Alternative Investments - REITs and MLPs
Written by Rick Welch
Alternative investments include many different types of investments or assets which fall outside of the three traditional asset classes known to most investors: cash, bonds and stocks. An investment can be considered alternative based on the type of assets it holds (real estate, natural resources or commodities) or by its investment strategy (examples include managed futures, hedge funds and private equity). Real estate investment trusts (REITs) and master limited partnerships (MLPs) are two types of publicly traded alternative investments found in many portfolios. REITs and MLPs both have the status of “pass-through” entities under the Internal Revenue Code, which means that their earnings are not subject to income tax at the corporate or partnership level so long as the entity restricts its operations to certain qualifying activities. This pass-through of earnings allows the investor to receive a rich yield, higher than the dividend yield of the S&P 500 and most fixed income asset classes. One method of distinguishing between traditional and alternative investments is by their return characteristics.
As a group, alternative investments have expected returns that are uncorrelated or only slightly correlated with the expected returns of the three traditional asset classes. An attractive dimension of this low correlation is that it indicates the potential to increase diversification within a portfolio of traditional assets. When two assets have low correlation we expect that when the price of one asset goes up, the price of the other will go down. Diversification which reduces risk, without impacting expected return, is a good way to produce superior risk-adjusted returns in a portfolio.
REITs were first authorized by the Real Estate Investment Trust Act of 1960 which provided the means for small investors to directly participate in the returns generated by diversified portfolios of income producing real estate. 75% of REIT owned assets must be real property, loans secured by real property, government securities or cash and 75% of REIT gross annual income must be derived from rents, interest from mortgages or other real estate investments. REITs have typically covered many real estate categories like industrial, office, apartment buildings, shopping centers and malls, hotels and health care. The understanding of what is real property continues to evolve to cover an ever-broader range of physical assets currently owned by companies who use those assets directly in their businesses. The rise of non-typical REIT formations and conversions has introduced a wide variety of new asset types into the REIT universe including timberland, farmland, cell towers, billboards, prisons, data centers and infrastructure. As an asset class, REITs have performed well returning, on average, +11.44% annually for the period of 2010-18 compared to the S&P 500 which returned +12.23%.
The two-tiered structure of an MLP, which consists of a corporate general partner and one or more limited partners, is unique in that it revolves around cash flow. When MLPs are traded it is based on a multiple of cash flow and not net income. All investors receive quarterly distributions which include a share of partnership pass-through income and a return of capital. MLPs typically own midstream energy assets which can include mining, process, transportation (marine, pipeline and road) and distribution activities. Over 80% of all MLPs are found in the oil and gas sector, which includes qualifying products like gasoline, kerosene, refined lubricating oils, propane and diesel fuel. Transportation of these products is qualifying so long as the delivery point is a bulk distribution center or public power generation utility and not to a retail outlet. The current yield of the Alerian MLP Index, which tracks midstream energy firms, is 7.96% compared to 2.71% for the Barclays US Aggregate Bond Index and 1.90% for the S&P 500.