Looking for Yield in All the Wrong Places

The Baby Boomers Dilemma

If you’re getting older and all commentators and advisors are recommending you start shifting and reducing your equity exposure in your individual account IRA or 401K to something more conservative, be very careful. Financial plans would advise a heavy reallocation to higher yielding sectors starting always with bonds. They’re just following what the asset allocation computer models recommend.

Certainly, there are other choices with higher yielding equity market sectors.

For investors in retirement they’re furiously hunting for yield and there’s little to be had. In fact, the more yield you find the riskier the source. Even U.S. Treasury Bonds, now just AA+ rated offer puny yields and a lot of interest rate risk. Color me jaded since as a bond trader in the 1970s I know full well how those investors holding locked-in low yields saw the value of their bonds collapse with inflation by as much as 30-50%. Even worse for retirees is the loss of purchasing power when locked-in yields become low.

Let’s assume you’re over 50 and now a card carrying member of the AARP or even 60 plus and wanting to follow the dictates of the allocation computer models. The first thing you should do is politely ignore these and better yet, run away!

What’s the alternative?

Hang on to your hats but one such alternative is (gulp) real estate.

Over the years we’ve seen real estate and stock market cycles that don’t always correlate well with each other.

Stocks can rise while real estate prices slump as they did recently from 2009 through early 2011. In the 1970s stock prices stagnated but real estate prices rose dramatically with inflation.You don’t need a chart to know this intuitively.

But, I would take what the market is giving you.

And, no, I don’t wish to cannibalize my own ETF business but just provide some reasonable advice and an alternative strategy. You will still need to have exposure to other ETF asset classes naturally so some leakage away isn’t a bad thing.

You don’t need me to tell you real estate prices nationally dropped significantly and in many areas are still declining.

My recommendation is based on the following simple plan. It can be adjusted to suit your own tastes and circumstances naturally.

In your IRA, 401K plan or just for yourself you may purchase real estate. Retirement accounts such as IRAs and 401Ks are subject to certain rules but you may own real estate under certain restrictions. One website with explanations we can’t verify as either correct or current is at this website. Once again you would need to consult with your own CPA as to current rules and law.

My advice, and if you’re not a contractor, is to buy well-constructed single family homes, well located, in great neighborhoods that need little work from motivated sellers at reasonable prices. I’m not suggesting foreclosures or trolling for garbage to flip.

If you can, put down 50% and get the best rate on a 15-year mortgage which is currently between 3.5-4%. You don’t need to put down such

a big down payment but it will reduce risk and anxiety.

As an example, let’s say you purchase such a home for $250K.

You’d put down $125K which is currently earning you at best 3% or $3,750 per year. The monthly payment on the house would be just over $400. Then you would rent the property for let’s say $1300 a month or more.

In addition hire a property manager who would take around 12% of the rental or $156 per month. This would spare you irksome tenant issues.

You’d have maintenance expenses, taxes and insurance which would whittle the yield to perhaps $1000 per month. Together these would reduce the yield to 9% on the $125,000 which you had invested in the bond.

What are the risks?

There would be maintenance costs and you should build an escrow account for this contingency from monthly rents. Besides, the point is to purchase something that’s contemporary in appointments, well-found and even in “turn-key” rentable condition.

Let’s even assume the home is unrented for 3 months each year which over the life of the investment and mortgage is most likely a worst case scenario. This would take the cash-flow (not including taxes, fees and maintenance) to $9000 or a little over 7% which is still beating the bond yield at 3.50%. It’s unlikely the property would become vacant for more than 3 months per year but the mortgage and expenses are low owing to the large down payment making it such a circumstance manageable.

There are closing costs to consider and if you can, have the motivated seller pay some or all these expenses.

But, real estate prices are still falling and may continue to do so won’t they? That’s true and quite possible overall but some regions are stabilizing. Even in stable areas the supply of listings makes for good opportunities. And, perhaps the lion’s share of price drops has already occurred. Over the next 15 years prices might actually appreciate as they’ve done in the past. Rents can always increase as they are throughout much of the country today. This is another reason to choose properties well located near schools, hospitals and other amenities. It would help if employment conditions are relatively superior with a large stable employer nearby.

But my bond is safe and I’ll get my money back at maturity won’t I? Depending on the credit rating and quality of the investment sure you will. What will be the value of the dollar then? Real estate can appreciate with inflation and I always operate under the assumption that authorities will choose inflation versus deflation if they’re able to do so. Besides, as I mentioned previously, high levels of inflation can occur (and are already by many measures like food and energy) making the yield from the bond providing less and less purchasing power.

And remember, bond prices can fall substantially before maturity. And, if they were still down at maturity you would know the value of dollars received at maturity would be lacking in purchasing power.

The positives are greatly increased yield, and as the mortgage maturity nears the property becomes gradually free and clear. It may be worth substantially more than the proceeds from the bond in current dollars. Finally rents can increase over time increasing the yield.

With many well-maintained, contemporary, turn-key properties in good communities with excellent locations available at fair prices and with excellent interest rate terms, why not take what the market’s giving you?

Disclosure: I am long SH, EFZ, EUM, BND, BSV, IEF, LQD, VGT, VWO, VNO, IAU, DJCI, DJP, VMBS, VIG, ILF, EWA, IEV, EWC, EWJ, EWG, EWU, GXG, THD, AFK, BRAQ, CHIQ, TUR, VNM.