Best REITs for Rising Interest Rates

real estate investmentReal Estate Investment Trusts (REITs), like master limited partnerships, have long been a staple of income portfolios.  Because they are required by law to pay out 90 percent of their earnings as dividends, they can provide investors with high yields.  Since 2009, the price of equity REITs has more than doubled due to demand from yield-hungry investors who have been faced with a low interest-rate environment.

A downside of investing in REITs is that they are generally very sensitive to interest rate increases.  Since most of their earnings are distributed as dividends, REITs do not keep much cash on hand, so they have an ongoing need to raise cash by borrowing money or selling shares.  When interest rates rise, their cost of capital also rises cutting into their earnings.  The spectre of rising interest rates hit the markets hard in May, and from May 21 to June 21 the market value of equity REITs declined by about 16 percent.

So given the likelihood that interest rates will probably be rising in the next few years, which REITs should be avoided and which ones might still offer opportunities?

I would suggest avoiding those REITs that are saddled with long-term leases.  Owning such REITs is comparable to owning bonds – they provide steady and reliable cash flow through rents, but as inflation picks up and interest rates rise, the REITs cannot make appropriate rent adjustments to cover increased capital costs (and, of course, dividends may suffer).  Examples of business types with long-term leases include landlords of single-tenant (triple net-lease) properties and most healthcare REITs.  The one exception I would make here is if you come upon any REITs that issue leases with rent escalators rather than fixed rents.  Those might still be worth investigating.

The REITs that may prove to be smart investments for income would be those that hold relatively short-term leases. In particular, I would explore multi-family REITs and self-storage REITs.

 

Multi-family Residential REITs

Multi-family (apartment) REITs have underperformed other REITs lately.  An improving housing market and the number of new apartments coming onto the markets have scared many potential investors away.  However, as the economy improves, these REITs are poised for a comeback.  An improving economy means more jobs, which directly impacts these REITs by increasing the number of potential tenants.  As interest rates rise, building of new apartments is also expected to drop off significantly, thus allowing current landlords more flexibility to increase the rents of existing residents.

Two popular multi-family REITs to investigate are:

Equity Residential (EQR, yield 2.8%)
AvalonBay Communities, Inc. (AVB, yield 3.2%)

Another possibility within this sector is with a student housing REIT:

American Campus Communities (ACC, yield 3.6%)

 

Self-Storage REITs

The self-storage industry consists of about 55,000 properties nationwide.  Some people consider the industry to be a somewhat counter-cyclical, i.e., a troubled economy = increased need for storage.  The industry is currently experiencing record-high occupancy rates of around 90 percent, and landlords have been raising rents 5 percent or higher on existing tenants over the past couple of years.

Self-storage operators are benefiting from low competition because supply is tight.  There are only about 200 self-storage facilities currently under construction nationwide.  This compares with over 2,500 facilities developed between 2003 and 2007.  High valuations for self-storage properties are likely to persist until there is another wave of development that saturates the market.

Three popular self-storage REITs to investigate are:

Public Storage (PSA, yield 3.3%)
Extra Space Storage, Inc. (EXR, yield 3.8%)
CubeSmart (CUBE, yield 2.7%)

Please be sure to conduct your own due diligence on any of the REITs mentioned in this post before investing.  I am not recommending these as investments, only as possibilities to explore.  (Disclosure: I own none of the REITs mentioned in this post, but may purchase one or more of them after doing more exhaustive analysis over the next week.)

 

 

Update: Income from Gold and Silver

investment income from precious metalsHere’s an update to the post I wrote last August on Income from Precious Metal Investments. In that post I mentioned that one possible strategy for deriving income from gold and silver was to write covered calls against investments in GLD and SLV. Well, it looks like someone else was thinking the same thing.

