Appendix B: Different Investment Asset Classes

Static Stocks, Bonds, Mutual Funds

This refers to any stock, bond, mutual fund, or derivative that is held for more than one year. I call this the “hope and pray” leg of the financial table. The vast majority of investors only know this asset class. This asset class tends to do well in bull markets. Since 2000, however, the problem is that we have been in a bear market, and this secular trend will most likely continue for many years.

This is the asset class that most applies to the classic brokerisms, “Buy and hold,” “Dollar Cost Average,” and so forth. Since most people know this category well, we won’t spend much time on it. I will reiterate a few points from previous chapters for clarification.

As with all investments, you should be aware of the real investment fees. Over time, fees tend to be a factor that makes or breaks a financial tool’s long-term performance. If you hold equity positions within a wrap account (assets which are charged a fee based on account value), be aware of the hidden stuff, which further compounds the issue. If you are pulling income from stock and bond positions, as previously discussed in the leaks chapter, be aware of the long-term effects of sideways markets and how pulling income and fees intensify the losing years and detract from the winning ones.

With bonds, consider that we are at historic interest rate lows in 2012, and the only reason rates are where they are is due to the Federal Reserve’s quantitative easing programs. That is, they are legally printing money to buy Treasury bonds and thus forcing interest rates to artificial lows.

Contrary to popular belief, other countries are not buying all of our debt. According to the 2011 Federal Reserve Flow of Funds report, the Federal Reserve purchased 61 percent of the total net treasury issuance in 2011. This creates the false appearance of demand for U.S. debt which has the effect of reducing yields. With the 10-year Treasury’s yield pricing around 1.5 percent, the 30-year around 2.7 percent, at what point does this manipulation of the free market stop and yields reset themselves to a proper level? In my opinion, the day this happens will be a blood bath for the price of long-term bonds, munis, and other debt instruments.

One particular client with a large municipal bond portfolio asked why we would suggest that she sell now that all her bonds were doing so well and were priced at a high. I responded with the old market saying, “Buy low and sell high.” People are used to selling when their stocks and bonds are low and have sustained losses. The losses compel them to take action. They will hesitate to sell at the top for fear of leaving money on the table, but isn’t that the point?

If the Federal Reserve believes printing money is good for the economy, why do they arrest people for counterfeiting? You think they would give them an award! Just a thought . . .

As with any financial concept, it is important to apply common sense in a rational, systematic approach. If one believes interest rates could effectively go below zero, which they hit in December 2008, then they should stay in their bonds hoping for more gains on the principal.

However, a reason to stay in bonds in these environments is if you already hold short durations that will mature reasonably soon. You should be protected fairly well, unless of course the municipality, corporation, or other debt issuing entity goes bankrupt. Stockton and Mammoth Lakes in CA and Harrisburg in PA are examples of cities that have gone bankrupt. As discussed previously, the tax-free benefits of muni bonds can essentially be replicated with other investments that have tax advantages, such as depreciation or other income deductions, yet respond favorably in rising interest rate environments.

Variable Annuities and Life

Essentially, the same as static accounts except issued by insurance companies and accompanied by more bells and whistles, such as death benefits and income guarantees. The more bells and whistles, generally, the more fees associated with a contract. Variable annuities can be considered liquid for a price, generally a high surrender fee which does decrease over time, usually a period of six to seven years. You can get your money fairly quickly but the insurance company is going to take their pound of flesh.

With variable contracts, you will have your typical mutual funds called sub-accounts. Many variable contracts use standard funds, which are easily found in Morningstar or other financial research tools. But with many variable contracts, they will use hybrid funds, which are similar in name but impossible to find through a standard search on the internet. You will have to go to the prospectus for the particular variable contract to find what the holdings of the funds are, some performance history, and so forth.

I personally own a variable universal life contract, mainly for the insurance provisions and loan attributes, and not for the sub-accounts or mutual funds from which I can pick. In order to see how a particular fund has performed over a period in time, I literally have to plot out the sub-account unit values every few days. Forget just pulling up Yahoo! Finance and looking at the six-month chart. It is impossible without hand mapping the data points. Most people are not interested in doing this much work to follow their investments and the insurance companies know this and depend on consumer complacency to keep the contracts in force.

