Get Higher Yields: MLPs, REITs, BDCs

MLPs

Now that you understand the concept of return of capital, let’s examine Master Limited Partnerships (MLPs). An MLP is a company that has a special structure that bypasses corporate taxes because it passes along (nearly) all of its profits to its shareholders in the form of a distribution.

These distributions are treated as return of capital by the Internal Revenue Service so investing in MLPs can be a tax-deferred strategy for generating income. As we discussed in the section on closed-end funds, the return of capital lowers your cost basis.

I’m simplifying things with this example, but if you bought an MLP at $25 per share and for ten years received a $1 per share distribution that was all return of capital, your cost basis would be reduced to $15.

Over those ten years, you would not pay taxes on those $10 in distributions ($1 X 10 years). However, when you go to sell, you will pay a capital gain tax on the difference between $15 and the selling price.

Talk to your tax professional before investing in MLPs, because the tax implications can be complex. Additionally, you receive a K-1 tax form from the company, which is different than the 1099-DIV that you get from regular dividend-paying companies. This can add to the cost and timeliness of your tax preparation.

About 80% of MLPs are energy companies. Most of them are oil and gas pipelines that aren’t impacted much by the price of oil or gas. Their business relies on volume of product that flows through its pipelines.

Other MLPs include infrastructure companies, financial firms, and even a cemetery operator.

MLPs are popular with income investors due to their strong tax-deferred dividends. The risk is that since all of the company’s profits are distributed back to shareholders, any decrease in earnings can result in a dividend cut. Although the dividend is high, it is usually not as stable as a strong dividend player like Clorox, which pays out only 54% of its profits in dividends and has raised its dividend for 34 consecutive years.

Kinder Morgan Energy Partners (NYSE: KMP) and Enterprise Product Partners (NYSE: EPD) are examples of two popular MLPs.

REITs

Real Estate Investment Trusts (REITs) are also very popular with income investors. A REIT is a company that has a collection of real estate, usually rental properties. Like an MLP, a REIT does not pay corporate taxes and instead must distribute the profits back to shareholders. So REITs often have fairly high yields.

There are REITs for nearly everything: REITs that specialize in apartment buildings, office buildings, shopping centers, hospitals, medical offices, nursing homes, data storage centers ...

REITs do not have the same tax implications as MLPs. In an MLP, you are considered a partner in the business. In a REIT, you are a unitholder. The dividends you receive from a REIT will usually be taxed as ordinary income, not at the dividend tax rate, although a portion of the income you receive may be considered return of capital, which would be tax deferred and would lower your cost basis, similar to an MLP. (However, it’s usually a much smaller percentage than with an MLP.)

Again—and I can’t stress this enough—talk to your tax professional about any questions you may have.

REITs can be volatile, just like the real estate market. If real estate values fall, so do the NAVs of the properties owned by the REIT. Additionally, a weak economy can lead to a greater number of vacancies, reducing profits and, as a result, the dividend.

The opposite is true. During the real estate bubble, the MSCI US REIT index rose 43% between January 2005 and January 2007 (of course, many houses appreciated considerably more), but it plummeted 78% over the next two years as real estate prices collapsed.

Examples of REITs include Healthcare REIT (NYSE: HCN), which owns housing facilities for seniors and other health care related properties, and Equity Residential (NYSE: EQR), which is the country’s largest apartment manager.

BDCs

A Business Development Company (BDC) is a publicly traded private equity investment firm. Usually you need boatloads of money or connections to get into a private equity investment.

Private equity firms create funds and usually invest in early-stage start-up companies. They can be anything from a biotech company with a new technology for treating cancer to a chain of coffee houses. Some private equity companies specialize in certain sectors, such as biotech, technology, or retail; others are generalists, entertaining opportunities wherever they lie.

Why would someone invest in a private equity fund? We all know how wealthy you could have become if you had invested in Microsoft and Apple when the companies had their initial public offerings (IPOs). Imagine how rich you would have been if you had invested even before they went public.

When early-stage companies are private and raising money, they can still sell shares, just not to the public in the markets. They sell them in privately arranged transactions. These transactions may be facilitated by pretty much anyone—an investment bank, a board member, or the CEO’s mom.

