Thoughts during this low-yielding environment

What to do in a time of low-yielding investments? One answer is non-traded securities with holdings in real estate, private equity and other assets. They might pay out in the mid- to high-single digits, far more than almost anything else.

The downside (and it is a big one): selling them, should you need to raise cash, is hard.

Low interest rates continue to frustrate investors as they watch gas, food and other prices rise. For most of 2020, the benchmark 10-year Treasury note rate was below 1.00% and the 30-year Treasury was hovering below 2%. The FDIC reported a national average of 0.07% APY on money market accounts with deposits under $100,000.

Adjusted for inflation and taxation, low yields on conventional savings offer a negative return and add little luster to one’s golden years.

Income-producing alternative investments

Consequently, a host of income-producing alternative investments are popular. These may include nontraded investments in real estate investment trusts (REITs), business development companies (BDCs) or “incubator” closed-end mutual funds.

REITs own collections of properties (or sometimes mortgages), and must pass along 90% of their taxable income in dividends to investors. BDCs are funds that invest in debt or equity of privately held companies. Closed-end funds that are launched may invest in real estate or business assets including debt instruments.

While these investments are public offerings, they do not trade on a stock exchange or trade daily like an open-end mutual fund. In other words, they are not immediately liquid. These investment vehicles may have publically traded counterparts, but because those are liquid, the yields generally are lower than non-traded investments.

Understanding liquidity

A liquid investment is either cash or something you can convert to cash in a short period. Stocks and bonds may be brought to cash after a defined settlement period.

A non-liquid investment is not immediately converted to cash. Examples are your house, land, other real estate, a closely held business and investment vehicles often called “direct” or “private placements.”

Some people do not understand the “liquidity premium.” If you can’t easily convert an investment to cash at a fair market value, a buyer may pay less for it or demand a higher yield than a liquid investment fetches. For instance, a non-traded REIT may pay a higher yield than a similar REIT that trades every business day on an exchange. It is that potentially higher yield that attracts investors in today’s low-yield environment.

The regulators are watching

Regulatory authorities want to make sure that investors have ample levels of liquidity, as well as sophistication and knowledge, prior to purchasing non-liquid investments.

For example, before investors can purchase an interest in a non-traded REIT or a non-traded BDC, they must usually demonstrate a net worth of $1m exclusive of home, car and personal effects. Some states, and some investments, require higher levels of income and net worth. Some states also limit the amount of non-traded, non-liquid investments to 10% of an investor’s net worth.

Prudent financial advisors must be aware of clients’ liquidity needs, and their clients’ ability to judge the risks and rewards of a particular investment. You may not need to sell new non-traded REIT and BDC offerings for a number of years. While many will redeem some shares periodically at a discount to a stated value, their advisor should ensure that the client understands the liquidity restrictions and is content to hold the investment for the income stream.

The chicken and the egg model

A widow was interested in a higher yielding investment but hesitated when her advisor explained its lack of immediate liquidity. She had other assets that were very liquid and more than met suitability requirements. She lived in a rural area, so the advisor asked her if she ever kept chickens.

When she said, “yes” the advisor asked why?

“For the eggs,” she replied.

Inquired the advisor, “Well, then, did you ever liquidate or kill a chicken for dinner?”

“No,” she said, “because then I wouldn’t get the eggs.”

Suddenly the tradeoff between liquidity and income stream became clear. She understood.