Since October 2012, gold and silver prices have gotten hammered (I wonder what Ron Paul’s portfolio looks like now!).  During this negative environment for precious metals, Credit Suisse launched a couple of exchange-traded notes (ETNs) that employ a covered call strategy to provide an income yield for underlying gold and silver holdings. GLDI was launched in January with a strategy to sell covered calls against GLD, and SLVO was launched in April to do the same for SLV. Although performance of these ETNs has been less than stellar so far, these products are still new and probably worth watching as possible investments for income.

My personal view is that these products are still unproven, and their risks should be considered carefully by potential investors. In addition to the concern I mentioned in the previous post about GLD and SLV being able to accurately reflect the price changes for the metals in all market conditions, there is also the uncertainty of Credit Suisse being able to back up the ETNs in all market conditions. I’m also a little concerned that the timing of these product launches may not be the best. Covered call strategies that involve selling and then buying back out-of-the-money calls from month to month are usually optimal when the prices for the underlying securities are flat or slightly bearish. In times when prices are rising significantly, the strategy gets tricky. Simply owning the underlying securities and foregoing the call income would usually maximize overall returns in a bullish situation, but of course then you would receive no income.

Over the past month (May 2013), we’ve seen long-term interest rates starting to creep up. If this turns out to be a precursor to the long-awaited inflationary cycle, then a covered call strategy for precious metals may not be the best strategy to pursue right now since gold and silver prices would also be expected to rise substantially. If, on the other hand, you believe that prices for gold and silver will remain relatively flat for some time, then these ETNs may prove to be smart investments for your income portfolio.

Are MLPs the Perfect Income Investment?

MLP Master Limited PartnershipMaster Limited Partnerships (MLPs) have been popular investments for income portfolios for the past couple decades, but over the past year there has been a noticeable push to promote these investments to a greater number of individual investors.  Everyone from Jim Cramer to Barron’s to the Motley Fool seem to have concluded that owning partnership units are the closest thing to a perfect investment as one can make for an income portfolio.  But are these investments too good to be true?

The basics of MLPs are explained pretty well at Investopedia and others websites.  The MLP world consists primarily of groups engaged in natural resource activities, notably oil and gas pipeline operations.  Because of the way they are structured and the tax-favored treatment they receive, MLPs are able to offer investors attractive high-yield returns.  Unlike regular dividends, the distributions from MLPs are treated as a combination of income and return of capital.  Many investors (myself included) are turned off by the paperwork and recordkeeping needed for tax purposes.  Partnerships are considered pass-through entities, so, as a unitholder, you are obligated to pay your share of the taxes for a partnership’s income.  Instead of 1099s, you would receive K-1 forms annually for your holdings.  The recordkeeping becomes even more involved if you hold these investments in a retirement account.  Understand the tax implications before investing in these entities. 

MLPs have bounced back nicely from the 2008 debacle, and earlier this month they actually looked overpriced.  Over the past week though (I’m writing this in late-May 2013), there has been a significant correction in the sector, so prices appear a little more palatable.  As with any high-yielding investment, these investments are sensitive to interest rate changes, so I would advise watching these investments closely going forward.

One way to bypass the tax headaches for these investments would be to invest in an MLP fund or ETF like AMLP or EMLP.  Before investing, I would run the numbers to make sure the fund expenses and fees are worth the return and income you are seeking.  If they are, then these may be smart investments for your income portfolio.

Smarter Bond Investing With Defined Maturity Funds

Defined-maturity fundsTwo popular ways to hold bonds in a portfolio are 1) to hold a collection of individual bonds or 2) to own shares of one or more bond funds. There are advantages and disadvantages to both approaches. Holding individual bonds guarantees return of your principal when a bond matures (assuming no defaults), but also requires a large amount to invest if you are to adequately “ladder” a portfolio to mitigate interest rate risks. If you have smaller amounts to invest, you can achieve better diversification with traditional bond funds or ETFs, but there is no guarantee that your initial investments will be returned at any time.

