The money wave powering REITs

By Markets Covestor

$150 billion is a lot of money.

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And, due to some planned changes by the makers of the S&P and MSCI indexes, that’s the amount of money that is likely to flow into shares of real estate investment trusts (REITs) over the next few months.

You see, up until now, REITs have been considered “financials” for the purposes of sector weighting.

Well, that’s just crazy, in my opinion.

 

 

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Flawed Logic

In my opinion, a landlord who owns a portfolio of rental properties really has little in common with a bank or an insurance company.

Yet that’s where REITs have historically been lumped.

But now that the index creators are fixing their mistake, I think there are going to be a lot of mutual fund managers and other institutional investors who will be pretty dramatically out of balance.

According to recent research by Jefferies, that $150 billion is how much would need to be reallocated to REITs so that mutual fund managers can meet their benchmark weightings.

 

Lifting REITs

I expect that the real number will be a decent bit lower than that. A lot of managers will be content to be underweight REITs relative to their benchmark.

But even if it ends up being half that amount, that’s a big enough inflow to seriously buoy REIT prices in my view. The entire sector is only worth about $800 billion.

If you believe in the REIT story, and expect REIT prices to go higher–and someone told you that you could buy a portfolio of REITs for 90 cents on the dollar–wouldn’t you jump at the opportunity?

Well, that’s exactly the situation today in the world of closed-end funds.

And in Peak Income, the new newsletter I write with Rodney Johnson, I recently recommended a closed-end REIT fund trading for about 90% of net asset value.

 

Triple Play

Out of fairness to the readers who pay for that information, I can’t share the specific stock with you. But I can definitely tell you how I chose this fund and what you should look for when evaluating closed-end funds on your own.

With most mutual funds, you can really only make money one way: the stocks in the portfolio must rise in value. Sure, dividends might chip in a couple extra percents. But for the most part, you only make money if the price of the stocks the manager buys goes up.

That’s not the case with closed-end funds. In fact, I believe that you can make good money in three ways with this particular investment vehicle:

 

#1 – Current dividend is generally a large component of returns.

Unlike traditional mutual funds, closed-end funds are specifically designed with an income focus in mind, so they tend to have some of the highest current yields of anything traded on the stock market.

This is partially due to leverage. Closed-end funds are able to borrow cheaply and use the proceeds to buy higher-yielding investments. This has the effect of juicing yields for you.

#2 – Returns delivered via portfolio appreciation. Just as with any mutual fund, you make money when the stocks your fund owns rise in value.

#3 – You have the potential for shrinkage of the discount or an increase in the premium to net asset value.

That sounds complicated, so I’ll explain. Because closed-end bond funds have a fixed number of shares that trade on the stock market like a stock, the share price can deviate from its fundamentals just like any stock can.

Sometimes, you can effectively buy a good portfolio of stocks, bonds or other assets for 80 or 90 cents on the dollar or even less from time to time.

But often, that same dollar’s worth of portfolio assets might be trading for $1.10 or higher on the market.

 

Solid Potential

Well, I’m not a big fan of paying a dollar and 10 cents for just a dollar’s worth of assets… no matter how much I might like those assets.

But I do rather like getting that same dollar’s worth at a temporary discount. And when that discount closes, your returns outpace those of the underlying portfolio.

In my opinion, the ideal closed-end fund investment should have solid potential from all three factors. It will pay a high current dividend, will have a portfolio poised to rise in value, and will be trading at a deep discount to net asset value.

Photo Credit: AJC ajcann via Flickr Creative Commons








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