For an audio version of this post, please click on the speaker icon (top left).

 

 

[Note: A version of this post has appeared on Millionaire Doc’s website when on May 1st, MD asked me if I wanted to do a guest post on alternative investing. 

My blog was only 8 days old at the time and I jumped at the opportunity to be on his website (still couldn’t believe anyone would want to read my stuff let alone ask me to contribute a post for them).  

I had the framework down for this post already but it was scheduled out for August to be a part of the basic investing series I created. 

So, as Jim from White Coat would often say, “If you haven’t seen it, then it’s new to you.”]

 

 

Alternative sometimes carries with it a negative connotation.

 

Synonyms include unconventional, unorthodox, nonconformist, radical, and the like.

Even though I am a part of the ever-growing FIRE (Financial Independence/Retire Early) community, which preaches a more traditional approach of investing (essentially the Boglehead 3 Funds Portfolio or a slight variation thereof), I sometimes find myself zigging when others zag.

“Two roads diverged in a wood, and I-

I took the one less traveled by,

And that has made all the difference.” 

-Robert Frost

It’s not that I am disagreeing with the more traditional lines of investing, because I truly believe it is a great way to create substantial wealth and allow one to have a successful drawdown period in retirement.

I am a staunch supporter of low cost index funds.

So much so that I used my influence as a trustee serving on the Pension Committee at my workplace to change our 401k offerings to now include low cost Vanguard index funds (Total Bond Index,  Real Estate Index, Total Stock Index,  Developing Markets Index, and Total International Stock Index).

It is these very funds that I have put considerable money into with both my taxable and tax-deferred accounts.

As an aside, everyone should look at their own employment retirement offerings and if they do not include low cost index funds as investment options, you need to petition the decision makers to make the appropriate changes immediately.

In fact they have a fiduciary responsibility to minimize excessive fees that can erode your retirement nest egg.

But I digress.

So why would someone, who is obviously a believer in index fund investing and a Boglehead reader/forum member, turn to the “dark side”?

For me it was a personal decision and how I wanted to access/preserve my nest egg.

I got drawn in by the power of real estate (investment in this class is considered “Alternative” as it diverges from the typical stock/bond/cash portfolio norm).

If you look at the very wealthy (in any country) and see how generational wealth is built, it is typically real estate holdings that form the backbone.

Tax laws in America have been designed to promote real estate as a wealth building tool.

Depreciation resulting in “paper losses” that offset real income tax liability, 1031 exchanges that allow continued deferral of potential capital gains tax, and step up in cost basis (to be fair this is also available in the more traditional asset classes) can allow the tax burden to be drastically minimized or even completely wiped out.

I really wanted to take advantage of this sector.

However after several bad experiences with two condominiums I rented (but no longer have because of the divorce decree) as well as some ongoing nuisances with my only remaining (guest house) rental property, I did not want a second job as a landlord.

Luckily there were still several options available to me which I have, and currently am, taking advantage of.

The easiest way for me, or anyone regardless of net worth, to get real estate exposure in their portfolio without becoming a landlord is purchasing shares in a publically traded REIT (Real Estate Investment Trust).

REITs can be sliced and diced in numerous ways and you can find a REIT to suit a particular real estate sector if you so choose (like retail, storage facilities, housing, health care based, etc.).

Personally I choose the Vanguard REIT as it has a broad exposure to a variety of real estate sectors.

As with any asset, there are advantages and disadvantages.

REITS:

• Advantages
  • Low buy in cost
    • Can buy as little as one share at market rate (in the 10s-100s of dollars range)
  • Very Liquid
    • Can be bought and sold almost instantaneously like a typical stock
  • Distributions can create yields far more attractive than Bonds in this low interest environment
    • By regulation, a REIT has to pay 90% of it’s taxable income to investors as distributions
• Disadvantages:
  • The majority of distribution is taxed as ordinary income (rather than more favorable capital gains typical with stocks)
  • Due to liquidity, REITs can be volatile and also have a higher correlation with stocks thus not adding as great a diversification as a true real estate holding
    • REITs are therefore sometimes referred to as just “real estate flavored stocks”

 

 

Personally in my Investment Policy Statement, I have relegated 20% of my “Market Trading” Portfolio component to the Alternative Class which is primarily composed of the Vanguard REIT (