Most of these contracts are sold with numerous bells and whistles, all for a fee of course. I urge you to get out the magnifying glass and review the fine print in your insurance contract and any prospectus describing the sub-accounts and their investment choices.

As described in Chapter 5, Leaks in the Bucket, knowing all about the various bells and whistles of these variable contracts is important. Make sure, if purchasing one, to listen not only to your advisor, who has a vested interest in your buying it but also to call the insurance company issuing the product. Ask for customer service and inquire as to the various benefits in the contract. The service representative will not be earning a commission on your purchase and usually will tell the whole story, the good and bad. I’ve found that this is usually a good practice no matter what investment product you are purchasing. Call the customer service department and ask lots of questions.

Other than the guaranteed growth rider we discussed in the fees section of Chapter 5, another commonly added benefit is the guaranteed income rider. This rider may be added to your contract so that, at a point in time, you can annuitize the contract. That means you can start a payment system, which will be based on a value generally equal to your original contract value or more with some small guaranteed growth component.

Having seen the market get clipped almost in half in 2008 and the following market rally the next few years, many of the variable annuity contracts are nowhere close to their previous highs from 2007. Mainly due to investor emotional buy and sell decisions as the DALBAR study described in Chapter 5 demonstrated, but also, in my opinion, the relatively high internal fee structures of variable annuities eating the principal each year.

In some of these variable contracts though, the guaranteed income rider can work to the investor’s advantage. I’ve seen that it’s possible to initiate the payment system on someone’s contract that is upside down more than 30 to 50 percent. By beginning a payment system that is around 6 percent or so, they effectively start the process of getting back their entire original principal with some to boot. Not the best option, but at least the client knows they will eventually get their money back. If they stay in the variable annuity without initiating the guaranteed income rider they will realistically have no means of seeing their original value ever again, unless of course they die.

One client who walked in my door in 2010 is a good example. In March of 2008, she put $228,000 into a particular variable annuity contract. By April 2009, she had $130,000 left and had positioned her funds within the contract in the money market sub-account out of fear of additional loss. For her to get back to even, she would have to earn 5.78 percent for the next 10 years. Add on top of that a fee of roughly 4 percent she is paying each year to be in the contract while it is in deferral, and now she has to average almost 9.8 percent every year to get back to even. How is any growth on her original principal going to occur?

The particular variable contract she was in had the guaranteed income rider attached, but there was no provision for required holding time, a big mistake this insurer overlooked when underwriting the contract. This income rider stated she could pull out 107 percent, her original principal plus growth of 7 percent for the previous year over a 14-year period. Sounds complicated right? A big complaint of these benefit riders is you have to re-read them many times and practically be a member of MENSA before you can comprehend all the rules and requirements. Long story short, by her initiating the payment system immediately, she stands to get all her money back within 14 years. Now the pressure is on the insurer to perform at least by 6 percent over that time period, and not her.

The main thing to remember about variable contracts is that they are still tied to the markets and are basically static accounts. Yes, there are features of some contracts that make them very appealing to some people, and for others they make no sense at all. Everyone is different and has different needs. As previously mentioned, I have a variable universal life contract for retirement income purposes. One feature of life insurance that is very appealing is the ability to pull income out of a contract via a loan and not have any tax to report.

For instance, you contribute $100,000 into a life insurance contract, have growth over the years, and now your cash value is approximately $200,000, you have $100,000 of taxable growth if you ever surrender the contract. A feature of most life insurance contracts is the ability to borrow from the contract, usually at an effective cost of 0 percent. Let’s say your contract reasonably earns 5 percent each year. That means each year, on $200,000, you are earning $10,000.

$200,000 × 5 percent (assumed growth) = $10,000 per year

Most life contracts will allow you to borrow the $10,000 each year from the contract as income, or whatever, and since you took out basically what the contract is earning, the result at the end of the year is neutral. You still have $200,000.