These kinds of deals are usually done by knowing the right people. When looking for funding for Marc Lichtenfeld’s Authentic Italian Trattoria, I may have reached out to some well-heeled investors whom I know have funds dedicated to this type of speculation, or my mom may have mentioned it to her mahjong group and one of her friends decided to invest $100,000 with me.

When you invest in an early-stage company, you typically get a larger portion of equity than if you bought shares once the company’s stock is publicly traded. When Microsoft went public in 1986, investors who bought $100,000 worth of stock at the IPO owned 0.15% of the company. Perhaps if someone invested $100,000 in 1977, when the company was still in its early stages, he might have received 2% of the company for that $100,000 (I’m making these 1977 numbers up just to illustrate the point).

Young companies have to sell larger portions of themselves early on in order to attract investment dollars. Those equity positions can become very lucrative as a company matures and particularly if it goes public.

Sometimes these private equity firms lend money to the start-up instead of taking an equity position. For early-stage companies with little revenue, getting a business loan can be difficult, particularly now that money is tight; for this reason, the start-ups may have to go to other sources.

A private equity firm may lend money to a start-up at, let’s say, 13% annual interest, even though the standard bank business loan might be 8%. Since the start-up can’t get a bank loan, it has to pony up the higher interest rate since the risk is larger.

Each loan is structured differently, but it is common for the lender to take an equity position or take possession of collateral, such as intellectual property, product, or equipment, if the loan is not paid back.

You Don’t Have to Play Mahjong with Mrs. Zuckerberg

Many investors would love the opportunity to get in on the early stages of exciting new companies. But unless you play mahjong with the mother of the next Mark Zuckerberg (Founder and CEO of Facebook), or you’re otherwise well connected, learning about these opportunities can be difficult.

BDCs allow the everyday investor to get involved with a portfolio of companies, spreading out the risk and very often paying a nice income stream.

For example, Main Street Capital Corporation (Nasdaq: MAIN) is a $500 million market cap BDC that, as of December 2011, paid a yield of about 8.2%.

It makes both equity and debt investments and has a wide variety of companies in its portfolio, including:

1. Hydratec Holdings, LLC, a Delano, California, manufacturer of micro-irrigation systems for farmers
2. River Aggregates, LLC, a Porter, Texas, sand and gravel supplier
3. Ziegler’s New York Pizza Department, a Phoenix, Arizona, pizza chain

Many BDCs pay a robust yield, but as with any investment, there is no such thing as a free lunch. (Unless you’re an investor in Main Street; maybe Ziegler’s hooks you up with a free slice of pizza. I don’t know, but it’s worth a shot.) The higher the yield (or potential reward), the higher the risk. So if you’re considering investing in a BDC with a high yield, do your homework on the company, see how consistent the dividend has been, and try to ascertain whether it will be sustainable.

Doing that might not be as easy as with your typical dividend-paying company, where you can look and see how many widgets it sells and what its profit margins and cash flow are. However, if a BDC has a long and consistent track record, you should have a bit more confidence that it can continue paying the dividend.   

As with a REIT, the Internal Revenue Service treats a BDC’s dividend differently. In order to pay no corporate income tax, a BDC must pass through at least 90% of its profits on to shareholders. Most pass on an even higher percentage of the profits.

Generally, you’ll be taxed on the kind of income the BDC received. If it earns interest on a loan, you probably will be taxed on that portion as ordinary income. If it sells a company for a capital gain, you will be taxed on that portion at the capital gain rate.

The BDC will send you a form with the breakdown so you’ll have all the information you’ll need.

Once again, if you have any tax-related questions, repeat this with me now: Talk to your tax professional.

Closed-end funds, MLPs, REITs, and BDCs can be an excellent way to add yield to your income portfolio. Many of these businesses generate a ton of cash and must pass that cash along to shareholders, which is why they are able to pay investors more than other companies.

When Exxon Mobil makes a profit, management decides what do to with that cash. Does it invest in new equipment, put a gym in the corporate headquarters, or give some back to shareholders? MLPs, REITs, and BDCs, by the laws of their corporate structure, must return profits to shareholders.

Keep in mind that such investments can be volatile as they are usually concentrated in one (often cyclical) sector and have more complex tax ramifications for shareholders. But if you don’t mind doing a little homework and talking to your tax professional (or handling it yourself with tax software), these investments can be an excellent way to boost the amount of income you receive every year.

