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. Taxes

    Tax Breaks For Volunteering

    Your volunteer ventures could earn you some welcome tax deductions, along with the satisfaction of helping others.
  2. Retirement

    5 Secrets You Didn’t Know About Traditional IRAs

    A traditional IRA gives you complete control over your contributions, and offers a nice complement to an employer-provided savings plan.
  3. Retirement

    Is Working Longer A Viable Retirement Plan?

    Fully funding someone’s life for three decades without work is tricky. The result is retirement has become, for many, a 30-year adventure.
  4. Retirement

    Don’t Retire Early, Change Careers Instead

    Though dreamed of by many, for most, early retirement is not a viable option. Instead, consider a midlife career change.
  5. Taxes

    Six Ways Your Tax Preparer Knows You’re Lying

    Cheating on your taxes is asking for trouble. You might get away with it, but you’re playing with fire and likely to get burned.
  6. Budgeting

    Preventing Medical Bankruptcy

    If you’re worried medical expenses could overwhelm you, there are some thing you can do to ease your concerns.
  7. Insurance

    Medicare 101: Do You Need All 4 Parts?

    Medicare is the United States’ health insurance program for those over age 65. Medicare has four parts, but you might not need them all.
  8. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  9. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  10. Retirement

    Using Your IRA to Invest in Property

    Explain how to use an IRA account to buy investment property.
  1. Can you have both a 401(k) and an IRA?

    Investors can have both a 401(k) and an individual retirement account (IRA) at the same time, and it is quite common to have ... Read Full Answer >>
  2. Are 401(k) contributions tax deductible?

    All contributions to qualified retirement plans such as 401(k)s reduce taxable income, which lowers the total taxes owed. ... Read Full Answer >>
  3. Are 401(k) rollovers taxable?

    401(k) rollovers are generally not taxable as long as the money goes into another qualifying plan, an individual retirement ... Read Full Answer >>
  4. Can FHA loans be used for investment property?

    Federal Housing Administration (FHA) loans were created to promote homeownership. These loans have lower down payment requirements ... Read Full Answer >>
  5. Is Apple Pay safe and free?

    Apple Pay is a mobile payment system created by Apple to reducing the number of times shoppers and buyers have to pay for ... Read Full Answer >>
  6. Do FHA loans have private mortgage insurance (PMI)?

    he When you make a down payment from 3 to 20% of the value of your home and take out a Federal Housing Administration (FHA) ... Read Full Answer >>

You May Also Like

Trading Center