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Risky Business

ALBUQUERQUE, N.M. — What if instead of the 1 or 2 percent yield you can get from a bank deposit or a government bond you could get 4 to 6 percent. You’d do it, right?

Maybe you should. An index of real estate investment trusts was yielding 4.65 percent as of October 31. An exchange traded fund that is used as a benchmark for performance of master limited partnerships yielded 6.35 percent earlier this month. Good REITs and MLPs are more exotic than a mutual fund of stocks, but they’re transparent, liquid, mainstream investments.

And maybe you shouldn’t. When interest rates are at unheard of lows, investors trying to generate income can be tempted to pay too much for a cash-producing asset. Like anything else, REITs and MLPs are only worth so much, and they have risks of their own. On top of that, MLPs can present tax complications some investors won’t like.

“Clearly, the desire for income or yield in an environment where there are increasingly few options is understandable,” said David Marion, managing director and head of wealth management at First National Bank of Santa Fe. “People need income, of course. One should tread carefully, do the homework and read the fine print.”

Brian Jackson, vice president and portfolio manager for New Mexico Bank and Trust, thinks most investors should consider REITs and MLPs, but only after they have built a solid, well-diversified portfolio of stocks and fixed-income securities. Even then, your portfolio should be composed of 5 percent each in REITs and MLPs at most.

A real estate investment trust invests in properties or mortgages or both. Some REITs specialize only in specific real estate, like shopping malls, and some invest only in certain geographic areas. REITs are publicly traded, and some mutual funds invest in a portfolio of REITs.

REITs are required by law to pay at least 90 percent of their taxable income to investors, which is one reason investors looking for income are tempted by them.

An investor in a master limited partnership becomes a partner in ventures that usually are in the business of transporting natural gas, gasoline and oil. The partnership typically owns pipelines and storage facilities. While a common stock will pay the investor a dividend, the MLP pays to its partners a proportional share of the taxable income the partnership generated.

The taxes due on the MLP’s earnings are paid by the partners on their individual income tax forms. The earnings are reported to the investor on a K-1 form. Some investors find it frustrating that K-1 forms typically arrive only weeks before the April 15 tax filing deadline. Marion urges investors considering MLPs to talk with a tax adviser first.

In the past year, exchange traded funds have been established to invest in MLPs, which makes tax treatment easier. MLPs also trade publicly.

Investors face the same questions with REITs and MLPs as they do with any investment: What are the risks, what are the rewards, how reliable are those rewards, what alternatives might provide similar returns at lower risk?

Right off the bat, said Marion, an REIT exposes the investor to the risks inherent in the real estate market.

“There also may be interest rate risk, which can take a number of forms,” Marion said. “Rising long-term rates can have a negative impact on the value of the underlying real estate.”

REITs that invest in mortgages “generally employ leverage, and sometimes significant leverage, which can be short-term in nature,” he said. That means the REIT could hold a lot of short-term debt that it might have trouble repaying if business conditions or interest rates change.

“You need to understand the real risk as opposed to paying for the dividend yields you hope to get,” Marion said.

A professional investor would dig deeply into the REIT’s business. “I would consider the overall real estate market in terms of supply,” Marion said. “I’d consider regional issues and concentrations.” Investors should understand how much the REIT has borrowed, at what interest rate and at what maturity. With any fund-like investment, it’s important to know who is managing the REIT and what the management team’s track record is.

“In the case of both REITs and MLPs, you want to look at the cash flow being generated to make sure they can support these yields,” Jackson said. “Sometimes you see REITs pay out dividends that far exceed their income. They are financing dividends through debt offerings. That can’t go on forever.”

REITs can be volatile, too, Jackson said. They enjoyed wide popularity in 2000. “Yields went from being reasonably attractive in the 4-, 5-, 6-percent range, then they started getting lower and lower. Then we saw a huge sell-off.” Both REITs and MLPs can decline in value, just like stocks can, so don’t forget in your hunt for yield that there is always a risk of capital loss.

Master limited partnerships are “a pretty hot asset class now,” Jackson said. “There is a lot of investor interest, so prices are being bid up somewhat.” That means yields might go down. It also means the potential of a price run-up in MLPs might not be as great as it has been.

MLPs do, however, tend to be less volatile than some equity investments because the businesses they tend to be in – charging a fee to move gasoline through a pipeline, for example – tend to be less volatile, Jackson said.

Total returns have been quite good over time. An analysis by Geneva Investment Management of Chicago found that the 10-year compounded annual growth rate of MLPs was 14.4 percent and 38.8 percent over the past three years. An index of utility stocks, which traditionally pay good dividends, grew 8.6 percent over the past 10 years and 21.6 percent in the past three years.

REITs grew 3.4 percent over 10 years and 4.1 percent in the past three years.

There are other instruments that offer yield, too, and Marion recommends investors looking for income consider them. For example, you could buy a high-yield bond fund. In early October, thanks to turmoil in the bond markets, yields were around 8 percent.