The best part though is that the $10,000 you took out is completely tax-free, since you pulled it out via a loan. That is $833 per month of income you could receive tax-free for your lifetime. Even though there is taxable growth inside the contract, you will never pay it. Eventually, when you kick the bucket, the loan that has built up over time will be paid back via the tax-free death benefits. The other thing to know is that there are no IRS age requirements to begin taking the loans. According to my plan, I will begin taking tax-free loans for income starting at age 50.

This is but one of many ways of structuring income to be protected from income tax. There are dozens of books that spend a great deal of time discussing these insurance strategies. Do a Google search on “income benefits” or “loan benefits of life insurance” to find out more.

Lastly, please remember that the variable contract I own is but one of many different legs on my financial table that will help feed my future income needs. I am not depending solely on this one contract to be my future protection, as it is still tied to the markets and my ability to time them.

Adaptive Managed Stocks and Bonds

There are investment managers who take an active role in changing the portfolio throughout the year to adapt to changes in the economy and the world. The managers I tend to recommend essentially rebuild their portfolios from scratch every quarter or more often and do not have restrictions in terms of which type of equity classes they can use to build the overall portfolio. For instance, they can use bonds, stocks, or commodities. They have the ability to mix and match any of the three equity classes as they see fit. The main criteria for the advisors I hire is that they cannot use leverage, only cash. This eliminates hedge funds.

Please note, not all hedge funds are bad. Many have excellent track records, and some have access to financial vehicles that most people wouldn’t believe could exist, for instance, Leveraged Trading Programs. There is a realm of finance beyond what most of us can comprehend. A Leveraged Trading Program is the use of tremendous leverage on a relatively small amount of money. Say $10 million is deposited into a checking account; this then opens up trading programs with 10 times that leverage. These groups now have $100M to play with. They buy bonds from one group at say 94 cents per $1 and sell that same day to another group for 97 cents on the $1. They pocket 3 cents or $3M on the trade, a 30 percent return on their original $10M investment. Not bad. Now, do this trade 20 times in a year, and voila, big bucks. Let’s come back to reality for us mere mortals, who will never have access to these types of programs.

Successful investing in the stock market requires a significant commitment of time, energy, and attention. While most investors manage their investments part-time, portfolio management or third party management, as it is called, is a means of hiring a team who spend their entire careers researching the markets and managing portfolios.

Most people don’t fix their own cars or learn to perform heart surgery. They hire people who spend their lives perfecting these skills. The same can be said for money management.

As an investor, you must stay the course to be successful. While returns on stocks and bonds have been very rewarding over the better part of the last century, the majority of investors have not been successful at growing their wealth in the stock and bond markets because of their lack of patience and emotional decisions on when to buy and sell. According to DALBAR, 20-year average returns of 3.47 percent for the average equity investor support this.

Time and time again, I hear, “I bought at the top and sold at the bottom.” Emotion and not following a disciplined, systematic approach are the primary reasons most investors fail to match the general stock market indexes.

There have been three major bull markets in the past 80 years, and each one has ended in a bubble. In each case, stocks moved up too far too fast, aided by borrowed money and greed. When the technology bubble burst in the mid 1960s, a long sideways market followed. By late summer of 1982, TIME magazine featured an article concluding that the stock market was like a “Roller Coaster to Nowhere.” It stated that the Dow Jones Industrial Average was 1000 in early 1966, but only 760 in August of 1982.

With the real possibility that we have entered another extended bear market, lasting 15 to 25 years, which began in 2000, the need for adaptive managers who have demonstrated the ability to provide reasonable returns in sideways markets is crucial.

How do they do this, you ask?

Within portfolio management, fund selection is one of the most important features designed to enhance overall portfolio performance. Once the manager has identified and targeted specific areas of investment opportunity, a proprietary fund selection process takes over. Your specific universe of mutual funds or sub-accounts is analyzed by applying a series of in-depth processes that rate and rank funds and their managers within a particular peer group. As the ranking screens are applied, mediocre funds are eliminated in an attempt to identify only top-performing funds for placement in your portfolio.

