Finding Value in Income-Generating Securities

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Ron DeutschHow to generate income in a low return world is a topic that’s currently on the mind of many investors. A reflection of how crowded some income-seeking strategies have become is certainly the premium valuation of  reliable dividend-paying equities such as 3M (MMM) or Walt Disney (DIS).

Searching for ways to generate income in other ways, and not stretching for yield, I recently had the pleasure of learning from Ronald Deutsch, Managing Director at Sage Capital Management based in New York. Ron is a veteran of the investment industry with over 25 years of experience, including in fixed-income at Kidder Peabody, Prudential Securities, Bear Stearns and BNP Paribas. In his current role at Sage Capital, which has provided independent investment advice and financial planning services to high net worth individuals and families since 1999, Ron is responsible for portfolio management and alternative investments.

I’m pleased to share below an excerpt from my conversation with Ron, in which he describes several areas of where he is finding value among income-generating securities as well as which investments to avoid.  The full video of my conversation with Ron Deutsch is available in The Manual of Ideas Members Area.

Ronald Deutsch on Where He Is Finding Value Among Income-Generating Securities

Says Ronald Deutsch:

“REITs in general have had a big run. The yields on REITs are now down to levels which again like we mentioned the large-cap dividend stocks, a lot of the public REITs now are yielding 3% and change, 3.5%, depending what they are. The risk return now is more heavily skewed to the risk side.

What we’ve done here on the real estate side is we’ve been able to find a lot of real estate niche type private firms. I’ll give you a couple of examples of the kinds of things we put our client’s money into in that last couple of months. We have a firm that we do business with, they have a fund that all the investing is in student housing, meaning that they’ve got their own models. They basically have about sixty public state universities around the country they’ve targeted which, and I don’t know if you have college-age kids, I have three of them, and very often in many schools, after sophomore you can’t get housing on the campus anymore. It’s that tight. There’s a dearth of student housing.

These guys, what they do is they’ll buy properties right around the college or universities, they’ll fix them up. The guy who runs the fund jokes, he says, when your kids move out of my student housing after they graduate college, it’s going to be a down tick to whatever apartment they move into for the real-time job because our place is so nice. We’ve seen pictures. It’s a very upscale thing. There’s a little bit of a premium to what’s it going to cost on campus.

Bottom line – they’re income producing and there’s capital appreciation. They buy these things, they lease them out, the parents all guarantee the leases for every student that that’s there. So you’ve got a safety as far as that goes. The cash flow that kicks off to my investors is 9% to 10% current income a year on top of their investment.

And if you’re fortunate enough which we were in the last fund, he’s on his third fund now, last fund what’s happening now is he goes out and buys a bunch of these, bundles them up and they end up being bought out by a public REIT. American Campus Communities [ACC] is a public REIT, that’s all they do – student housing. They can’t buy these little projects. It’s such a big company. They’re the buyer of his stuff and the returns have been really good.

That’s a sector which is very nichy but at a firm like ours the beauty is we’re a medium size shop, we do our own due diligence, we’ll speak to so many fund managers and we’re able to uncover some of this stuff. The bigger firms, the Morgan Stanleys, the UBS’s, they have compliance departments, they’re with the very big firms, the very big funds. So, we’re able to uncover a lot of stuff.

We have money with a real estate fund right now that buys parking lots and municipal garages, that’s all they do. They go out, they buy undervalued garages, they fix them up, and it’s a cash flow deal. Again, it’s usually in urban areas. I’m sure you’ve tried to park in New York at some point. At $50 for a day or whatever, they’re cash cows.

These are the kinds of investments that we find, we’re getting 9% or 10% from that side of the investment, combine it with the other things I’m mentioning, we can get a fairly nice yield. Also realize the real estate it’s all secured. This isn’t just unsecured bonds – you’re secured by the underlying properties. And our managers, typically we demand they have at least 5% to 10% of their own money in their funds and deals so we know we’re on the same page with them or they’re on the same page with us. Those are some private type of things.

On the other side, back to the public market, we’ve bought selectively mortgage REITS and some business development companies, BDCs. Mortgage REITs are basically a form of a leveraged kind of bond fund. What they do is go out and they’re buying a lot of mortgage-backed securities.

And depending which ones you’re buying, it can be non-agency, it could be agency, and then they can lever up two to three times. And with the short rates so low, and you’re getting 3% on the other stuff, and you leverage it up, the returns on those things, the current yields on the common stocks are in the area of anywhere from 10% to 15%.

We’re even buying the preferred stocks of many of them and their yielding about 8-8.5% also. Now, the preferred stocks we’re buying because most of these companies have common equity in the area of a couple billion dollars, they’re also supported by government-backed paper which is liquid. So if they got a capital call or this and that, and they have to liquidate it, there’s enough under us as far as capital cushion, that the preferreds we feel very good about and we’re getting paid a lot to own them. That’s number one. Number two also is the common stocks are paying dividends like I said 3 or so %. They have to eliminate all those common dividends first before we even have to worry about our preferreds.

The other one I mentioned is business development companies. Those are firms which basically lend money to small to middle market type of companies that may have for various reasons trouble borrowing from the banks. This is like the public leveraged loans I mentioned before. These guys basically lend money to these companies, typically it’s floating rate not fixed rate, it is senior security in many cases also, so you’re very high up in the capital structure, and the dividend yields on most of these kinds of stocks are again, depending on how large or small the BDC is, 7% to 12% or 13%, 14%, and we’ve unearthed a number of these.

This isn’t a new idea. But again, it’s another tool in our tool belt to mix in with the rest of the things we’re talking about. We’ve had a couple of private ones we’ve looked at as well. There the yields are even higher but they are a number of public ones as well. We pull all these things together under that alternative bucket to offset a lot of straight fixed income. That would be it.

But the public REIT market, we just don’t feel we’re getting paid enough. We can get much better yields in the private market and we prefer to do that. You’ve had a quick recovery in some parts of the country in real estate, and we’re not sure how long that holds. Rates are where they are but when rates starts moving up I’m not sure what the consequences are going to be, so we’d rather do it the way we do it.”

Ronald Deutsch is one of the instructors at the fully online Equity Income Summit 2013 on August 6-7.

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