Author’s note: This article was released to CEF/ETF Income Laboratory members on Sept. 28, 2020 with certain numbers updated. Please check latest data before investing.
This month, I’d like to take a look at Principal Real Estate Income Fund (PGZ), the top ranked DxYxZ fund (and frequent entrant) in our latest “High-High-Low” report.
As of Oct. 7, PGZ exhibited an attractive -24.78% discount with a -1.9 z-score. At the time of publication of our “High-High-Low” report, PGZ sported a a 12.10% yield that was 98% covered. However, the fund just announced a reduction in its monthly distribution from $0.11 to $0.08/month for the next three months, starting from November. This lowers the forward yield to 8.81% with a concomitant NAV yield of 6.63% as of the latest prices.
PGZ has come up in the chat several times recently as a possible high-risk/reward contrarian play, but we haven’t had a dedicated look at this fund in our articles so far. PGZ also uses 29% leverage and charges a baseline expense ratio of 2.02%.
PGZ is fairly unique among real estate CEFs in that it doesn’t invest in equity REITs and preferreds. Instead, its largest allocations (~70%) are in commercial mortgage-backed securities, or CMBS for short. CMBS are akin to the residential MBS (or RMBS) holdings frequently discussed for the PIMCO taxable CEFs, except that for CMBS, the original pool of loans comes from commercial rather than residential mortgages. These commercial mortgage loans are then packaged or “securitized” into tranches with various levels of seniority (and hence risk/reward).
Another 14.69% in “U.S. Real Estate Securities” and 13.27% in “International Real Estate Securities” rounds out the rest of PGZ’s portfolio.
It’s not a secret that commercial real estate is under significant pressure due to COVID-19. According to S&P Global Market Intelligence, the delinquency rate for CMBS loans reached 10.32% in June, near all-time highs. At first glance, this might make the solid performance of the iShares CMBS Bond ETF (CMBS), which is up +6.35% over the past year (recovering quickly from a ~5% drawdown in March), rather surprising. The iShares MBS ETF (MBB), which tracks mainly agency MBS, also is included for comparison.
Meanwhile, PGZ’s has performed quite miserably, down -32.44% over the same period.
Why the stark difference? The reason is that CMBS tracks an a CMBS index composed of only investment-grade CEFs. In fact, more than 90% of CMBS’s holdings are AAA-rated. These were the tranches that benefited from the Fed’s asset-buying program (“Term Asset-Backed Securities Loan Facility program”).
In contrast, PGZ holds the riskier tranches of CMBS. We don’t have the credit breakdown of the fund available, however commentary from their latest semi-annual report implies that they have purchased mainly the BBB and BB-rated slices.
The performance of the CMBS holdings within the Fund reflect the dramatic widening of BBB- and BB- rated CMBS in response to the widening mid-March and the continued pressure on prices given the market uncertainty around the duration of the health crisis and ultimate impact on demand for commercial real estate. The price recovery for the portfolio holdings will be driven by how quickly economic activity recovers both in anticipation of and after a vaccine for COVID-19 is available. This is especially true for hotel and retail properties and how long owners can continue making mortgage payments to protect their properties from foreclosure during this period. Current market prices assume that a large percentage of owners will not be able to do so, which will result in loan level losses that put BBB- and BB- rated CMBS at risk of default. We believe this expected stress on commercial real estate is why CMBS is lagging the broader market recovery that started with the intervention by the Fed.
Hence, PGZ should be considered as a higher risk/reward proposition compared to CMBS and MBS, which are actually quite safe. In fact, PGZ had soundly trounced the two ETFs in the years leading up to 2020.
Of course, COVID-19 then made short work of this outperformance. In a classic “flight-to-safety” move, CMBS AAA yields moved lower (2.4% to 1.5%) while CMBS BBB yields nearly doubled higher (from 4.4% to 8.0%) during the first half of 2020.
In our initial report (published before the cut announcement), this is what we had written:
However, the fund will find it difficult to regain its past NAV due to the deleveraging that it had to undertake during the crash. Between Oct. 31, 2019 and April 30, 2020, the fund reduced its line of credit from $60 million to $40 million. This means that there’s likely to be downward pressure on its earnings (which had actually been rising for three years since 2017) when the fund reports again in October 2020. As a result, the current coverage of 98% is likely to be overstated and I would not be too surprised to see a distribution cut at some point in the future to preserve NAV. PGZ’s current NAV yield is 9.39%, which is boosted to a market yield of 12.10% thanks to its -22.32% discount.
It turns out that prediction was quite timely as the fund announced a cut shortly afterwards. While some may be disappointed at a cut, I do believe that it’s a prudent move in order to conserve NAV. The cut also is consistent with the notion that the coverage as calculated from their latest earnings numbers were overstated.
Regarding the cut, the managers had this to say:
The unprecedented COVID-19 related market volatility in the first quarter of 2020 had a significant impact on the Commercial Mortgage Backed Securities market. As a result, the increased default risk has resulted in lower risk adjusted yields in the portfolio.
The new forward yield is 8.81%, while the NAV yield is a reasonable 6.63%.
Where do we go from here? First of all, valuation wise, the -24.78% discount is decidedly attractive on its own merits, exceeding the valuations recorded during the March rout. The current discount is far wider than its one-, three- and five-year average discounts of -13.70%, -12.55% and -11.85%, respectively.
Fundamentally, the performance of PGZ will hinge on prospects of an economic recovery which now seems to depend on the availability of a vaccine for COVID-19. On average, CMBS deals have 10%-15% exposure to hotels and 25%-30% exposure to retail, two of the hardest hit sectors due to the shutdowns. If a vaccine is not developed, commercial mortgage defaults will continue to put pressure on the lower-rates tranches that are owned by PGZ and the NAV will be under continued threat.
Overall, PGZ would be an attractive choice for the risk-tolerant contrarian investor that’s bullish on the recovery of commercial US real estate. With the cut already in place, the forward yield of 8.8% should be stable for the time being while the -24.78% discount provides a wide margin of safety for the CEF investor.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.