I have been a huge fan of real estate investment trusts (REITs) and master limited partnerships (MLPs) since I began investing. These tax-advantaged entities avoid paying corporate-level taxes as long as they pass on a certain level of income or fulfill other requirements.

There’s certainly been no shortage of interest in these and other income-producing investments over the past few years. But these days, some income-producing investments are looking a little risky. Shares of consumer staples and utility companies are trading at multiples well above their historical averages. Many have been warning of frothiness in the market for junk-rated debt and bank loans.

But even those groups may be a better bet than a new yield structure that recently caught my eye. This new type of income-producing company is getting a lot of attention from dividend investors -- but might not be all it's cracked up to be.

The alternative energy industry (such as solar power and hydroelectric) hasn’t been able to use the MLP structure like traditional energy companies. Yield-hungry investors, eager for the income they see in MLPs and the growth in alternative energy, have been disappointed, but the Yieldco has stepped in to fill the gap. (My colleague David Sterman took a closer look at Yieldcos in May.)

The Yieldco structure is still relatively new with the first company, NRG Yield (NYSE:NYLD), spun off from NRG Energy (NYSE:NRG) in July 2013. The idea works a lot like MLPs, with assets spun off from a parent company and providing low-cost funding.

Alternative energy companies set up an infrastructure asset -- say, a solar or wind farm -- and contract the energy output with a utility. A collection of these assets is then spun off into a new company, a Yieldco, that manages the project and collects the contract revenue. Because the infrastructure and contract are already in place, the income from the pool of assets is relatively safe, and the new company can issue debt at a rate below what the parent company might be able to obtain.

The Yieldco then uses depreciation to shelter as much of the earnings as it can and pass income on to the parent company and investors.

However, there are two problems with Yieldcos. First, there is no benefit on a tax basis: Yieldcos still must pay corporate-level taxes, and income passed to investors is taxed again as dividends.

Second, there's the possibility of a conflict between the parent company and investors. The parent normally maintains majority control and voting rights to the new company, which may mean investors’ interests are subordinated at the board level.

TerraForm Power (Nasdaq:TERP) is the newest Yieldco to come to market, spun off from SunEdison (NYSE:SUNE) last month. Shares are already down nearly 10% from their close on July 18 as investors analyze the new company.

TerraForm is expected to distribute about 85% of available cash but the parent company will receive 65% of that. Investors will only get 28% of the distributed cash.
TerraForm estimated a dividend of $0.90 for 2015, a yield of 3% on the current share price. The new company will own projects located in the U.S., Canada, U.K. and Chile with an estimated 783 megawatts (MW) of nameplate capacity this year and an additional 400 MW in 2015. On this total 2015 capacity, TerraForm projects operating income of $110 million and net income of $22.5 million.

TerraForm Power will carry the debt associated with its projects and looks significantly overleveraged with $546 million in project-level debt. Interest expense alone is projected at $73 million in 2015, nearly three-quarters of operating profits.

Since TERP investors have rights to only 28% of distributed cash flow, I estimate they are paying a price multiple of 473 times for their $6.3 million in 2015 expected net income. Even on the total $22.5 million in expected 2015 net income, TERP is trading at 132 times earnings. By comparison, Chinese solar companies Trina Solar (NYSE:TSL) and Yingli Green Energy (NYSE:YGE) trade at 7.4 times and 28 times expected 2015 earnings, respectively.

While I am excited to see the income-producing idea come to alternative energy companies, Yieldcos might not be the answer. Despite the advantage to lower-cost debt, these new structures seem to me like little more than a guaranteed buyer and funding mechanism for the parent company.

Risks to Consider: As long as interest rates stay painfully low, investors will flock to income-paying shares and may bid up the price even for expensive companies. Avoid the expensive and tax-inefficient Yieldco structure in favor of other traditional yield investments.

Action to Take --> Yieldcos are an interesting option for income investors, but they don't offer the same advantages as other tax-efficient structures. Shares of TerraForm Power are trading for a significant premium compared to Chinese solar names, and a potential conflict between the parent and investors makes for an unfavorable outlook.

MLPs and REITs have long been used by America's wealthiest investors to generate safe, rising income. In our latest High-Yield Investing research, we've found another little-known group of investments the wealthy have been using for decades to generate dividend yields of 12% or more. To learn more about these special investments, follow this link.

]]>

Related Articles
  1. Personal Finance

    Salary Secrets: What Is Considered a Big Raise?

    A 4% or 5% annual jump in pay may not sound huge, but in today’s environment, it actually means you’re faring better than most.
  2. Retirement

    6 Steps to Update or Change Your Will

    Life changes – a new marriage, the birth of a child – can necessitate changes in your will.
  3. Insurance

    What Does It Cost To Raise a Child in America?

    Having a family can be an expensive proposition, but couples who know the numbers can strategize to lower the costs.
  4. Bonds & Fixed Income

    Calculating Yield to Worst

    Yield to worst is the lowest possible yield on a bond that may be called in the future.
  5. Economics

    What Does Vesting Mean?

    Vesting is the process of accruing non-forfeitable rights.
  6. Economics

    Understanding Retail Banking

    Retail banking refers to the mass-marketed, consumer-oriented products and services offered by the local branch of the commercial bank.
  7. Investing Basics

    Explaining Foreign Exchange Risk

    Foreign exchange risk is the chance that an investment’s value will decrease due to changes in currency exchange rates.
  8. Economics

    What Happened at the Fiscal Cliff?

    The fiscal cliff refers to a scenario on December 31, 2012, in which the Bush-era tax cuts were set to expire.
  9. Economics

    Explaining Enterprise Resource Planning

    Enterprise resource planning (ERP) is management software that integrates a business’ essential departments.
  10. Investing Basics

    What's Current Portion of Long-Term Debt?

    The current portion of long-term debt is the part of a company’s long-term debt that must be repaid within the next year.
RELATED TERMS
  1. Sticky Wage Theory

    An economic hypothesis theorizing that pay of employees tends ...
  2. Cost Of Funds

    The interest rate paid by financial institutions for the funds ...
  3. Earnings Before Interest & Tax ...

    An indicator of a company's profitability, calculated as revenue ...
  4. Implied Volatility - IV

    The estimated volatility of a security's price.
  5. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  6. Operating Cost

    Expenses associated with the maintenance and administration of ...
RELATED FAQS
  1. Are dividends considered passive or ordinary income?

    Despite the fact that earning dividends requires no active participation on the part of the shareholder, they do not meet ... Read Full Answer >>
  2. Is dividend income taxable?

    Dividend income is taxable but it is taxed in different ways depending on whether the dividends are qualified or nonqualified. ... Read Full Answer >>
  3. How do dividends affect net asset value (NAV) in mutual funds?

    Distribution of dividends reduces the net asset value (NAV) of mutual fund shares. However, this doesn't mean that fund investors ... Read Full Answer >>
  4. Are mutual funds considered retirement accounts?

    Unlike a 401(k) or Individual Retirement Account (IRA), mutual funds are not classified as retirement accounts. Employers ... Read Full Answer >>
  5. How do dividends affect the balance sheet?

    Dividends paid in cash affect a company's balance sheet by decreasing the company's cash account on the asset side and decreasing ... Read Full Answer >>
  6. Do mutual funds invest only in stocks?

    Mutual funds invest in stocks, but certain types also invest in government and corporate bonds. Stocks are subject to the ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!