Combining Covered Calls with REITs: When The Active Will Kill You

Introduction

At Option Generator, we steadfastly believe in strategic investing through different strategies and non-correlated assets. If an investment strategy relies heavily upon luck or directional exposure (rising/declining share prices) along with a relatively weak probability of profit, the impact of market timing will start to hurt us at some point in time.

Our Favorite Investment Vehicles: Real Assets and Options

Now the question becomes: what strategies are we talking about?

First, positive-theta option strategies of which directional exposure can be tweaked to one's personal risk appetite. Over the past months, we've developed and backtested 5 different strategies for our premium members looking to strike a balance between risk and reward.

Second, investing in real assets such as income-producing properties (apartments, garages), infrastructure, senior housing/student housing et cetera. Jussi Askola, one of Seeking Alpha's best real estate experts, previously wrote about why should invest heavily in real assets. In our situation, we have a tilt toward logistic real estate, data centers, infrastructure, windmills and cell towers. More specifically, 30% of our capital invested in the stock market is dedicated to REITs, utilities and infrastructure companies. One of them is VGP, our largest holding specialized in logistic real estate (currently representing 14% of our invested capital). It's no secret that we love this fast-growing, family-owned real estate developer (semi-REIT) which has so far suffered little from the coronavirus outbreak. In fact, the rapidly growing e-commerce business and thus the warehouses needed to store products are a multi-year tailwind for VGP. There's a lot to like about this company, but thoroughly analyzing its prospects is not the purpose of this article. Fortunately, you're always free to read our last year's interview with the company CEO Jan Van Geet.

(Source: VGP's logistic park in Munich)

Why are we bringing up the idea of investing in REITs, infrastructure, windmills, utilities in conjunction with long-term option selling strategies? First of all, there's no one-size-does-fit-all approach out there: it's about reaping the fruits of strategy combinations to reduce risk and stay engaged over the long haul. Over the past years, we've learned that a consistently income-producing portfolio strategy enables us to stay in the game. We want to minimize the impact of luck and randomness on our performance. Investing in real assets, companies with a wide moat and high cash conversion rates along with covered option strategies has been very good to our results. Why? Instead of targeting a potentially higher reward, the thrilling factor in this whole story is the increased rate of consistency and thus less volatility in your P&L. Don't chase high absolute returns, but focus on the road to achieve superior risk-adjusted results instead.

Covered-Call Writing on REITs: When It Doesn't Work Out That Well

One of the most basic, yet very powerful, option strategies is the covered-call write. To make it clearer to you that not every stock is treated equally, let me review 3 stocks on which this simple approach has recently been backtested. All of the returns mentioned for both buy-and-hold and covered-call writing exclude dividends.

1. Essex Property Trust (ESS)

Essex Property Trust owns and operates West Coast multifamily properties. It's been a great investment for REIT investors over the past decades. More importantly, its implied volatility utilized in options pricing offers plenty of opportunities for cost-basis reduction.

The graph plotted below consists of 3 curves representing buy and hold investing (excluding dividends) and an at-the-money covered call (or as close as possible) but with a different management tactic. The red line does not roll down the strike when a correction occurs, whereas the green line continuously adjusts this 'limit' price.

As you already know, this is the price that we're willing to sell our shares for. Since we want to track the overall performance of selling at-the-money covered calls on ESS, we will sometimes be forced to roll out for a debit. There's no upside beyond the strike price. If the price of the stock goes up, we roll out regardless of whether or not we're paying a net debit. That's because - under real-life circumstances - we still want to hold onto our long-term winners and generate time value by selecting strike prices close to their share price.

(Source: Option Generator Research)

Over the past 10 years, the annual returns and annualized standard deviation (in monthly performance) from selling at-the-money covered calls on ESS would have been as follows:

• 24.8% standard deviation in ESS's share price, with an annualized return of 8.8% excluding dividends

• The red line had a standard deviation of 16.8%, a reduction of 32.2%, while delivering an annualized return of 12.2% excluding dividends. The risk-adjusted return is thus 106% higher than the baseline (buy-and-hold performance)

• The green line has an annualized standard deviation of 16.3%, a reduction of 34.4%, while producing an annualized return of 7.2%. The risk-adjusted return is thus 24% higher than that of the baseline.

Zeroing in on the probability of profit, 68% of all months were profitable for the passive covered-call strategy (red line) compared to 61% for a buy-and-hold investor. The active option strategy which continuously adjusts the strike price enjoys a 76% win rate.

