In today’s low interest rate environment, the search for yield is driving an increasing number of investment decisions. However, higher yield options are somewhat limited in more liquid investments, such as rated bonds or stabilized stocks or mutual funds, causing investors to seek out other avenues to achieve their income goals. Alternative investments are increasingly filling this need in today’s portfolio construction. However, such products are often selected based on quoted yield without taking into account the underlying risk-return tradeoff. The alternative investment industry may have lost track of appropriate compensation for the risk investors are assuming since stated yield often sells itself.
Similar structure does not mean similar risk
For example, a number of public, non-traded REITs have patterned their fee structure off of Blackstone Real Estate Income Trust, Inc. This makes sense given Blackstone’s market share and the need for similar products to compete in the market. However, all 5% performance hurdles are not created equal. The appropriateness of the 5% performance hurdle seems to have become detached from the risks posed by underlying asset class. While a 5% hurdle might make sense for stabilized multifamily properties, does it really compensate investors for the risks associated with other asset classes, such as hospitality, which was hard hit by COVID-19, or office properties that have an uncertain future?
Understand what is really backing the cash flow
Sponsors have also begun to offer several structural options for high-income products through private placements. Recent months have seen a resurgence in bond offerings that provide a fixed rate of income (and sometimes contingent interest payments or limited upside participation) while allowing the sponsor to keep most, if not all, of the upside. Investors are attracted to these offerings based upon the program’s contractual obligation to pay interest, and the perceived liquidity provided by the stated maturity date. What investors might be losing sight of is that the lower interest payment often associated with bond offerings (as compared to equity offerings) is designed to compensate investors for investing at a higher level of the capital stack. In certain of these offerings, these bond issuances lack a key element typically associated with bonds—a common equity cushion. In such cases, investors have direct exposure to the performance of the underlying assets (and perhaps the ability of the issuer to refinance or successfully sell the underlying asset.) Investors typically supply all of the capital at risk for the underlying investments, bringing into question the value of the guaranty implicit in bond offerings. People living on the cashflow generated from such programs might perceive an advantage in this type of structure versus preferred equity (which itself is often offered without a common equity cushion) because they believe they will receive current payments rather than waiting until the underlying assets can actually support such distributions. However, needless to say, this structure is likely to stress the program’s ultimate ability to return capital.
Is providing for current yield the most efficient use of capital?
Over the last couple of years, certain limited partnership programs have invested in assets before they provide current cash flow. Nevertheless, some of the programs carve out current income options. For example, certain development deals offer current pay options that typically involve funding reserves out of offering proceeds to pay current income until the development project is refinanced and/or is leased and stabilized. This might be an attractive option for investors. However, it might represent a drain on the overall risk-return profile of the offerings, since capital is often sitting in a bank account that earns little or no return while the issuer is paying the stated interest rate or the preferred return on these borrowed funds. An analysis of overall economics is necessary to see if such an arrangement makes sense. For example, the overall economics might make sense if the income option only applies to a portion of the units and these units serve to replace more expensive bridge financing.
Even as interest rates are anticipated to gradually increase, inflation is likely to drive investors to continue to seek higher current income investments. Appropriate current income vehicles exist, especially those that provide a capital cushion that protects investors. Just remember that when you reach for the highest yields, you almost inevitably move up the risk-return tradeoff. Understanding client suitability and the risk-return tradeoff of the investment are essential to making the right investments for your client’s success.
"More money has been lost reaching for yield than at the point of a gun."
- Raymond DeVoe Jr.
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