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• CEF 100% Rate It
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• NAV 100% Rate It

By Henry Hoffman

Cohen & Steers Quality Income Realty Fund ( RQI ) is a closed-end fund (( CEF )) that invests in public real estate equities in the United States and is managed by Cohen and Steers. Cohen and Steers is a well known investment manager specializing in income generating equity securities including real estate, large cap value stocks, infrastructure and preferred securities. Unlike open-end mutual funds which issue and redeem shares and thus trade at the value of the assets it holds, closed-end funds have a limited number of shares that are not redeemable for the underlying securities or cash (except in liquidations when the fund distributes all assets). Therefore, CEFs can trade at prices dislocated from the value of the securities held by the fund, known as its net asset value (( NAV )). In the case of RQI, shares trade for 15% less than the net value of its assets.

There are many reasons why CEFs can trade at large discounts or premiums to NAV. Some are more or less theoretically justified, such as liquidity, management's ability to generate competitive returns, management fees, corporate governance and leverage. Other reasons appear to be more a reflection of the preferences or even misunderstandings of investors, such as distribution rates and general sentiment. It seems the latter has been the cause of RQI's large discount to NAV. The once sought after real estate sector has been out of favor among investors leading to both depressed REIT security valuations and doubly mirrored in the discounts of real estate themed closed-end funds. Also, similar to the reaction in other CEFs that cut distributions over the last couple years, investors dumped RQI shares following quarterly distribution cuts in 4Q08 from $0.15/share to $0.133/share then another reduction in1Q09 to $0.0933/share leading to brief discounts in excess of 30%.

The wide discount to the easily calculated underlying publically listed equities creates a buying opportunity in RQI shares. The poor investor sentiment is already reflected in the prices for the underlying securities and an additionally discount of 15% is unwarranted, in our opinion, particularly because RQI is large, liquid, transparent and shareholder friendly (at least relative to their peer group). Furthermore, based on recent actions, it appears that Cohen & Steers is focused on narrowing the discount. They have authorized large share repurchase programs and recently increased the quarterly dividend to $0.18/share from $0.933 giving shares a dividend yield of 9.5% today.

Repurchasing shares is a wonderful way to return value to shareholders of a closed-end fund trading at a discount. It both raises the NAV per share for the fund and narrows the discount for shareholders. However, often fund managements do not see it to be in their own interest as it also lowers the assets under management, which the typical asset manager's fee is based upon. The Cohen & Steers funds have taken the higher road and their closed end funds have been authorized to repurchase up to 10% of outstanding common shares each calendar year. As seen in the table below, managers are using this authorization to continue to repurchase shares during the second quarter. Management repurchased 390,500 shares (approx. $2.8 million) of RQI over the course of the second quarter which traded at an average discount to NAV of 17.3%.

The distribution yield as a percentage of NAV is seemingly one of the most indicative factors of a closed-end funds discount to NAV. Interestingly, investors seem to ignore whether the distribution is paid from net investment income or simply a return of investors capital. In any case, shareholders bid up prices of CEFs that pay larger distributions. Last week, Cohen & Steers raised the distribution on six of its seven CEFs, essentially doubling it for RQI. Not only does this resonate positively for yield seeking investors but also speaks to management's positive sector outlook.

*Source: Morningstar's FundData

To determine an appropriate current market discount target for RQI, we compare its current yield to other CEFs that also focus on public real estate equities in the United States. Isolating the sector, and taking into account RQI's positive alpha over 1 and 3-yr periods, diversified portfolio, large relative asset size, repurchase program, and larger than average distribution on NAV yield; RQI's recent distribution increase suggests share price appreciation of at least 7% versus its peers. Meanwhile, RQI shareholders will collect the 9.5% dividend yield.

Disclosure: Author long RQI with hedge

See also Is the Fed Crossing the Line? on seekingalpha.com

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