As interior decorators love to explain to neophyte clients, yes, of course you can paint your walls white. But there’s so much more you can do: complementary accents, ragging, wallpaper, decorative inlays, etc. The same goes for your portfolio. Sure, you can invest solely in mutual funds and consider yourself blessed if you keep pace with the market. Yet there are scores of asset classes out there that most investors either don’t know about or deliberately ignore. Most investors don’t know the difference between financial assets and real assets, nor how the latter have advantages that the former can only dream of.
Real assets, as distinguished from financial assets, means stuff you can touch: oil, gold, pork bellies, your grandfather’s stamp collection. For our purposes here, we’ll use the subset of real assets that encompasses dirt: real estate and its related investments. Mind you, houses, unimproved land, and commercial and industrial property are just the start. There are sophisticated investments that go beyond mere ownership of a plot of earth. They include real estate investment trusts (REITs), which are the real estate equivalent of mutual funds, and master limited partnerships (MLPs), which we’ll get to in a second.
REITs For The Masses
Most REITs are privately held, so good luck finding one of those to invest in. Fortunately, there are publicly held REITs as well. They trade on stock exchanges right next to the stocks. Just like the underlying properties they consist of, publicly held REITs concentrate in certain sectors, e.g. retail, office, residential, medical. Most REITs own real estate (equity REITs), while a handful merely lend their money (mortgage REITs) and a few more do both (hybrid REITs).
The advantages to REITs are unmistakable. By law, at least 90% of REITs’ taxable income must be paid out as dividends. With only 200 or so publicly traded REITs in the United States, it shouldn’t be hard to find one that suits your criteria. Most notably, REIT dividend yields are about quadruple those of dividend-paying stocks. Like any investment, a REIT is a two-way street. A company that owns and operates real estate requires investors to expand or maintain its operations, and said investors need the likelihood of returns.
As an example of one of the most promising, proven and highly regarded REITs available today, Glendale, Calif.-based PS Business Parks Inc. (NYSE:PSB) is somewhat typical of the genre. The company owns commercial buildings in eight states, which total about 30 million square feet, or more than a square mile of usable space. With both a market capitalization and total shareholders’ equity of $2 billion, PS Business Parks fits nobody’s definition of a colossus. But the company is exceedingly profitable and has enjoyed rising revenue and income over the last few years, again under a structure that minimizes corporate taxes. Its stock price has gained steadily since the company’s inception, the sole exception being the financial downturn at the end of the last decade that hit most sectors, but real estate in particular. As an aside, PS Business Parks’ former sister company is Public Storage (NYSE:PSA), the billion-dollar self-storage concern that today not only operates as a REIT in its own right, but boasts profit margins comparable to PS Business Parks.
One disadvantage of REITs is that their dividend payouts can be a curse when it’s not a blessing. By limiting the amount of cash REITs have on hand, it can make it harder for the REIT to grow without incurring debt. Thus, most dynamic REITs either borrow money to finance future operations or are successful enough that they can grow organically from their own cash on hand. Given the choice, those in the latter category are probably the ones you want to invest in. Also, most REIT dividends and not qualified dividends and are instead taxed up to the maximum rate or 43.4%. That's not to say there aren't exceptions, though, based on income and other variables.
What Real Assets Can Do for Your Portfolio
As for MLPs, a one-paragraph refresher on limited partnerships. Unlike a general partnership, in which every owner of the business is liable for losses beyond his or her contribution, limited partners can’t lose more than they put in – much in the same way as owners of a corporation. A master limited partnership is just a publicly traded limited partnership, albeit with at least one general partner.
MLPs have additional restrictions. At least 90% of their cash flow must come from either real estate, commodities or natural resources. There are about as many MLPs for you to invest in as there are publicly trading REITs. While they’re allowed to invest in real estate, it’s rare to find an MLP that isn’t in the oil or gas business, or something similar or related. Houston-based Enterprise Products Partners LP (NYSE:EPD) is a classic MLP, its interests being mostly in oil pipelines.
MLPs that aren’t in the energy business are hard to find, but they do exist. Two of the largest carry names familiar to even the casual investor: New York-based Icahn Enterprises LP (Nasdaq:IEP) and KKR & Co. LP (NYSE:KKR). We’ll examine the former in a little more detail.
First, don’t waste your time trying to mount a hostile takeover of your own. Founder and eponym Carl Icahn is the majority owner and thus the general partner, which means he receives most of the MLP’s dividends, which are currently at a healthy 6% yield as the MLP trades in the $100 range. His majority position isn’t 50.0000001%, either. More like 90.5%. Those of us who are fortunate enough to be among that remaining 9.5% are investing in a company that goes beyond the hydrocarbons that make up most of the MLP industry. Icahn Enterprises’ stated business segments include automotive, railcar, food packaging, home fashion and, yes, real estate. The company holds significant positions in plenty of companies you’ve heard of and perhaps patronize regularly, from computer/electronics giants and online auction sites to car manufacturers. While such an MLP is perhaps a step removed from what are commonly considered real assets, the company is nevertheless a shining example of low price/earnings ratio, rising stock price and aggressive management with little tolerance for underperformance.
One downside to MLPs is that like REITs, they’re often reduced to borrowing to augment operations. Thus, they’re at the mercy of interest rates. On the other hand, if you’re committed to investing in MLPs in some form, there’s a compelling argument for eschewing the majority of MLPs that are in the energy business in favor of something a little more diversified. That way, you’ll be less subject to fluctuations in commodity prices.
The Bottom Line
Never buy into exotic investments without knowing what you’re doing. But real estate, REITs and MLPs really aren’t that outlandish. With a little knowledge – not much more than this article offered – you can find a non-mutual fund investment with clear tax benefits and a comfortable income stream. Real assets offer advantages that intangible assets can only hope to emulate. And unlike a stock investment, a real asset investment has something concrete underlying it; hence the name. Even the most underperforming single-family residence has value as shelter. Worst-case scenario, you can live inside it. Try doing that with your 401(k).