Defined Maturity Funds Make It Easier

Over the last year or so, new bond investment products have become available which combine the advantages of individual bonds with the advantages of funds. These so-called Defined Maturity Funds (mutual funds and ETFs) allow income investors to structure an income ladder that reduces interest rate risks while not requiring balances as large as would be required for individual bonds. Defined maturity fund products are currently available from Fidelity, iShares, and Guggenheim.

To explore more about these products and what can be done with them, check out these articles:
Build a Bond Ladder
Defined Maturity Fund Basics
Pros and Cons

Income From Precious Metal Investments

gold silver investment incomeIn response to popular economic forecasts, many people are considering making investments in hard assets. A couple of weeks ago, PIMCO’s Bill Gross tweeted the following message to his followers:

Gross: w/ neg real intrest rates out to 20 yrs in US bond mkt, how wl investrs maintain purchasing powr? Stocks maybe. Real assets bettr bet

Real assets do sound good to me, but the question for income investors is whether or not there are viable ways to produce reliable income from real assets. Generating income from real estate and property investments is straightforward enough since they lend themselves to rental arrangements. But what about generating income from precious metal holdings?

Gold and silver holdings are often considered dead weight in a portfolio. They provide a good hedge against currency devaluation and inflation, but they do not produce income, and their financial benefits are not realized until after the hard assets themselves are actually sold. The next best thing to owning the physical metals would be to own securities that are closely linked to the value of precious metals. Even better would be to generate income from such securities. Be aware that various hair-brained schemes (and scams) to produce income from precious metal holdings have been attempted in the past (see here for example), but these have always ended with great disappointment and tears for investors. If you are interested in trying to squeeze some income from precious metal investments, consider these two more conventional ways of doing it.

Buy Gold and Silver Mining Stocks that Pay Dividends

As experienced investors will tell you, the price of a mining company’s stock is somewhat correlated to the price of the underlying metals that the company extracts, but the link is far from perfect. My own unscientific observation is that the share prices of mining companies are much more volatile than the prices of the metals themselves. Although the prices do not move completely in step with each other, shares of gold and silver mining companies should fare well during any period of inflation. A list of dividend-paying gold and silver mining companies can be found at this site.

Write Covered Calls Against GLD or SLV

The Gold (GLD) and Silver (SLV) ETFs track the price movements of their respective metals. Although bullion purists are skeptical about the ability of the ETF price-tracking mechanisms to continue to operate properly under extreme conditions, to date these ETFs appear to be working just fine. Both ETFs are optionable, and based on the open interest volumes and the relatively narrow bid-ask spreads, the markets for their options appear to be comfortably liquid for traders. If you have the required resources, and a conservative options income strategy appeals to you, you can generate monthly or weekly income by selling covered calls against these ETFs. I don’t consider this to be passive income since it does take some work, but it is better than no income at all. As with all options investing, do your homework and make sure market conditions are favorable for your strategy before acting.

Since generating income from real assets is a topic of increasing interest, I hope to update this post in the future as I discover other possible approaches that pass my “sensible and workable” criteria.

Are Floating-Rate Funds Too Risky?

floating-rate fundsFloating-rate funds provide higher yield income to investors by buying bank loans made to companies with low credit quality. I like to think of these bank notes as intermediate-term junk securities (loan maturities are about seven years). Yields are higher because of the greater credit risk, but the banks consider the risk of loss somewhat limited because they have priority over other bondholders in the event of default. The securities are “floating-rate” because the bank loans are variable-rate loans. Since fund yields rise as interest rates rise, many investors see these floating-rate funds as attractive income investments that can hedge against inflation.

But are there other risks that investors should be aware of? In July 2011, the Financial Industry Regulatory Authority (FINRA) issued an investor alert warning on floating-rate funds. Here are some things you need to be aware of if you are considering investing in these funds:

– Bank loans are traded over the counter, not on an exchange. Thus, they are less liquid than investment grade bonds, and determining appropriate valuations for individual loans is difficult.

