Adding Value and Reducing Risk
Diversification’s goal is to reduce the risk taken in a portfolio of investments without significantly reducing the expected return of the portfolio. We view real estate and inflation hedges as separate asset classes that have the potential to increase portfolio value and at the same time lower portfolio volatility and risk.
Real estate is an asset class that offers diversification benefits to most stock portfolios or portfolios balanced between bonds and stock.
To take advantage of real estate's risk modifying benefits, an investor can buy real property directly or use a REIT (pronounced REET).
REIT is short for Real Estate Investment Trust. REITs are companies that invest in and/or manage real estate. Individual REIT’s often invest in one specific type of property. Investors can buy shares in REITs that invest in apartments, office parks, golf courses and hotels just to mention a few. The benefits of using REITs instead of directly investing in real estate are:
- liquidity - most REITs are traded on a major stock exchange and can be bought and sold easily.
- current valuation - REITs values are determined every day by the market. No periodic appraisal is required.
- ease of diversification - for a relatively modest investment, exposure to a wide range of real property can be obtained.
A REIT must meet at least the following criteria before Lyon Capital Management will buy it as an investment:
- It must have a reasonable level of assets relative to debt.
- It should have a good dividend yield.
- The property should be in a geographic area that is not overbuilt.
- We look for experienced management. And,
- The properties must be well maintained.
With our REIT investments we look for a 10 to 15 percent annual total return and reduction of the total risk of the portfolio. We only use REITs listed on a major U.S. exchange. We use the REIT as a vehicle to reduce our client’s risk by diversifying their portfolios as well as generating income.
TREASURY INFLATION PROTECTED SECURITIES
T.I.P.S or Treasury Inflation Protected Securities were introduced in the late 1990’s. Lyon Capital Management began using them before they became popular. T.I.P.S. are interesting investment vehicle that any astute investor should investigate. T.I.P.S. are issued by the U.S. Treasury. The payments of their interest and principal are made and backed by the U.S. government. T.I.P.S. are so named because the principal value is protected from inflation. The return investors can expect from T.I.P.S. is in two forms:
- Interest paid by the borrower (the federal government) at a constant rate semi-annually over the life of the bond.
- Increases in the principal value of the bonds based on the level of inflation over the life of the bond.
Interest paid by T.I.P.S. is like that of conventional bonds. The increases in principal value, however, need a little explaining. When the bond is first issued the principal value or par value is $1,000 per bond. Over the life of the bond the principal value changes with the consumer price index (CPI), a common measure of inflation. If the investor bought a 10-year bond when it was originally issued and held it to maturity and inflation averaged 2% per year, the principal the investor would receive at maturity is $1,220 per bond. An investor in a bond without inflation protection would receive $1,000. While the principal value of T.I.P.S. goes up, and sometimes down, with changes in consumer prices, the principal value never goes below $1,000 or par. In addition, the interest paid every six-months is interest on the new adjusted principal value. The interest rate itself is does not change, but the dollar amount paid out does due to the higher adjusted principal value.
The interest on T.I.P.S. is subject to federal income tax just like any other taxable bond. Any increases in the principal value due to changes in the CPI are also taxable in the year of the increase, not at maturity. Because of this feature of taxing an increase in principal when no income is received, we typically hold T.I.P.S. only in tax-deferred accounts like IRAs, 401k's, 403(b)s and Profit Sharing accounts.
At the current time inflation does not appear to be a problem. As we all know events happen in cycles. And, often when something seems least likely to occur, that is when that event does happen. Even though inflation is not a problem now, that could change in the future. The advantage of T.I.P.S. are that they offer a hedge against inflation.
T.I.P.S. have a place in most tax-deferred portfolios. $$