REIT sector. When REIT prices fall, it generally underperforms the broader REIT sector.

The amplifying effect of leverage is further enhanced by the fact that CEFs are free to trade at deep discounts and large premiums to their underlying NAV. As a result, when REITs are in favor, RQI’s share price generally trades at a higher ratio relative to its NAV, whereas when REITs are out of favor, RQI’s share price generally trades at a wider discount to its NAV. Ultimately, this means that RQI is a pretty volatile instrument, negating much of the supposed diversification benefits that come from holding a large fund like RQI or VNQ for REIT exposure.

Moreover, research has shown that most retail investors tend to vastly underperform the broader market for one simple reason: they become victims of their emotions and tend to sell during volatile market crashes, thereby locking in steep losses and oftentimes missing out on some of the strongest upward moving days that the market experiences. As a result, by investing in leveraged, volatile products like RQI, chances are you are setting yourself up for long-term underperformance. In other words: retail investor beware, buy RQI at your own risk and make certain that you can continue to hold it even during violent market crashes while it is underperforming the broader REIT sector.

Another reason why we believe RQI is poised to disappoint investors moving forward is summed up in the wisdom of Warren Buffett:

Performance comes, performance goes. Fees never falter.

While RQI may like to trumpet its period of outperformance, the fact of the matter is that with interest rates having risen and likely to remain higher for longer at the same time that commercial real estate is being disrupted like seldom before, the fund is going to have an increasingly challenging time delivering attractive returns for shareholders. This will prove even more to be the case when you take into account that it charges 1.34% in fees and expenses to shareholders on top of the interest expense for its leverage.

Last, but not least, while RQI’s current distribution yield of 8.75% looks attractive, it is important to keep in mind that it has been cut numerous times in the past and may not prove to be sustainable during a recession in which some of its underlying holdings may have to cut their dividends. The high leverage ratio on the fund may exacerbate the impacts of these potential cuts by even more.

Five Real Estate High Yielders To Buy Instead

Instead of investing in RQI, we believe investors would be better served by purchasing the following high-yield blue chip REITs:

• EPR Properties (EPR) – an entertainment focused triple net lease REIT that boasts a high and well-covered yield, trades at a steep discount to NAV, and has pretty solid long-term growth potential, all backed by an investment grade balance sheet with plenty of liquidity.
• Alexandria Real Estate Equities (ARE) – a very high quality life science lab space landlord that has a tremendous track record of delivering market-crushing total returns, robust dividend growth every year, and has one of the strongest balance sheets in the REIT space. It is currently priced at a deep discount to NAV and should deliver double-digit returns alongside a low risk profile.
• Simon Property Group (SPG) – the leading mall and outlet center landlord that owns a well-diversified and high quality portfolio of properties. Property level fundamentals are booming and the dividend is growing. Meanwhile, the balance sheet is one of the strongest in the REIT space and earns an A- credit rating from S&P. Despite all of this, the stock price is heavily discounted relative to historic averages and the dividend yield has soared to ~7.25%.
• STAG Industrial (STAG) – an industrial REIT with a strong balance sheet and robust growth rates that is priced at a discount to NAV. For a REIT in an in-favor sector like this that also enjoys some defensive qualities ahead of a recession, we think this is one of the most no-brainer buys in the REIT space today.
• W.P. Carey (WPC) – last but not least, WPC offers one of the best all-around risk-adjusted high yields in the market today, combining a very safe and growing 6.3% dividend yield with a very defensive portfolio that is increasingly focused on mission-critical triple net lease industrial properties. Moreover, it derives most of its rent from leases with inflation-linked contractual rent escalators, and its BBB+ credit rating gives it an attractive cost of capital.

Investor Takeaway

RQI certainly has an alluring investment case: a track record of outperforming VNQ over the long-term, a high monthly distribution, and the promise of security that comes from a well-diversified portfolio managed by a reputable fund manager.

That said, investors need to keep in mind that RQI’s management fees are quite high and that the high yield and periods of outperformance are largely due to the very high leverage ratio that the company has assumed. While this has served RQI well in the past during periods of low interest rates and economic prosperity, we are now in a high interest rate and declining economic environment. As a result, investors are setting themselves up for a potentially wild roller coaster ride in RQI and the research suggests this will lead most retail investors to underperform over time as they allow their emotions to get the best of them during market crashes.

As a result, we would caution retail investors to do some thorough self-examination before buying RQI to ensure that you have the psychological makeup to hold it through volatile periods. Moreover, we think investors will do just as well – if not better – over the long-term by forgoing the high fees and risky leverage of RQI and simply build themselves a portfolio of blue chip REITs like those mentioned in this article. That is what we have done at High Yield Investor, and it has served us very well.