– Many floating-rate funds limit your ability to withdraw your money. Minimum holding periods and redemption fees are common.

– Many floating-rate funds have high expense ratios.

– Some floating-rate funds are leveraged (i.e., they borrow money to purchase additional loans to get higher returns). For these funds, the consequences of loan defaults could be more severe since the cost of buying on margin has to be factored in.

In one of his articles (here), Larry Swedroe makes the case that floating-rate funds really have equity-like risks and behave more like stocks than Treasury bonds.

At the present time, I don’t like these funds for all of the reasons given above, and because it is still likely that low interest rates may persist for a while longer (remember that in August 2011 Bernanke promised low interest rates through mid-2013). In the future, after an inflation trend has been established, I may take another look at them, but right now, I still see significant downside risk to owning these funds. In my book, they are not smart investments for income.

The Case for Equity Income Investments

Dividend incomeThe author Richard Stooker makes a compelling case for building portfolio income through equity investments. Although he comes down pretty hard against growth investing, the prudent investor will probably have no problem at all with the idea that at least some significant part of one’s portfolio should be devoted to current income production through equities. Stooker’s book is pretty good. Look for a link to it somewhere on this website. The following is from one of his articles:

Investing for Income — FAQ for Ordinary Investors

1. Dividends are so low, they’re a joke. Why should I invest for such a small return on my money?

If you buy only stocks in the Mergent index, you’ll get quality companies that have raised their dividends every year for at least 10 years — some of them for over 100 years.

Besides, dividends are no longer as small as they were during the peak of the dot com boom when the average S&P 500 stock paid under 1%. Thanks to the low stock market, you can pick up stocks that pay up to 8% or more.

2. What kinds of stock offer such high returns?

Brand name consumer stocks aren’t quite that high, but offer dependability and safety — such as Coca-Cola and McDonalds. Real estate investment trusts (REITs) are required to pay out over 90% of their cash. So are master limited partnerships (MLPs) — which transport oil and natural gas through pipelines. Utility companies are the traditional widows and orphans stocks, because they pay dividends and are so safe.

3. What if the economy goes into another Great Depression?

Every company would suffer, no doubt about it. And people would not be able to pay higher rents, they wouldn’t use as much electricity and they wouldn’t go out to eat as much. Companies that pay dividends might have to reduce them, or not raise them as much as they’d like.

However, unless a universal catastrophe sends the entire world back to the Stone Age (and if that happens, you won’t care about your stock portfolio’s performance anyway), people are still going to turn on electric lights, chew gum and buy hamburgers.

4. Everybody says that when you buy a stock and its price goes down, you’ve lost money. How can I avoid losing money?

Any stock you buy could go down in price at any time. Income investors don’t have to care, because they still receive quarterly checks.

5. Why shouldn’t I just put my money into an index fund?

If you insist on investing for capital gains, that’s the smartest way to do it. You can’t pick individual winners, so go with the broad market. However, index fund holders gained nothing from 1999 to mid-2008. And the future doesn’t look any better. Here’re some bad signs for the future:

1. Rising oil and other energy prices — with political unrest, war and possible war with Iran threatening to move the price of oil even higher.

2. Rising gold and silver prices.

3. The sinking U.S. dollar.

4. The baby boomer generation has started to retire, which will place enormous strains on the Social Security and Medicare trust funds, take experienced labor out of the economy and depress stock and bond prices as they sell off their portfolios.

5. Terrorists still want to convert the entire world to their version of Islam.

Index fund advocates say that in the long run the market will go up because our capitalist economy creates wealth. I support the sentiment, because I strongly support capitalism. I just don’t see any guarantees from God that capitalism will triumph, or that human progress has to continue.

We’ve seen a lot of scientific advancement, social progress and wealth creation over the past 500 years. But we’ve also seen periods of human history, such as the fall of the Roman Empire, where previous gains were erased — for hundreds of years.