Secondly, the manager will perform the daily research and analysis across the broad equity, fixed income, and global markets, with the intention of maintaining the most accurate financial forecast possible. From this analysis or forecast, the manager will make the investment selection (stocks versus bonds, large cap versus small cap, foreign versus domestic, etc.) and fund selection for your portfolio, as well as monitor and update these selections on an ongoing basis.

Unless one has several hours a day to study the economic universe and constantly select investments, qualified portfolio managers allow for one to place their hard earned money into proven hands and know their money is being carefully reallocated according to prevailing market conditions.

How many times did your investment advisor change your portfolio in the year 2008? How many times did he or she even call you in 2008?

As stated many times before in this text, no single manager is going to be right all the time. I use a number of managers in order to diversify even within this product category.

Consumer Grade Real Estate

In general, this includes real estate valued at $5M or less. This includes residential homes, and apartment buildings, as well as small commercial properties. The prices of these properties tend to fluctuate far more than large commercial properties due to the type of buyer. The typical buyer tends to be less sophisticated than a group purchasing say a $100M property. More emotion is involved, which may cause larger increases in good years but potentially more significant drops in bad years.

Look at the real estate market increases during 2003 to 2006. This was primarily a factor of easy credit, commission hungry representatives, and unsophisticated or wide-eyed buyers. A couple shows up to an open house, looks at the beautiful blue pearl granite countertops with the fancy ogee edge, and sees four other couples also drooling over the ogee edgework. Feeling the urgency to place a bid for the $500,000 home before someone else snatches it up, and knowing they are pre-qualified up to $750,000, they overbid the house by $100,000, taking the price up to $600,000, with the recommendation of their well seasoned, three-month veteran real estate agent.

Thankfully, their stated income, stated asset, negative amortization loan will come through and allow them to afford this great house.

Is the house worth $600,000? Probably not, but that is what they paid due to their emotional desire to buy the house, which enabled the sale. Had the couple used a more rational financial viewpoint, they would have seen the house down the block with the 1970s Formica countertops and old kitchen selling for $400,000 and realized that with a month of rework and around $20,000, they too could have the fancy blue pearl ogee edgework granite countertops, besides having an extra $80,000 to $180,000 saved on the purchase price of the home. This example is similar to the faulty purchase of a car via cash versus buying a rental property to pay for the car, as described earlier. The financially savvy choice is not always the easy, path-of-least-resistance choice.

As stated earlier in the book, one of my favorite categories for any net worth investor is single-family rentals in the value of $60,000 to $80,000 if such a purchase is suitable for their situation.

Since the real estate bubble peaked in 2006, many areas of the country have now fallen well more than 30 percent in value. In several areas of the country, houses which used to be $100,000 plus are now in the $60,000 to $80,000 range. As the values continue to fall, the gross rents as a percentage of the value of the home continue to rise. For instance, a house that rents for $8,000 per year and used to be worth $100,000 had a gross rent of 8 percent. That house, having fallen in value to $70,000, now has a gross rent of 11.4 percent assuming the rent stays the same.

$8,000 Rent ÷ $100,000 Previous Home Value = 8 percent Gross Rent

$8,000 Rent ÷ $70,000 Reduced Home Value = 11.4 percent Gross Rent

Historically, when gross rents approach 15 percent, you are getting very close to the bottom of a particular market’s cycle. This is not speaking for the country as a whole being at the bottom of its real estate cycle, just the particular area (zip code) where the gross rents are now approaching 15 percent. Why 15 percent? Maybe it is a psychological number where investors will start to buy. Can the rest of the country continue to fall? Absolutely! Places which still have large numbers of foreclosed properties waiting to hit the market as well as gross rents that are in the single digit percentages have a ways to fall in my opinion. California, Las Vegas, Arizona, and Florida come to mind that match this criteria today in 2012.