[My “Market Trading” Portfolio is broken down as such: 75% stocks (55% domestic, 20% international, all Vanguard index funds); 20% Alternative, 5% Bonds (Vanguard Index Funds)]

 

My other Alternative Holdings are as follows:

1. Part owner in my multispecialty office building
   • This has been my home run investment to date, with my initial investment made in March 2007.
     • Last appraised value (April 2018) has shown 863% gain on initial shares bought.
     • In subsequent offering rounds I have always bought the maximum amount, giving a total blended investment gain of 547%
   • This creates a passive income stream currently at $17,850/yr from distributions
   • This asset represents 25% of my total net worth (which I exclude the value of my primary home)
2. Guest House
   • Currently long term lease in place bringing $9,000/yr in semi-passive income
   • Disadvantages:
     • Occasional nuisance issues that I have to deal with
3. Private Placement Investments
   • This is the current asset class I have been channeling all my investment dollars into (after hitting the maximum contribution limits to my retirement vehicles) since May 2017.
   •  I have invested solely into 37th Parallel Properties who is the syndicator for these deals [full disclosure 37th parallel is now a paid advertiser on this blog]
     • The properties they deal with are larger commercial multifamily apartments (typically 150+ units), Class B grading.
       • This asset class appeals to me above all other real estate sectors as it is considered an “evergreen” asset class
         • There will always be a demand for shelter as it is a basic need
         • Class B investments offer opportunity for value add improvements to accelerate equity appreciation
   • The distributions from my current holdings in this class is on pace to provide approximately $23,500/yr in passive income
   • This asset represents 23% of my total net worth (again excluding the value of my primary home)
   • Advantages
     • Can reap the tax benefits of direct real estate ownership without having to manage property yourself
       • Investors become part owners in a LLC (Limited Liability Corporation) for each individual holding
     • Can truly be a Passive Income stream (aka “Mailbox Money”)
     • Longer time horizon for holdings (>7 years typical, if not longer)
     • Periodic capture of “lazy equity”
       • When equity increases in a building to a certain level, a refinance can be performed and distributed back to investors tax free (can then redeploy this money exponentially expanding passive income stream)
   • Disadvantages
     • Have to be an accredited investor
       • Net worth > $1 million dollars (excluding primary home) or income > $200k/yr if single or $300k/yr if married for past 2 years  with expectation to continue at that level in future.
     • High up-front costs
       • Minimum required investments typically at $50k or higher
     • Less liquidity
     • Great importance choosing a trustworthy/reliable syndicator who has a proven track record

 

 

In addition, prior to discovering 37th Parallel Properties, I had invested in a crowdfunding platform (Realty Shares) in October 2016 with a contribution totaling 3.5% of my net worth at the time spread over 3 holdings (my particular investments were debt only, with 9.5% interest).

These holdings have since matured and both the capital and distributions promised were fully received.

• Advantages:
  • Lower buy in for each investment, could be as low as $2.5-5k
  • Less volatility/correlation than stocks providing diversification
• Disadvantages:
  • Investment periods were often short (mine were 1 year) requiring more effort to redeploy capital
  • Current SEC regulations place a $1 million cap on funds from non-accredited investors.
    • This limits the size of properties that can be offered at these sites

 

As you can see, the combined passive income from my Alternative Class holdings totals (minus REITS) is $50,350/yr

Passive income from Dividends (stocks/bonds/REITS) is as follows (based on Dec 2017 end of year statements):

• Taxable Brokerage Account: $9350/yr
• Tax Deferred Accounts: $12750/yr

 

Thus using a combination of traditional and alternative investing I can expect an ongoing passive income stream (expected to even grow further as I continue to add capital) of:

• Pre-retirement age: $59,700/yr
• Post-retirement age: $72,450/yr
  • Not including expected social security benefits (amount depends on how early I end up retiring, but estimating $27k/yr benefit
  • Not including a pension benefit expected at $14,500/yr
    • Accounting for the above two would bring the amount to $113,950/yr.

 

 

As an aside, my “traditional assets” comprise 46% of my net worth (excluding primary home value) yet only contribute 31% to the passive income stream.

With this amount of passive income providing a relatively safe floor, I feel I can weather market fluctuations and be more aggressive in my asset allocation at any stage of life.

Granted although a severe market downturn could lead to lowered dividends/distributions, and make this passive income stream dry up some,  I still expect a sufficient cash flow to more than cover my needs and make it unlikely for me to have to touch the capital (allowing it time to recover).