If the terrorists succeed in setting off a nuclear bomb, it could be many decades before the U.S. stock market can rise above current levels.

I’m not going to say this is going to happen, but none of us has any guarantee it won’t.

6. Dividends are only for rich people who inherited a bunch of stock. I need to get rich in a hurry.

It’s true that you’re not going to receive a million dollars a year in dividend income unless you’re starting out with at least $20 million. However, investing is not — and never has been — a way to get rich quick. People who try it usually lose their money.

If you want to speed up the process, you must start a business of your own that solves problems for many people. If you think they’re shortcuts to such success, you’ll lose your money to the many con artists that prey on people like you.

7. The stock market is so low, and may go lower — I’m afraid of it. What should I do?

Realize that this is the best income investing opportunity to come along in a long time. Because stock prices are so low, there’re many opportunities to pick up brand names, utilities, Canadian income trusts, master limited partnerships and real estate investment trusts at bargain prices.

Now is the best time in years to lock in high — and ever-growing — dividend yields.

SUMMARY

With today’s financial markets as uncertain and unstable as they are, traditional buy and hold, and pick winning stocks, strategies don’t promise much return. You must rely on luck, and that’s not reliable over the long term. Stocks have gone nowhere since 1999. Yet people who invest for income have received regular quarterly dividends.

TIPS: Negative Yield vs. Inflation Hedge

TIPS bond incomeYields on 10–year Treasury Inflation-Protected Securities (TIPS) are at record lows. As of this writing (July 2012), the 10-year TIPS have a negative yield of -0.637%. This indicates that investors believe so strongly in future inflation that they are willing to bid up prices of the security to the point of negative returns. It’s important to understand that in practice, when you purchase a TIPS with a negative yield, you don’t have to actually make interest payments back to the Treasury. The Treasury will payout interest to you at 0.125%, but an appropriate premium is added to the price you pay for the security so that the stream of interest payments minus the premium is equivalent to the negative yield. Some analysts believe it makes no sense at all to buy securities with negative yields. Others, however, say that you should consider current economic conditions and prospects to determine if buying negative-yield TIPS might make sense.

The Math

Let’s look at the arithmetic. The current 10-yr Treasury yield is 1.43%. Buyers of the 10-yr TIPS are therefore betting that inflation over the next ten years will average at least 2.067% (Treasury yield minus TIPS yield). That seems like a very reasonable assumption to me. Under this scenario, the TIPS investors believe that the TIPS inflation adjustments will increase the principal of their holdings at a rate that will more than make up for the initial price premium they paid for the security. The greater the inflation rate is over the period, the greater their return. Theoretically, this all sounds okay to me. In practice, I do have a couple of concerns.

Concerns

One of my concerns is the inflation scenario. Let’s say I buy a 10-year TIPS today (holding it in a tax-favored account of course). Suppose due to political and other factors, the Fed undertakes no further quantitative easing, and the economy stagnates. Over the next 5 years the inflation rate is -1.0% (deflation). Then a new political order takes power, circumstances change, and the Fed goes forth with quantitative easing resulting in inflation of greater than 4% annually over the final 3 years prior to my TIPS maturing. If, averaged over the 10-year period, the annual inflation rate turns out to be 2.2%, would that mean I made money on this investment? Not necessarily. I haven’t run the numbers, but I don’t think it would be too hard to come up with a scenario where an initial deflationary period reduces the adjusted principal (and, thus, the associated interest payments) to the point where later inflation adjustments on the smaller adjusted principal balance don’t make up for the earlier losses. I would get my principal back at maturity, but the total interest payments that I received might not be enough to offset the initial price premium I paid when I purchased the security.

A more fundamental concern I have is with the basis of the inflation adjustment. TIPS adjustments are based on CPI-U. Because of the way that statistic is calculated, there is a 2-month lag in the adjustment. Again, if significant inflation occurs during the final months prior to maturity, the lag in adjustments means there may be a couple months of inflation that are unaccounted for at maturity. Also, as a government statistic, CPI-U can always be manipulated and redefined for political reasons.

