This Month’s Newsletter

The Search for Yield: Chapter 2 Join our Monthly Newsletter November 2019

Mark R. Hoffman

CEO, Principal

Last month, our partner Trip’s article focused on the search for yield. Given today’s rate environment (lower rates for longer), where can you go to find high quality, income-producing investments? High yield bonds? That’s a crowded trade and there is always default risk. Treasuries? Low risk, but also low yield and low return. Dividend-yielding stocks? Also a popular trade and there is always the potential for a long-overdue market correction. Where do you look?

At Lanier, we are constantly barraged by fund managers trying to sell us on their latest investment ideas. Some are good ideas. Most are ho-hum. Very few are – in our opinion – solid income-producing investments (i.e., bond replacements) that provide potential for strong upside returns. But they are out there. You just have to look hard.

As an example, we recently discovered one very intriguing strategy. An experienced management team recently launched a series of alternative real estate funds. Fund I completed fundraising and closed in October. The Fund sold out in a month. Fund II is planned to launch in early 2020. The Fund is targeted to pay 8%/year yield on capital deployed with additional return expected at the end of the 4-6 year expected life of the fund. How does it work?

The strategy will invest in the undersupplied, multi-family, affordable housing market. Their targeted segment of the market offers highly predictable returns with countertrend characteristics to the US economy. The fund managers identify properties where prudent capital improvements can substantially improve the living conditions in the complex and justify an increase in rent from below-market levels to market levels. How do they know they will be able to increase the rents? 70-80% of the Fund will be invested in Section 8 apartment buildings where the rent increases are subsidized by government programs and have no impact to the amount that the tenant pays. And how do they know the increased subsidies will occur? Because they negotiate the deals with HUD before they buy the properties. Brilliant. Low vacancies on the properties because of long waiting lists of renters that want to move in. Low bad debt as HUD pays ~80% of the rent via a monthly wire to the owner.

Once the properties are purchased and the capital improvements have been made, they will be held for a year or two (season them) and then package them and sell them to a long list of strategic buyers: REITs, insurance companies, pension funds, private equity funds, etc. All of these potential buyers are eager to find stable cash-generating investments but don’t want to spend the time chasing $5 million deals that won’t move the needle. But a $200 million deal will. Brilliant.

Are there downsides? Sure. Your investment is illiquid over the 4-6 year expected life of the fund. Could the government eliminate subsidies? Yes, but removing or reducing this benefit to working class America would be political suicide. Could the real estate market fall apart just when they are trying to sell? It could, but they have the flexibility to wait to sell and you are still getting paid 2%/quarter to wait! And if the economy heads south and you own a property where HUD is paying 80% of the rent, won’t that be somewhat shielded from the downside? We think it will.

This strategy isn’t for everyone. And it is limited to sophisticated, accredited investors. But we think it is truly interesting. It’s a niche strategy, but one that could fit well in a bunch of portfolios (including mine!).

Yield producing strategies do exist. You just have to turn over a bunch of rocks before you find the good ones.

Mark is a co-founder of Lanier Asset Management and serves as its Chief Executive Officer. Prior to founding Lanier, he was a partner at The Boston Consulting Group. Mark is an honors graduate of The University of North Carolina at Chapel Hill with a BA in Economics, and holds an MBA from The Harvard Business School.