REITs have been one of the worst-performing sectors over the past few years, as the interest rate-sensitive sector has gotten hammered by the rapid rise in interest rates.

That said, the underlying fundamentals of these companies have, for the most part, been strong. Rents have continued to grow in most cases, balance sheets remain in remarkably strong shape, and asset values, while in numerous instances declining to account for expanding cap rates in response to rising interest rates, have proven to be remarkably resilient. As a result, the market sell-off is largely overblown, and now many REITs trade at steep discounts to their private market net asset values.

This has created a very attractive opportunity that billionaire investors like Blackstone (BX) are taking advantage of by acquiring REITs like Apartment Income REIT (AIRC), Tricon Residential, and others. Moreover, they plan to continue investing aggressively in the real estate sector for years to come to take advantage of the current public-private market disconnect. As a result, now may be a great time on a risk-adjusted basis for investors to increase their own capital allocation to the sector.

One way that this can be done in a fairly easy and lower-risk manner is by buying broadly diversified REIT funds. In this article, we will compare two of the most popular ones today: the Cohen & Steers Quality Income Realty Fund (RQI) and the Vanguard Real Estate Index Fund ETF (NYSEARCA:VNQ) and share our take on which is a better way to play the potential recovery in REITs.

RQI CEF Vs. VNQ ETF

The most significant difference between these funds is that RQI is a CEF (closed-end fund), whereas VNQ is an ETF (exchange-traded fund). What this means is that VNQ always trades in line with the underlying value of its holdings, whereas RQI can fluctuate, trading at times at a premium and at other times discounted to the underlying value of its assets. Currently, given that REITs are out of favor, RQI trades at a near 6.5% discount to its underlying net asset value. However, in its history, it has at times traded at a premium to the underlying value of its holdings, particularly when REITs have been in favor. This means that investors who buy now could potentially see an additional boost to their total returns by the discount to its underlying holdings closing as REITs come back into favor.

Another important aspect of RQI that differentiates it from VNQ is that it applies leverage. In fact, it has nearly 30% leverage applied. What this means is that it increases the volatility of the fund, so that when REITs appreciate, RQI tends to outperform the broader REIT sector, whereas when prices are declining, it tends to underperform.

The biggest risk to this, though, is that with that amount of leverage applied, if the market were to experience a sharp crash right now, RQI could potentially be forced into a margin call since its equity would drop below a certain threshold necessary to secure that debt on its balance sheet, which would force it to sell a potentially meaningful amount of its portfolio in the midst of a market crash, thereby locking in permanent impairment to its value and even possibly forcing a dividend cut. This has happened in the past to other CEFs, such as one operated by Nuveen (JMF) during the 2020 energy sector crash, and so it certainly could happen again to a CEF like RQI.

Another difference between RQI and VNQ is RQI's management expense. RQI's expense ratio, not counting the interest from its debt, is quite high at 1.42%, whereas VNQ's is quite low at 0.13%. On the other hand, thanks in large part to RQI's significant leverage, it currently offers a very attractive 8.26% dividend yield, whereas VNQ's is barely over half that at 4.27%. When it comes to their underlying holdings, both are virtually entirely invested in the real estate sector. However, RQI has some exposure to fixed-income instruments, with 11.75% in preferreds and 8.51% in bonds, whereas VNQ is 100% invested in equities. Beyond that, they have very similar top holdings. RQI's top holdings include American Tower (AMT), Prologis (PLD), Welltower (WELL), Simon Property Group (SPG), and Digital Realty Trust (DLR), all of which factor into the top 10 holdings for VNQ as well. Additionally, RQI is more diversified than VNQ as it has 206 total holdings, whereas VNQ only has 163, and both have roughly half of their portfolio concentrated in their top 10 holdings.

When it comes to comparing their long-term track records, RQI has significantly outperformed VNQ over the past 10 years, with a 124.6% total return compared to VNQ's 66.23%.

However, it is noteworthy that during the 2020 crash, RQI dropped significantly more than VNQ did. This indicates, once again, that due to the use of leverage, RQI will be much more volatile, but as long as the market moves up over time, it's also likely going to significantly outperform. It is also likely because RQI is actively managed, and REITs are a sector that tends to be less efficient than others, and therefore active management is likely to be more effective. This may even be more the case right now with consolidation taking place in the space, with major investors like Blackstone along with other alternative asset managers pouring tons of capital into this sector.

Investor Takeaway

So, what are investors supposed to do, and how can they best play the potential recovery in REITs? Both of these funds have their pros and cons, with RQI's skilled active management certainly being a major pro. Additionally, the discount to the underlying value of its holdings could be a major tailwind, if REITs return to favor and RQI returns to trading in line with or even at a premium to its net asset value. Finally, the leverage and the higher yield could also significantly boost returns to shareholders if REITs return to a bull market, as has been seen in the past. That being said, RQI is much more expensive than VNQ on an expense ratio basis, its leverage dramatically increases risks, and while RQI is somewhat actively managed, it still has massive diversification, which minimizes the positive impacts of the active management that investors are paying so much for.

As a result, our personal preference is to actively invest in REITs ourselves, which we have actually done with remarkable results that have outperformed both RQI and VNQ over time. However, for investors who do not want to pick individual REITs, we think that right now, if we had to pick between these two, we would pick RQI simply for the fact that it offers greater upside potential in the event of a bull market, and since we're bullish on REITs, we think that this is the most likely scenario. However, we would want to keep such exposure limited because of the elevated leverage that RQI has and the growing geopolitical and macroeconomic risks that could lead to a market crash at any time.

As a result, if we were to not actively manage stocks and were open to holding both, our ideal approach would be to hold both in roughly equal amounts to reduce the risk that comes with RQI's leverage but also increase our yield and our upside potential through its use of leverage and active management. Additionally, we think this approach offers the best risk-reward, since it also reduces our average expense ratio by having VNQ's lower expense ratio averaged in.

Whichever path you take, we think that now is a very prudent time to allocate capital to REITs as long as investors maintain proper overall portfolio diversification and follow their uniquely tailored investment strategies that are crafted in consultation with their personal financial planner and/or financial advisor.