Become Extremely Discerning When Investing for Income
Are you among the many looking for quality income investments, with acceptable yields, backed by real assets? Perhaps the low interest rates offered by traditional investments are not sufficient to meet your needs? Today’s article will cover some of the most popular private income investment types, features to look for when selecting, and pitfalls to avoid.
Popular Private Income Investment Offerings
Here are some of the most popular income investments offered on a private basis:
- Mortgage Investment Corporations (MICs)- Have become extremely popular as rates on traditional investments have come down. A MIC will underwrite mortgages to borrowers who do not necessarily meet traditional bank lending criteria. Their posted rates are normally much higher than traditional investments to compensate for additional risk. I have described a few notes of caution in a previous post “The Mighty MIC: Panacea or Poison”
- Factored Receivables- An attractive option for those looking to generate monthly income at 7%+ per annum. A full explanation of features and risks can be found in my previous article “Investing For Income: Factoring Receivables Explained”
- Private REITs- This income investment will purchase income-producing real properties to pay monthly interest to unitholders. Due to the return of capital (ROC) structure, the attractive yields can be extremely tax effective, when investing on a non-registered basis. Be sure to consult your licensed tax advisor for clarification.
- Auto Loans- As banks have tightened lending criteria to qualify for car loans, the market for non-traditional auto lending has grown, resulting in private income investments that lend to car buyers.
- Purchase of Conventional Energy Production- Quite simply, these investments purchase producing oil and gas wells, and pay regular distributions based on net income received.
- Purchase of Alternative Energy Assets- Private income investments exist that aggregate alternative energy assets, such as wind and solar, backed by attractive government subsidies.
First and Second Level Thinking
In his fascinating book The Most Important Thing, Howard Marks (Chariman of Oaktree Investment Management with an incredible track record) explains that, in order to be a truly successful investor, we must go beyond what he terms first level thinking. An example:
First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”
Marks tells us that “Those who consider the investment process simple generally aren’t aware of the need for-or even the existence of- second-level thinking. Thus, many people are misled into believing that everyone can be a successful investor. Not everyone can. But the good news is that the prevalence of first-level thinkers increases the returns available to second-level thinkers. To consistently achieve superior investment returns, you must be one of them.”
When considering private income investments, it is useful to recognize first-level thinking, which can lead you to follow the crowd into popular but unsuitable offerings. Let’s see if we can help you look under the hood a bit more towards second-level thinking when considering income choices.
What to Look For In a Quality Income Offering
All too often I find that investors become preoccupied with the posted yield, say 6, 8, or 10%, and less with how much safety and security is associated with those returns. As prudent investors, we must realize that the posted yield is actually one of least important factors, as compared with the following:
- Quality of Management- I know, I have mentioned this a number of times in previous articles, but this is probably the single most important determinant of an income investment’s success or failure. As an investor you must be relentlessly discerning when choosing your management team. Look for management with an established track record of success, a stellar reputation, and specialized expertise which creates high barriers to entry. Since this is your hard-earned money being invested, don’t be afraid to call the issuer, ask to speak with the manager. Hearing a manger describe his/ her investment methodology can make all the difference when it comes to gaining a sense of confidence that your money is being managed prudently.
- Interest Coverage- This factor is extremely important when assessing the level of safety an investment product offers. Let’s say the income investment being considered has a posted target rate of 8% per annum. It would make sense to find out how much the investment actually generates in yield net of expenses. If the example above actually generates 16% net yield, then interest coverage is said to be 2 times (16%=8%x2). The higher the interest coverage, the more certain the yield payout will be, all other things being equal. Look for high interest coverage.
- Leverage- Some private income investments will borrow to finance the purchase of income producing assets. While this isn’t necessarily a bad thing, it does increase risk, because the variability of interest rates is now introduced. In addition, the investment must now generate sufficient yield to make regular finance payments, which may present a problem if too much leverage is used. Keep in mind that the use of leverage can magnify returns greatly but can also magnify losses. The more conservative you are, the more you will avoid leveraged investments, all other things being equal. Look for a low debt/ equity ratio for additional safety.
- What Are the Assets Being Purchased?- As there are many different types of income producing assets to purchase, which ones does your product being considered specialize in, and what does the market look like for these assets? Does the income investment have a wide and flexible range, or a narrow and opportunistic focus? On one hand an example of a market that has been saturated of late has been Mortgage Investment Corps (MICs). As a result of both competition and economic pressures many MICs have been forced to cut yields. On the flip side, a private income product that specializes in purchasing oil and gas assets could possibly find great bargains in today’s economy, with supply and demand in it’s favour. The ability to assess which assets are over- and under-valued, given current economic conditions, can contribute greatly to making wise investment choices.
- Size of the Fund- In general, a small fund has more flexibility, and can capitalize on investment opportunities that may not be as economically positive for larger funds. Using MICs as an example, there are some who started of small and nimble, lending prudently and making timely distributions. Then, as a result of success, more investors discover the product. Perhaps the fund grows from $5 Million to $50 Million. Now they have 10x as much capital to deploy, and they are forced to widen the scope of available lending possibilities, which can lead to problems if management is not prepared to cap the fund and stop the capital intake. Popularity and success can sometimes become a negative. This must be considered in context of course.
The number of private income investment products available to purchase can make the process confusing. This confusion can lead to many investment mistakes. One of the keys is to recognize first-level thinking, which is how the crowd acts, and dig deeper into second-level thinking. Knowing which questions to ask, and why those questions are important, can become the difference between success or failure when investing for income.
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