The opportunity lies in the fact that today loans are extremely difficult to get. You need solid income, high credit scores, and low debt to qualify for even the smallest loans. The biggest barrier to entry is the required down payment. Many of the potential buyers, families with local jobs and kids in the nearby schools, have some money saved, but not $20,000 to $30,000, so are forced to keep renting. They do not wish to be in apartments and would rather raise their kids in a single family residence. The unfortunate aspect is the rents in these homes are rather high, again, roughly 15 percent of the value. Not having the down payment forces them to pay rent, and this is the opportunity for investors with sufficient cash, whether in a self-directed IRA or after-tax dollars, to purchase these investment homes.

Pitfalls of Distantly Owned Real Estate

There are three big headaches that accompany distant owned rental real estate. The first being repairs, the second being a bad manager who usually exacerbates the first problem, and the last being rental vacancies.

Let’s deal with the first major problem, repairs. My goal with clients is to try and find almost turn-key properties. Properties which have had most if not all the significant issues rehabbed or replaced recently—the roof, hot water heaters, plumbing, electrical, air conditioner, furnace, flooring, and so forth. Do not have carpets in a rental. Make sure everything is a hard surface so when the eventual tenant leaves, you do not have to clean carpets each time. Just grab a mop and you’re done.

The second problem is a bigger issue: Finding the right property manager. You will want to do background checks, financial checks, and referral checks on the group you eventually hire to maintain and rent your property.

I saw a manager in Tennessee start charging $10 per month for grass mowing. Though there was a foot of snow on the ground, they were supposedly mowing the lawns. What really was happening was this particular manager was short his personal mortgage payment and felt it was acceptable to charge a couple hundred rental properties an extra $10 each to cover his personal financial deficiency. Needless to say, this property manager was fired.

When considering the vacancy issue in the area where you are looking to buy, ask for the records from the property management company showing the rental history for many different properties they manage. Ask to see the inquiry log for a particular house when it became vacant and how many people called on the property. You are looking for multiple prospective tenants wishing to rent the house. The more people putting in applications, the more likely you will be to find a viable tenant. If the logs show few calls for their vacant properties, then you should look for another area to buy in which has more demand for rentals.

There are hundreds of books discussing the topic of buying rental property and it is highly suggested to read a few before jumping into the rental business. With the expected headaches and nuisances can come very significant rewards and long-term stable cash flow.

I have found reasonable levels of success is using real estate investment groups that specialize in packaging these turn-key single family properties with management for the hands-off, distant owner. Again, prudence is imperative in doing your homework and making sure the real estate investment group is top notch.

There will always be good and bad times to buy rental properties. Warren Buffett was quoted in February 2012 as stating one of his favorite investments was single-family residences. His problem was he had no way of managing 200,000 homes, the amount he stated he would need to buy to make a dent for his fund Berkshire Hathaway. The good thing for most of us, we won’t have the problem of needing to buy 200,000 homes to make an economic benefit to our personal wealth. One, two, five, or more will suffice.

Buying Your Personal Residence

One small suggestion when buying a home: Consider building it instead of finding the turnkey property. A small secret of wealthy individuals who understand banks and equity is to have the bank fund their down payment. Instead of buying a home for $1M, ready to move in, the road less traveled is to buy the lot and build from scratch.

The turnkey buyer puts up at least $200,000 as a down payment and finances $800,000. The builder potentially buys an old, beaten down shack on a good lot for $500,000 and needs to put down only $100,000. Then with $20,000 in architecture plans, the builder presents the plans and lot to the bank that wrote the first loan and gets an appraisal for the completed house for $1M. Just like the turnkey house down the block.

The house costs $300,000 to build, bringing the total loans to $700,000, one hundred thousand dollars less than the turnkey buyer will have to repay with interest. The bottom line, for $120,000 out of pocket, eighty thousand dollars less than the turnkey buyer, the builder has the same home, worth $1M, and $180,000 of sweat equity courtesy of the bank. Maybe that is why so many real estate builders have the nicest houses on your block.

