Stocks can have a lot of overhead
So you are entrusted with investing an endowment and are looking at the various options thinking there has to be a better way. After all, the overhead in stock investing is quite significant. Think about how much boards are willing to bestow on their CEO in the form of cash and stock compensation. If the organization does well, employees receive generous bonuses. If the company doesn’t do so well the company may want to give those being let go a large chunk of dough. Blackberry is a recent example, disclosing that the release of 4,500 employees will cost in excess of $450 million. At $100,000 per released employee, I have to think there could be a line of tickets purchased for that gravy train.
Perks are another interesting sidelight. Taxpayers were not impressed with the private jets the CEOs of the Big Three arrived in for hearings in Washington back in 2008. Junkets to exotic ports of call for leadership meetings or shareholder gatherings, expensive real estate with corporate dining rooms and fitness centers, and company bashes for employees that use up huge sums of cash round out the laundry list of excesses. All of these items diminish what is left over for the shareholder.
But wait … there’s more.
Wall Street and our government love to get in on the action as well. Wall Street wants a company to have glossy brochures encouraging people to invest. There are whole departments dedicated to shareholder relations, expensive visits with money managers, filing of various reports with the SEC and myriad other shareholder communications, even research on the stock that the company pays for – called “sponsored research reports.” Added to this is a cost structure amongst investment firms to cover analysts and brokers and we have created a nifty way to strip off a good chunk of a company’s earnings. And, let’s not forget healthy commissions here and there.
Mind you, some CEOs and leadership teams deliver the goods and are deserving of a good measure of quid pro dough. Still, many view the largesse of corporate America with such disdain that they are reluctant to participate in what appears to be a phony approach to enriching those who happen to reach the halls of power. Recall all the CEOs who make out like bandits while laying off thousands and posting losses.
Owning Income Producing Real Estate
So, a number of well-heeled investors have moved from passive investments in garden variety stocks to a more active, direct approach to making money. After all, those who made it big in business didn’t tend to do so solely through the stock market. One of the more appealing areas to invest in at the moment is commercial real estate and multi-unit residential property. It is a leveraged investment in that a mere 20% down will control 100% of the revenue generation. This doesn’t mean that your institution is saddled with managing these assets directly– that is something well beyond the capability of the skill set of most administrators. Capable management companies are engaged to be operators and deliver cash flow and appreciation over time.
Yes, one could use a REIT to provide a similar form of diversification but the costs of such organizations can be quite significant relative to the revenue generated by the underlying assets. Also, they are subject to the ups and downs of the market. My interest in real estate relates in part to residual influences from the collapse of the residential market in 2008 and the dearth of new construction thereafter. Population keeps rising and stringent mortgage requirements are keeping buyers at bay. People will live somewhere, particularly when young people get married and hope to raise a family. Over the coming years, the need for additional housing represents a staggering number. Most of it will be made up of commercial apartments, particularly with interest rates on the rise.
The opportunity presented by a direct ownership strategy is that established complexes in convenient locations will be all the more in demand as time marches on. Newly constructed units will have to either develop vacant parcels further away from population centers or will pay up for existing real estate that is closer in. Rent will likely increase as the cost of commuting continues to head upwards and expensive projects are undertaken in less convenient places. For a longer term investment of, say, ten years or more, owning multi-unit residential real estate could be a solid play, providing current income and greater than average appreciation.
And, there is the same benefit that I mentioned when talking about bonds. Owning real estate means that the vagaries of interest rates and market valuations are not reflected on your balance sheet. A long-term investment is not subject to frequent revaluation but delivers cash flow and appreciates until it is time to realize the gain.
Commercial real estate is similar to residential, although it is subject to greater swings in occupancy rates. So often when visiting potential sites for a commercial lease, I learn that a pension fund owns the facility. I don’t think that is a coincidence.
Here’s one I stumbled on a few years ago. It is a mechanism used by higher net worth individuals to generate solid annual cash flows and some upside appreciation. There are myriad variations of this but one that is common looks something like this:
A corporation has some net operating loss carryforwards, meaning that it can earn a bunch of money without paying tax on it. It also owns some real estate – say, a factory – that has appreciated in value, even though it has been depreciated down to a low value. Because of past operating losses, the company wants some cash to spend but it’s a little difficult to glean dollars from a typical lender relationship.
Enter the structured financing – kind of a sale leaseback. The company sells the factory to a lending consortium including accredited investors and institutions, agreeing to lease the factory from the new owner, with an intrinsic interest rate substantially higher than a normal mortgage. There is also the opportunity for the company to repurchase the asset – at a guaranteed premium that provides a nice capital gain to the investor.
What makes this interesting is that it is, again, a leveraged investment. The accredited investor borrows about half the value of the asset from a bank at a low rate. An example is in order.
The deal is for $10 million and the interest rate intrinsic in the lease is 12%, with no principal reduction during the lease term. The investor can borrow $5 million for this kind of an arrangement at 6%. The gross interest income is thus $1.2 million but the interest paid for the half borrowed by the investor is $300,000. The net interest income (NII) is thus $900,000. Dividing the NII by the $5 million of cash put up by the investor yields a rate of return of 18% per year. Not bad work, if you can get it.
Five years into the arrangement, the original owner wants to buy back the facility and the contract allows for a 5% premium above the original sale amount. So, the investment is unwound with an additional $500,000 given to the investor, representing a 10% premium on closing out the contract. The rate of return winds up being 28% that year.
There are banks that work these deals, along with other variations on the theme. It is a good way to generate solid returns without being subjected to the vagaries of the market.
Rather than owning mutual funds supported by precious metals, it may be preferable to hold the metals themselves. This is for a minority portion of your portfolio (maybe 5%) but it is a hedge against inflation and has the potential for short-term appreciation from what I will term peak production. At times, the economy grows faster than certain metals can be extracted from the ground, causing a surge in prices. Certain processes have to use precious metals. Car production relies on platinum and palladium for catalytic converters. Computers use silver. Gold is used in car airbag actuation switches and other high tech applications where conductivity and lack of corrosion are needed.
With interest rates continuing to be held down at abnormally low levels and countries fighting to make their currencies cheaper than their trading partners, room exists for growth in precious metals, if only from monetary policy influences. Also, as the economy grows and production remains somewhat constant, peaks will happen, particularly with growth in cars, smartphones and other technologies.
Other Investments and strategies
Let me add a list of a few ideas here for consideration. Active trading strategies use the abilities of experienced traders to move in and out or positions frequently to make money. Venture capital funds can be risky but if only one in fifteen hits the jackpot, the return can be quite attractive. Hedge funds are most commonly of the long-short fund of funds variety. There is a lot of overhead in these deals but they have performed well for the most part, with 2008 a glaring exception.
The point is that investment in the market may make up the majority of your portfolio but some enhancement from other strategies is a good way to smooth out market ups and downs with more consistent returns over time.
Enjoy the ride!