NRO: High-Yielding Real Estate CEF Is Risky, Payout Unsustainable

~ by Snehasish Chaudhuri, MBA (Finance).

Neuberger Berman Real Estate Securities Income Fund Inc (NYSE:NRO) is a closed-end fund, or CEF, that invests in stocks of companies operating in the real estate sector including real estate investment trusts ("REITS"). Investments in real estate both help in wealth preservation as well income generation. The fund benchmarks its performance against the NAREIT Equity Index and S&P 500 Index (SP500).

NRO is currently trading at a discount. The fund offers a monthly payout and generates strong yield. Annual average yield recorded since 2018 has been little over 10 percent. Despite this double-digit annual average yield, total return has been only 1.35 percent over the same period. This raises serious concern about the sources of dividends and sustainability of its payouts over the long run.

NRO Has A Relatively Low Asset Base And Comparatively High Expense Ratio

This closed-ended equity mutual fund was launched by Neuberger Berman LLC during October 2003, almost 20 years back. The fund is co-managed by Neuberger Berman Management LLC. It employs a fundamental analysis including on-site real estate analysis, frequent meetings with company management, and thorough investigation of various REITs. Almost 65 percent of its assets are invested in the U.S. equity market, and remaining assets are invested primarily in convertible securities. NRO has a high expense ratio of 2.06 percent on a relatively small asset under management ("AUM") of $162 million. High expense ratio on a small asset base may create problems in the absence of adequate returns, delivered on a consistent basis. Neuberger Berman Real Estate Securities Income Fund also has a low turnover ratio of 27 percent.

Despite Such Low AUM, NRO’s Equity Portfolio Consist Of Well-Known REITs

Neuberger Berman Real Estate Securities Income Fund has made large bets on specialized REITs and healthcare REITs. Significant investment in specialized REITs included global leader in logistics real estate - Prologis, Inc. (PLD), operator of multitenant communications real estate like American Tower Corp (AMT) and Crown Castle Inc (CCI), world’s largest self-storage REIT - Public Storage (PSA), largest data center REIT - Digital Realty Trust, Inc. (DLR), global leader for storage and information management services - Iron Mountain Incorporated (IRM) and world’s largest gaming facilities REIT - VICI Properties Inc (VICI). Some of the largest healthcare REITs like Welltower Inc (WELL), Ventas, Inc. (VTR) and Omega Healthcare Investors, Inc (OHI), also featured among the top 50 percent of NRO’s equity investments.

Almost 55 percent of NRO’s equity portfolio consisted of only 20 REITs, and half of those companies are specialized and healthcare REITs. Post covid-19 pandemic, REITs in these sectors have performed much better than other REITS, such as office, residential, mortgage and hospitality REITs. Neuberger Berman Real Estate Securities Income Fund has invested almost 12 percent in few residential REITs like Apartment Income REIT Corp. (AIRC), Equity Residential (EQR), AvalonBay Communities, Inc. (AVB) and Essex Property Trust, Inc. (ESS); and some mortgage REITs like Starwood Property Trust, Inc. (STWD), Blackstone Mortgage Trust Inc (BXMT) and Annaly Capital Management Inc (NLY); Retail REITs such as Tanger Factory Outlet Centers, Inc. (SKT), Simon Property Group, Inc. (SPG), and Realty Income Corporation (O) also feature among the top 20 REIT investments of this real estate fund.

Price Performance And Future Prospects Of Top REITs In NRO’s Portfolio

Specialized REITs and Healthcare REITs performed well during the past six months. Barring OHI, all other stocks generated positive price growth. Prices of WELL, PLD, VTR and IRM grew in excess of 20 percent, which is quite phenomenal. All the three retail REITs (SKT, SPG and O) also registered price growth in excess of 15 percent during the same period. On the other hand, residential REITs and mortgage REITs had disappointing performance. Barring NLY, not a single strong was able to register positive price growth during the same period. The cut-off period of six months is of significance, since July 31st, 2022, was the last time when new stocks were introduced within the top equity portfolio of Neuberger Berman Real Estate Securities Income Fund.

“Specialized REIT” is seldom used as a broad umbrella term, which may include various property types like self-storage REIT, data storage REIT, farmland REIT, tower infrastructure REIT, etc. Healthcare REITs are also a type of specialty REITs. However, generally this is considered a different segment. Both specialized REITs and healthcare REITs are highly cyclical in nature, as they create and operate specific and unique types of facilities. These specific infrastructures will always have lower supply and higher demand. Retail REITs have suffered immensely during covid-19 pandemic, but are slowly recovering.

As the economy opens up and consumer spending goes up, this segment is also expected to grow much faster than other REIT segments. Increase in population and purchasing power will continue to generate demand for retail REITs. The same cannot be said about residential REITs and mortgage REITs. Due to interest rate hikes, high unemployment and economic uncertainty, residential REITs likely will have a tough time in the near future. When residential REITs suffer, mortgage REITs suffer, too; although they are in a relatively better position due to their indirect exposure. Other categories of REITs, too, create demand for mortgage REITs. Fortunately, the percentage of investment in those two sectors is not that high. So, overall, Neuberger Berman Real Estate Securities Income Fund has selected the right segments for investments.

Neuberger Berman Real Estate Securities Income Fund Has An Attractive Valuation

Overpaying or overspending for any equity stock under most circumstances leads to suboptimal returns. Such a scenario may indicate that investors are paying more than they are actually worth. That is fortunately not the case with Neuberger Berman Real Estate Securities Income Fund. Not only this fund is trading at almost 10 percent discount, but also has a much lower price to earnings (P/E) ratio of 23.8 as compared to index P/E of 30.45. The price to cash flow (P/CF) ratio of 9.46 is also a little lower than that of its benchmark index.

Investing In NRO Is Risky And Its Payout Doesn’t Seem Sustainable

The Neuberger Berman Real Estate Securities Income Fund borrows money from the markets and utilizes that borrowed capital to purchase real estate securities. When the yield of the purchased securities is higher than the interest rate on the borrowed capital, leverage increases the overall yield. Fortunately, NRO can borrow at institutional rates, which are significantly lower than retail lending rates, and overall, the real estate sector generates strong returns. So far, this strategy has worked and the fund has been able to provide monthly pay-out and generate double-digit yield on an average. Overall, NRO has selected the right segments for investments. The fund is also available at a significant discount, and valuation seems to be right.

Despite all these positives, NRO has failed to attract me. Neuberger Berman Real Estate Securities Income Fund Inc does not appear to be well-positioned to sail through economic hardships. Neuberger Berman Real Estate Securities Income Fund is also failing to cover its distributions and this current level of yield doesn't seem sustainable. The price growth generated by the constituent equity investments are reasonable, but no way enough to support such a high yield. The market obviously understands this, and that’s why NRO’s average annual total return since 2018 was only 1.35 percent, whereas the average yield was little over 10 percent. The reason was that the price of Neuberger Berman Real Estate Securities Income Fund Inc almost halved during this period. Its high expense ratio on a small asset base is bound to create problems in the absence of adequate returns. For these reasons, I’d prefer to stay away from this high-yielding real estate CEF.

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