Bottom Line

So do I invest in TIPS now? For me personally, the answer is no. I will wait until the yield on 10-year TIPS turns positive, i.e. at least 1.5%. After all, I am primarily interested in investments for income, not just capital
preservation. If I can get at least 1.5% yield, and the 10-year Treasury yield remains below 4.0%, I’m in.

Best Ways to Get Income From Preferred Stock

preferred stock incomeJust as I don’t believe in holding the common shares of only one company in my portfolio, I don’t believe in buying the preferred stock of just one or two companies either. The more you rely on an income stream from preferred stock, the more reason you have to be mindful of diversifying to minimize risk. The down side of diversification for most individual investors, however, is the need to do a lot of research. I, for one, am willing to forgo a little (very little) return in order to save some personal time and not have to do so much research. If you are of the same mind, then maybe you should consider investing in preferred stock ETFs.

Unlike bond funds, which I generally don’t care for, the yields for some preferred stock ETFs are currently high enough that you actually do okay even after fund expenses are subtracted. If you can stand the high volatility usually associated with closed-end high-yield funds, you can start exploring these investment options by taking a look at these:

iShares S&P U.S. Preferred Stock Index (PFF), yield 5.89%

PowerShares Preferred ETF (PGX), yield 6.44%

SPDR Wells Fargo Preferred Stock (PSK), yield 6.3%

The holdings of all three of these funds are heavily weighted towards the financial sector, so if that makes your stomach turn, it’s probably a good idea for you to look elsewhere.

Alternative Real Estate Investments for Income

real estate investingSo you’ve designed an income portfolio containing a healthy mix of equity and debt instruments tailored to your personal situation and taking into account the current economic climate. Congratulations!

But wait – something is still bothering you.

After some thought you realize that all of the investments in your portfolio depend on the performance of the financial markets. Based on recent past experience you recall how these markets were actually quite correlated in their response to the financial shocks that hit a few years ago. Isn’t there a way to diversify a bit more and invest in income producing assets that are not so dependent on the financial markets? The answer is a resounding………maybe.

On the face of it, the price of real tangible assets like real estate and commodities would appear to be uncorrelated with stock valuations or interest rate fluctuations. However, common inter-market forces (e.g., significant changes to the value of the dollar), can affect both financial markets and the price of real assets at the same time. Assuming you find this bit of correlation acceptable, then real estate does present some possible income investments to explore.

Of course the most common real estate investment is to buy residential rental property (preferably at a deep discount) and generate income from the rent. The internet is full of resources to assist you in finding suitable properties. Here I want to mention some other types of real estate investments for income.

Agricultural Properties

Agricultural properties include farms that generate income. You can own and operate the farm for income yourself, or you can purchase property and just lease it to a farmer for the rental income. Good basic information on agricultural investments can be found here and here.

Forestry Assets

Forestry assets include timberland that provides raw materials for paper products, construction, and fuel. The primary driver for forestry investments is the fact that timber grows in physical size, giving owners exposure to financial growth that is independent of financial markets. In addition to income from timber sales, forest owners can derive additional income from hunting leases. Helpful information to jump start your research for these investments is located in Chapter 2 of this Forest Landowners’ Guide.  Forestry assets tend to be longer-term investments, but once established, the income is fairly secure.

Rural Land

Selective investing in rural land might also have potential income possibilities although much research is needed to make this kind of investment pan out. The most common way in the U.S. to derive income from raw land is to own property with a high probability of oil or natural gas reserves underneath, and to then lease the land to drillers. Another way to generate income is to buy rural land that has commercial potential (location, location, location!) and lease it. The website LandsofAmerica.com is a good resource for finding land properties.

Like every other investment class, these all come with their own sets of risks and rewards, so research is absolutely required, but a careful investor can be successful in diversifying an income portfolio by adding alternative real estate investments for income.