Finding income in a low rate environment

Many investors preparing for retirement or in the early stages, are trying to figure out how to generate monthly income from their assets. Most of them just want to buy a CD from the bank that pays 5-7% per year. But with 5 year CD rates around 2.25% they tend to pass.

Nearly every investor has been pitched an annuity for guaranteed income. There are plenty of articles that speak at length to the pros and cons of the complex annuity landscape. With low returns and high fees, fixed annuities don’t tend to offer the net returns investors are looking for.

With lack of yield in the bond market and a view that rates will eventually rise many people gravitate towards purchasing rental property. Real estate has worked very well since the bottom of the subprime crash, in part because prices have significantly appreciated from their lows.

But as price appreciation begins to normalize, the total returns are less attractive. Rental income from a single family home is not spectacular. Once you net out property taxes, insurance, mortgage costs, vacancies and repairs. Add to that the hassle of managing tenants – it feels like you break even at best. You could hire a property management company, but that takes your income down another notch. Many individual investors I’ve met with fail to put all these numbers in a spreadsheet to calculate their net yield. Lots of people ball park it in their heads, but every time they put it on paper, it surprises them. In some cases, net income from single family home rental was sub 2% before taxes.

Retirement Income Alternatives

If you are comfortable with real estate one option would be trust deeds. A trust deed is a private loan attached to a property. These vary widely by state and geography but have been a favored investment by many hedge funds and institutional investors. A typical trust deed might look like this: a real estate investor needs a loan to purchase a dated house they want to rehab and sell. If they go to a bank it will take too long to get the loan and a competing investor will purchase the property. So they go to a private lender for speed and in return they pay higher interest. Say the property is worth $500,000 as is, the borrower has $250,000 in cash and borrows the other $250,000 from the private lender. So the trust deed is a loan for $250,000. The property is worth $500,000 which equates to a loan to value ratio of 50%. The term of the loan is short in this case let’s say 1 year.These loans typically require interest only payments and the rate is usually between 8% and 12% per year. In our example lets say 10%. Now that we have the basic tenants of the deal we can analyze it as an investor.

I invest $250,000, in return I get 10% annual interest paid to me monthly which equals $2,083 per month. At the end of 1 year I get my $250,000 back. So if all goes well my total return leaves me with $275,000. If things go bad and the borrower fails to pay me my money, I take back the property that is worth $500,000. This sounds like a great deal. However, it is very important to note that there are many additional considerations that are not covered in this article.

Let’s say you like the concept but don’t want to hunt these deals down and just want to enjoy the income stream. Then you can look at investing in a trust deed fund. You put your money in the fund and a professional manager can do the rest. You will pay a small fee for this but in return you get to receive monthly income checks without the headaches. These funds currently pay between 8-11% per year. Keep in mind many trust deed funds went bust in 2008, but not all. The ones that didn’t survive typically had too much leverage and concentrations in land and condo developments. I like to invest with funds that have a track record through the down market, but just because they survived then doesn’t mean they will next time. Making it very important to be able to analyze their portfolio composition, loan loss reserves, etc. If you’re not up to the task make sure you hire a professional advisor with experience in this market to help with due diligence. When done properly this can be an excellent source of monthly income, but keep in mind there are lots of risks to navigate as well.

Another alternative investors have turned to are peer to peer loans. These come from the newly minted online lending companies such as Lending Club, Prosper and others. In short, you can lend your money direct to other people over the internet. The online lender applies an algorithm to determine the credit risk, interest rate and dollar amount. Typically, borrowers use proceeds to pay off higher interest rate credit cards, pay for home improvement projects or grow a small business. There is not collateral or property backing consumer loans. There has been significant interest from institutional investors in this space and rates have been driven down as a result. The peer to peer lending market still appears to be in it’s infancy relative to traditional lenders. As reported by PeerIQ, the P2P market was 1.1 billion in 2014 compared to the 3.2 trillion consumer lending market as a whole. There are also funds that will invest in these loans on your behalf, but the threshold to get in is typically higher than other funds including trust deed funds. Returns from the funds seem to range between 7-11% depending on the amount of leverage used. Again, there are far more variables to consider than covered in this article.

Both of these categories of alternative investment offer nice protection from rising interest rates because they typically have short maturities and they are generally held to maturity. They do come with their own unique set of risks and it is critical that investors educate themselves prior to investing or seek the help of a professional. Otherwise, in a low rate environment these types of alternatives do appear very attractive.

Contact Softwealth today if you have any questions about retirement income alternatives.