Alternative Income Investing: Preferred Stocks, CEFs, REITs and MLPs

Dividend-paying stocks are the bread and butter of income investors, and we’ve published plenty of explanations of their advantages. But we dabble in alternative income investing vehicles too, for variety, higher yields, more security, and other reasons.


reit, real estate investment

Today I thought I’d review some alternative income investing types.

Alternative Income Investing Types:

Preferred Stocks

Preferred stocks can make an interesting addition to an income-focused portfolio because they combine some of the safety and income of bonds with some of the appreciation potential and the ease of trading of ordinary stocks.

Harry Domash wrote, “Although traded like common stocks, preferreds are more like bonds in that they represent debt, not ownership. Consequently, you buy them for the steady income, not capital gains. Most preferreds … are issued at $25. Preferreds issued at that price typically trade in the $23 to $27 range depending on market conditions and how the market feels about the outlook for the issuing company.”

Although Domash says the primary reason for owning preferreds is income, their ability to trade several points away from their face value can provide opportunities for investors to make money buying underpriced preferreds.

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CEFs

Closed-end funds or CEFs, which are often income-focused, are different from other funds because they issue a limited number of shares. So the size of the fund doesn’t change when new investors buy in.

In addition, CEFs trade at a market-determined price like common stocks, not at their net asset value (NAV) like mutual funds. This both makes trading easier and can give savvy investors opportunities to buy CEFs when they’re trading at a discount.

REITs

REITs are a unique type of business that are granted special tax status as long as they stick to a defined set of business activities. Equity REITs own real estate, like office buildings, shopping centers, apartments and hotels, directly. They usually specialize in one type of property, like “commercial,” or even something more specific, like self-storage. Equity REITs get most of their income directly from their tenants’ rents.

The other kind of REIT is a mortgage REIT. Mortgage REITs, sometimes called mREITs, don’t own property directly. Instead, they own property mortgages and mortgage-backed securities. Their income comes from the interest they’re paid on the mortgages.

Both types of REITs are given special tax status as long as they pay out at least 90% of their income to investors so they make a good choice for alternative income investing. While REITs are subject to other corporate taxes, they don’t have to pay taxes on current income (rents or interest payments from the current period) that is distributed to unitholders (the trust version of shareholders). Essentially, the REIT is treated as a “pass through” entity, collecting the rents or interest payments and then passing them on to investors. It’s as if you own a sliver of the properties or mortgagees themselves.

But that doesn’t mean REITs have no growth potential. While they’re taxed on any earnings they retain, limiting how much they can invest in their business, REITs can still improve properties, raise rents and sell and buy properties. Plus, as with the preferred stocks and CEFs above, REITs can gain value in the eyes of investors. Both mortgage REITs and equity REITs were badly hurt by the housing and financial crisis, so there have been some great opportunities to get capital gains by buying undervalued REITs in recent years. I focused on the growth potential of REITs when I wrote about them in June.

MLPs

MLPs are like REITs in that, for tax purposes, they’re treated as a way for investors to own a sliver of income-generating assets. They’re also subject to requirements on how much of their cash flow they must give directly to unitholders in order to be treated as a pass through entity. And there are also limits on the kind of business MLPs are allowed to conduct: they must get at least 90% of revenues from real estate, commodities or natural resources.

But MLPs have a few more twists you should understand before getting into this alternative investing vehicle, including the relationship between the limited partner (LP) and general partner (GP) and the tax implications for unitholders.

 

 

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