Avoiding the income trap
High-quality Reits were sounder than alternative-income funds, but rising rates make it prudent to diversify
A few years ago, I made small investments in some of the alternative income funds that were listing on the London Stock Exchange. This was partly because yields seemed decent and partly because we were covering them a lot in MoneyWeek at the time and I try to have some skin in the game on major themes to help me analyse them. Many of these looked very attractive on the surface, yet my overall results were more or less breakeven and there were a couple of notable flops.
I don’t hold any of these anymore, largely because that changed my income strategy. My first step now is to decide whether I am investing in a true asset, or whether I am providing a way for somebody to offload their liabilities. A highquality building in a prime district of a highdemand city should be an asset. If the current tenants no longer want it, you should be able to get new ones. A very specific type of building or other asset for a tiny number of potential users is not the same. If the client wants to pay less rent, you may not be able to shop around for a better deal. If they go bust, you have a white elephant.
Owner or bagholder?
Some of these income vehicles were essentially backed by these latter kind of assets, either through a secured loan, a sale and leaseback deal, or an agreement to build to the client’s requirements. I concluded that the “asset” in these cases was a bit of an illusion and that in practice one could easily end up as the bagholder, with limited fixed upside and plenty of potential downside. Deals like that can still be okay if the fixed return is high enough – but in a yieldstarved environment, they generally weren’t by the time they got onto public markets. So I limited most of my income investing to fairly high-quality real estate investment trusts (Reits) and bought when markets wobbled a bit.
That’s worked pretty well – but as I continue reviewing my strategies this year, I’m aware that there is a big embedded bet on interest rates. This should be fine if inflation-driven rent increases keep up with higher rates when debt is refinanced, but if rates become more strongly positive in inflation-adjusted terms, it will hurt. Income available for distribution will lag and cap rates (see below) will rise, hurting capital values. We also need to be think about certain trends – eg, some US offices may be more affected by working from home than most of the world and too many warehouses may have been built to meet e-commerce demand – but only interest rates affect the whole strategy.
Thus my strategic shift has to be to diversify beyond what’s worked well, without falling into the same trap as with alternative income funds. The reality is that there aren’t many great options, but since energy is a key theme, I will be looking at energy infrastructure for opportunities.