(Source: Option Generator Research)

More importantly, 9 out of 10 years would have been positive for the passive covered-call strategy. Based on the data, increasing volatility in ESS's share price hurts the active covered-call strategy the most. It, therefore, doesn't make sense to chase the strike price down aggressively and vice versa.

(Source: Option Generator Research)

As can be noticed from the graph below, sideways market environments generally favor a covered-call strategy. So while a simple buy-and-hold approach doesn't make a dime, the accumulative effect of harvesting option premiums can create a huge return gap. However, the most striking element is that the active covered-call strategy aiming at rolling down during corrections doesn't yield better returns.

Why has the passive covered-call writing played out very well for ESS over the long run? Well, because 74% of all monthly price changes fell within either 1 standard deviation below or 1 standard deviation above the starting price. Stated differently, there is not a tonne of outliers and the options carry a decent amount of implied volatility resulting in juicy option premiums.

(Source: Option Generator Research)

(Source: Option Generator Research)

2. Crown Castle International (CCI)

Did the same backtesting program on CCI, a leading cell tower REIT, come to the same conclusions as ESS? Let's figure that out!

(Source: Option Generator Research)

Over the past 10 years, the annual returns and annualized standard deviation (in monthly performance) from selling at-the-money covered calls would have looked as follows:

• 21.4% standard deviation in CCI's share price, with an annualized return of 15.8% excluding dividends

• The red line had a standard deviation of 14.8%, a reduction of 31.1%, while delivering an annualized return of 15.7% excluding dividends. The risk-adjusted return is thus 44% higher than the baseline (buy-and-hold performance)

• The green line has an annualized standard deviation of 12.4%, a reduction of 42.2%, while producing an annualized return of 11.0%. The risk-adjusted return is thus 20% higher than that of the baseline.

Zooming in on the probability of profit, 65% of all months were profitable for the passive covered-call strategy (red line) compared to 55% for a buy-and-hold investor. The active option strategy which continuously adjusts the strike price enjoys a 75% win rate.

(Source: Option Generator Research)

Based on the backtesting results, increasing volatility in CCI's share price hurts the active covered-call strategy the most. We, therefore, should resist the temptation of overadjusting our strike prices, i.e., chasing the strike price down aggressively and vice versa. Doing nothing and waiting for the stock to come back will be more beneficial to our final outcome.

(Source: Option Generator Research)

(Source: Option Generator Research)

Why has the passive covered-call writing played out very well for CCI over the long run? Well, because 70.4% of all monthly price changes fell within either 1 standard deviation below or 1 standard deviation above the starting price. Stated differently, there is not a tonne of outliers and the options carry a decent amount of implied volatility resulting in juicy option premiums. This is exactly the same factor we've seen in ESS.

(Source: Option Generator Research)

3. Realty Income (O)

Realty Income, one of the best triple net-lease REITs in the world, is probably the worst underlying we've come across so far in backtesting monthly covered-call writing and other option strategies. The combination of low implied volatility and a sudden outlier move will hurt both active and passive covered-call writers. 55.8% of all the monthly price changes fell within either 1 standard deviation above or 1 standard deviation below the starting price. It's this kind of tail risk (including Covid-19 crash) that won't favor the option seller.

Over the past 10 years, the annual returns and annualized standard deviation (in monthly performance) from selling at-the-money covered calls on Realty Income would have looked as follows:

• 27.5% standard deviation in O's share price, with an annualized return of 5.4% excluding dividends

• The red line had a standard deviation of 27.1%, a reduction of 1.6%, while delivering an annualized return of 3.5% excluding dividends. The risk-adjusted return is thus 34% lower than the baseline (buy-and-hold performance)

• The green line has an annualized standard deviation of 38.6%, a increase of 40.4%, while producing an annualized return of -12.5%. And that's not a typo... The risk-adjusted return is thus 264% (!) lower than that of the baseline.

(Source: Option Generator Research)

The following graphs tell the whole story. There's one conclusion to draw from these backtesting results: don't incorporate O in your option selling strategies, unless sporadically.

(Source: Option Generator Research)

(Source: Option Generator Research)

(Source: Option Generator Research)

Overall Conclusions

In the world of REITs, one has to be very selective in deciding what underlyings fit a covered-call writing strategy. CCI, ESS, but also PLD, AMT and EQIX have proven to be great vehicles for covered option selling, producing risk-adjusted returns superior to those of a buy-and-hold approach. Lower-volatility stocks that can suddenly fall victim to intensifying fluctuations don't fit the bill. By providing this information, we hope to put context around a basic and oft-cited safe option strategy when it comes to REIT investing. Don't underestimate tail risk and verify whether the option premiums will reward you over the long haul.