It is quite rare to find well-covered and sustainable double-digit dividend yields. It is even rarer to find this from a company that is simultaneously buying back stock aggressively, growing its dividend aggressively, and advancing promising organic growth initiatives. The good news is that there is at least one such stock available today: OneMain Holdings (NYSE:OMF).

OMF offers a near 11% dividend yield that is well-covered by earnings, recently hiked its dividend by 5.3%, and is pouring cash into an aggressive stock buyback program, making it a dream stock for those who put a lot of emphasis on shareholder capital returns. Meanwhile, the balance sheet remains in sound shape and the company is advancing a high-potential organic growth initiative in its credit card business.

If this all sounds good, read on because in this article, we will look at this opportunity a little bit closer to help you decide if OMF stock is right for your portfolio.

Is OMF Stock The Dividend Opportunity Of A Lifetime?

As we already mentioned, OMF is a rare find in today’s market. Its latest quarterly results continued to confirm our conviction in the stock as well. Highlights included:

• Adjusted diluted earnings per share continued to decline sequentially due to an increase in charge-offs, a more conservative approach to underwriting of new loans (causing originations to fall from $3.5 billion to $2.8 billion sequentially), and a decline in leverage. That said, the dividend remained very well covered with a 1.46x coverage ratio (68.5% payout ratio).
• The credit card business continued to grow, with over 160,000 cards and $122 million in receivables at quarter end and the company remains on track to achieve their goal of over $100 million in capital generation per year from the credit card business alone by 2025.
• While net charge-offs continued to rise from 6.88% in Q4 2022 to 7.72% during Q1 2023, the increase in charge-offs did begin to decelerate some and delinquencies began to decline after several quarters in a row of increases. This signals that OMF is nearing a peak in net charge-offs barring a sharp deterioration in the economy. Moreover, these increases in net charge-offs were widely expected and are merely a normalization of conditions following the strong tailwind provided by the stimulus checks that were sent out to consumers in 2020 and 2021. Last, but not least, its portfolio is becoming increasingly skewed towards higher credit quality loans, so this should also lead to fewer delinquencies and ultimately net charge-offs in the coming months and quarters.
• The company is managing operating expenses quite well, with its OpEx ratio remaining flat sequentially.
• The balance sheet remains in strong shape with leverage declining for the second quarter in a row and plenty of liquidity remaining.
• Despite the company focusing on strengthening its underwriting and balance sheet in order to more conservatively position itself for a slowing economic environment, OMF continued to buy back a meaningful number (~0.6% of shares outstanding) of shares in Q1:

We repurchased about 700,000 shares for $27 million. As we discussed last quarter, we have moderated our share repurchases, given the uncertain economic environment and our desire to maintain strategic optionality. That said, we remain a programmatic buyer of our shares, and we’ll adapt the pace of repurchases as the environment evolves.

What Are The Risks In OMF Stock?

While this all sounds great, apparently Mr. Market has yet to get the memo, as the stock has floundered since early February:

What is Mr. Market so concerned about?

Well, first and foremost, it is important to zoom out a little bit more on the stock chart as OMF has actually been a huge outperformer in the three years since the COVID-19 crash:

The reasons for this are numerous, but one of the biggest drivers of OMF’s outstanding performance over the past three years was the government stimulus checks that enabled many of OMF’s borrowers to pay off their debts at a much higher rate than normal.

Now that this stimulus has worn off and inflation has surged, consumer buying power is drying up and loan default rates among OMF’s borrowers have normalized to a great extent.

Moreover, there is a growing body of compelling evidence that we are headed for a recession. If an economic downturn indeed materializes and unemployment spikes from its current persistently low level, OMF will likely see a further increase in defaults on its loans.

For these two reasons, OMF’s stock has pulled back. However, it is important to keep in mind that – as OMF has pointed out repeatedly – charge-offs would have to exceed Great Financial Crisis/Great Recession levels for OMF to no longer be profitable and – between its liquidity runway and current profitability levels – it has significant flexibility before its ability to pay out its quarterly dividend would be threatened. After all, it recently hiked its dividend by a substantial amount, signaling that management has a large amount of confidence in its ability to sustain its dividend moving forward. Moreover, OMF continues to buy back stock at a pretty good clip, thereby reducing its total dividend payout burden and making the dividend even more sustainable in the future.

Investor Takeaway

Given recession concerns, Mr. Market has reason to be a bit jittery about OMF stock and we certainly concur that it is not a low risk investment. That said, between its near 11% dividend yield, substantial buyback program, healthy balance sheet, solid underwriting performance in its core business, and encouraging credit card business growth, OMF remains an attractive high yield stock for us among numerous other sustainable and growing high yield stocks in our portfolio.