REITs & MLPs

REITs and MLPs are financial instruments found mainly in the United States, with particularly generous payouts. You could say that they are cousins, both similar in their operating mechanism and different in their structure. The stability of their business model, their relative independence from the equity market, and of course the attractive income they generate, may represent an interesting opportunity for (future) annuitants. What's more, these instruments have a special feature that is rarely mentioned: the protection they offer against currency risk, particularly that of their reference currency, the dollar.

First, let's take a look at what's behind these two unflattering terms.

REITs

A "REIT" is a company that derives most of its assets and income from real estate. Each year, it must distribute at least 90% of its net income in the form of dividends. The interesting thing about this is that dividends paid out can be deducted from income before tax. This obviously encourages the company to pay out its entire net income...

Real estate activities do not generate as high a return as those of listed companies. The State therefore favors them by avoiding double taxation: on the company's profits and on the dividends received by shareholders. Nevertheless, while returns are lower than in other sectors, they are also more stable and, above all, more sustainable. The return on Equity REITs (real estate leasing) reaches 12% per year (in total return) when the investment horizon exceeds the length of a real estate cycle (around ten years).

THE Mortgage REITs (mortgage investments) can pay out particularly generous dividends. They also sometimes deliver extreme returns, as in 2001, with 77%. But this comes at the price of dissuasive volatility, with very sharp falls (-42% in 2007). Mortgage REITs are purely debt-based, with a backdrop of assets that can melt away like snow in the sun. Unlike Equity REITs, they do not benefit from property appreciation. Their annual return is a modest 4% over a 10-year investment horizon (total return).

REITs have the advantage of offering a wide range of real estate choices, with specializations by sector and/or region. In general, the more concentrated they are in a particular market, the better, as they can benefit from a competitive advantage and/or niche market. Each sector has its own characteristics. Hotels, for example, are highly sensitive to economic conditions. Offices, on the other hand, are slightly less dependent on growth, while posting occupancy rates generally between 90 and 95%. Residential property is even less sensitive to economic ups and downs. Commercial real estate is certainly the least profitable sector, but it's also the most stable, thanks to very strict standards governing the duration and revaluation of rents. Finally, medical centers are also largely unaffected by the economic climate, and even have the luxury of an occupancy rate generally between 95 and 100%.

In short, if you want to invest in REITs for the long term, to generate solid income, it's better to focus on Equity REITs, which derive their income from the rental of real estate assets, rather than Mortgage REITs, which derive their income from mortgage debt. In addition, it's better to focus on the retail, healthcare and residential sectors, which are less subject to the vagaries of the economy.

Despite these precautions, any investment involves risks. Of course, the one that threatens the real estate sector the most is the rise in interest rate. A sudden, sharp rise in inflation could, for example, cause the Fed to reconsider its particularly accommodating monetary policy, thereby endangering REITs. On the other hand, this interest-rate sensitivity is paradoxically useful for hedging against currency risk. A tightening of the Fed's monetary policy is bad for a REIT's share price, but it also strengthens its reference currency, the dollar. And vice versa.

Another risk of a REIT is that the money simply doesn't flow into the company's coffers. This can happen if the properties to be rented don't find takers, or if a tenant can no longer pay the rent. To mitigate these risks, it is in the company's interest to strongly diversify both its tenants and its properties. The greater the number and diversity of properties and tenants, the lower the risk. In the commercial sector, for example, a spread over several different areas of activity will prevent a large number of tenants from simultaneously defaulting on their payments due to a structural or cyclical crisis affecting a particular sector.

Finally, it should also be noted that REITs are generally highly volatileThe relative standard deviation can easily be double that of a listed stock. The relative standard deviation can very easily be double that of a listed stock. This is something you need to be aware of before investing in this type of asset. On the other hand, this volatility has historically not been too closely linked to that of equities, which means that market risk is not a major concern. But since the subprime crisis, this advantage has faded.

MLPs

With interest rates on traditional fixed-income investments falling sharply in recent years, investors have increasingly turned to specialized investment vehicles to provide the income they need. MLPs have gained considerable popularity precisely because they can offer very high returns, thanks to the tax advantages they enjoy, much like their cousins the REITs. MLPs pay no tax before distributing their profits, allowing them to be more generous with their shareholders. To benefit from this tax advantage, 90% of an MLP's income must come from activities in real estate, raw materials or natural resources (mining, timber or energy).

MLPs are controlled by a general partner, who usually holds a 2% stake. These are mostly privately-owned companies, but some are also listed on the stock exchange. In these cases, the general partner pays most of its cash flow to its shareholders. Take Kinder Morgan (NYSE:KMI), general partner of MLP Kinder Morgan Energy Partners (NYSE:KMP). While Kinder Morgan offers a yield of 4.5%, Kinder Morgan Energy Partners pays distributions of 6.5%. This gives an idea of the tax benefits available to MLPs...

MLPs seem to have a Particularly attractive for large producers of natural gas and oil. Many of them have transferred their assets and pipelines to MLPs, which they control as general partners. Oil operators' fees are regulated and based on the volume of products transported, not on the price of oil. In this way, long-term profit growth follows that of the economy as a whole, and is not dependent on the price of oil. For natural gas operators, on the other hand, margins can vary with the price of the commodity. Some operators use hedging strategies to reduce their vulnerability to price fluctuations. But not all do so, as this limits their upside potential.

Just like REITs, MLPs are very volatileand may not suit the risk profile of all investors. On the other hand, they are also relatively insensitive to equity market fluctuations, which is always an advantage when it comes to diversifying a portfolio. Last but not least, like their cousins, they offer a excellent protection against currency risk the dollar, with its perennial structural weakness.

Finally, let's note a small technical detail that could be of importance depending on the tax treatment to which the individual investor who chooses this type of investment is subject. MLPs do not pay dividends, but distributions, which comprise a small amount of income and a large amount of capital gain. In theory, this could mean that a large part of this distribution is not taxable in Switzerland. It remains to be seen how this will be treated in practice, taking into account the additional US withholding tax. Unfortunately, it's a safe bet that this will be handled according to the usual rule applied to US dividends (15% non-recoverable US tax and 15% recoverable CH tax).

In conclusion

REITs and MLPs, although operating in different sectors and with different structures, are ultimately very similar. Their tax treatment allows them to pay generous distributions. I'm usually very sceptical about high returns. Most of the time, they are a sign of irresponsible corporate management and/or economic or structural difficulties. However, in the case of these two instruments, these generous distributions are, on the contrary, the fruit of a tax mechanism that allows and even encourages them to pay out more dividends to their owners.

Very often, high yields are also synonymous with sluggish dividend growth. We are all too familiar with this phenomenon in Utilities companies, such as the Consolidated Edison (NYSE:ED). Of course, this is also true of REITs and MLPs, but not necessarily so. Many of them have nothing to envy even to the famous dividend aristocrats, even if their track record of increasing distributions is much more modest.

Of course, all is not rosy either. Even if they are relatively sheltered from stock market fluctuations, the volatility of REITs and MLPs is very high indeed. Many investors will certainly live with it. Others, accustomed to defensive investments that deliver stable, growing dividends, may quickly become frightened.

However, as I mentioned in my introduction, these two types of instrument have a characteristic that is often overlooked by European investors, and Swiss investors in particular, who buy US securities. REITs and MLPs love a weak dollar... and needless to say, historically, this damn currency has a tendency to lose value.

Taking all these considerations into account, I decided to add a new dividend growth strategy to my portfolio, based on MLPs and REITs. To start with, it includes over 30 titles and is available in the member section.