Preferred Stocks

Preferred stocks are sort of a combination of a bond and a stock. They pay a higher dividend, sometimes can be converted into common stock, and are higher in the pecking order than common stock if the company is liquidated. However, they come after bonds in that situation.

If a company declares bankruptcy and its assets are sold off, bondholders will be paid first. Next come preferred shareholders, then shareholders of common stock.

Many preferred shares, known as cumulative preferred stock, will accumulate the dividend if it is not paid. When a dividend of a common stock is not paid or is cut, the shareholder is out of luck. If, sometime in the future, the company re-establishes a dividend, the shareholder starts from whatever dividend the company declared.

Cumulative preferred shareholders, however, see their dividends accumulate during the period that the company did not pay dividends. So if a company has an annual preferred dividend of $1 per share, stops paying a dividend for two years, and later introduces a $1 preferred dividend in year 3, the preferred shareholders will have to get paid out $3 per share ($1 plus the $2 missed) before any common shareholders can receive a dividend.

As a result of this greater stability, preferred shares are not as volatile as common stock. Preferred share investors typically will not see the swings in share price that investors will see with common shares—although during the financial crisis of 2008 and 2009, numerous preferred shares of financial stocks were decimated because of fears that the companies might collapse. However, many of them came roaring back in 2009 and 2010.

Like a bond, a preferred is issued at par value, and the dividend is usually fixed. The dividend is not going to grow like a Perpetual Dividend Raiser. But for some investors, particularly those who need the income now, the higher rate today may be worth sacrificing growth tomorrow.

Also, like a bond, the dividend is rated by credit rating agencies. And unlike a stock, preferred shareholders have no voting rights. They are not owners of the company; they are creditors.

Financial institutions make up about 85% of all preferreds, so if the financial sector is strong, preferreds should do well. If financials are weak, as they were during the 2008 crisis, preferreds will be hit hard.

For example, insurer MetLife has the MetLife Preferred B Shares (NYSE: METPrB) that pays a fixed rate of 6.5% annually (on the par value, which is $25), with dividends paid quarterly. As I write this, it is trading at $25.56, slightly above par value, so the yield is 6.4%. If you can buy a stock below par, you can get a yield higher than the declared yield, just like a bond.

Par value: The face value (price at which it was first offered) of a bond or preferred stock.

Preferred stocks are often redeemable 30 years after they are issued, although some have no redemption date. Of course, you can always sell the stocks in the open market, although they are generally not as liquid as common stock.

I’m not a huge fan of preferreds because they are much closer to bonds than to stocks and typically don’t grow dividends. A 6.5% yield might be attractive today, but it won’t keep up with inflation, even a low level of inflation such as 3%.

Think about it this way. If you invest $1,000 in a preferred with a 6.5% yield, you’ll receive $65 per year. However, in three years at 3% inflation, you’ll need $1,092 to have the same buying power as $1,000 three years prior. Your $65 per year won’t keep up with inflation. You need a dividend growing faster than inflation to do that.

The benefit of a preferred stock is that the dividend is higher than a stock, particularly for a blue chip company. The downside is that it probably will not keep pace with inflation. Also, most preferreds do not let you reinvest the dividends in more preferred shares. However, some do let you reinvest the preferred dividends into common stock.

Like some of the other higher-yielding, less traditional income investments, there’s nothing wrong with sprinkling one or two preferreds into a portfolio. But since preferreds are a kind of quasi-bond, you want the majority of your holdings to be Perpetual Dividend Raisers.

SUMMARY

• Closed-end funds are mutual funds that trade like stocks.
• Return of capital is a cash distribution that is tax deferred and lowers your cost basis.
• REITs invest in real estate assets.
• MLPs are partnerships, often energy pipelines.
• BDCs are similar to publicly traded private equity firms.
• Preferred stocks are as much like bonds as they are like stocks.
• Closed-end funds, REITs, MLPs, BDCs and preferred stock are alternatives to regular dividend payers in that they usually have higher-than-average yields—but they can have complex tax implications as well.
• Playing mahjong with Mrs. Zuckerberg might be a great way to get lucrative investing ideas.