Rare American Coins and Bullion

Two very significant dates have affected this category; March 1934 and August 1971. The first was when Franklin D. Roosevelt made it illegal to own gold, and which established the cutoff date for rare gold coins. The second of course is the day the world entered by fiat into a currency-credit system. The latter is what has led to the financial debacle we are experiencing today, in 2012.

Whether you believe the dollar is going to come crashing down or that the status quo of the global debt explosion can continue on indefinitely, having real wealth, gold, or other precious bullion could be a smart way to protect purchasing power.

If the client feels so inclined, their well-diversified portfolio might contain at least 10 percent to 15 percent of gold or other precious metals. Why gold/silver? Because it has been a foundation of money since the beginning of civilization. Don’t just rely on my opinion, check out any religious text or history book and count the number of times gold and/or silver is mentioned. Who believes this? China for one. By mid 2012, China will have more than doubled its gold reserves and is continuing to mine more and more by the day, as well as purchase mines around the world. They realize the massive foreign reserves they hold will need to be offset by something tangible; otherwise, they will be left holding the bag when inflation further destroys their holdings.

There are four easy ways to buy bullion.

The easiest route to own precious metals is to use an exchange traded fund (ETF) such as SIVR, SGOL, or others. When you purchase one share of SGOL for example, you are effectively buying 1/10 oz. of gold. Likewise, when you purchase one share of SIVR you are basically buying one oz. of silver. With these ETFs you never have the right to call them up and ask for the underlying precious metal. You do have the ease of these ETFs trading on a public exchange and the correlating ability to buy and sell quickly.

The most popular metal ETFs are GLD and SLV but I’m personally a fan of the Swiss versions mentioned above. It’s nice to know the Swiss government audits the holdings of these two ETFs. Check out their respective prospectus for more details.

Keep one thing in mind. When you own these ETFs, you do not get the same capital gains rate for taxes as with traditional stocks. All bullion capital gain rates are 28 percent under current tax law.

The second way to own gold or silver bullion is to use a bank such as www.Everbank.com or www.PerthMint.com to actually buy the gold at a price close to the spot price of gold, plus a small commission, and they can store the gold in either a pooled account or in a holding account.

A pooled account is a less expensive way to own gold or silver. Your purchased metal is pooled with other investors, saving you from paying storage or maintenance fees. In a holding account, you directly own gold or silver bars and coins with this storage option, which incurs a custodial fee.

For those who wish to know with certainty that they could get their gold or silver, you can use an allocated custodian such as Bullionvault.com or Goldmoney.com. They store the precious metals for you in allocated accounts, which are individually audited and guaranteed to be in possession. Their vaults are in places such as London, Hong Kong, and Switzerland. With these types of bullion ownership you could request they send you your precious metals. Of course if all hell is breaking loose, good luck getting the delivery.

The last way to buy gold, silver, or other metals is through physical possession. Whether you are buying American Gold Eagles and Buffalos, Canadian Maple Leafs, or Krugerrands, this gives you something to put in your safe at home. If the value of the dollar goes to zilch, you’ll be able to go down to Wal-Mart and buy some milk and cookies. Today, you don’t need to bite into coins to make sure they’re real; just make sure you purchase from reputable dealers. One thing to keep in mind: commissions can be huge on coins. Make sure you ask exactly what they are charging. Around 2 to 4 percent above the spot price is the norm, but I’ve seen groups charging in excess of 10 percent.

In terms of which ownership route is best, that depends on the clients’ personal feelings. A happy medium between a few of the ownerships is good but for most people, owning the ETFs is sufficient.

To understand a bit about 1934, U.S. citizens were exchanging their gold certificates for actual gold due to concerns about the economy. President Franklin D. Roosevelt, in his first week in office, signed executive orders 6073 and 6102, and the Senate passed the Emergency Banking Act, effectively making it illegal for U.S. citizens to own gold and changing the price overnight to $35 from approximately $20. Please note that these laws are still on the books, and it’s interesting to observe that, on the back of American Gold Eagles, it still says a value of $50.

Rare Coins

Rare coins that have collectors’ value were exempt from the great confiscation and tend to have a higher multiple in protecting against inflation. The key with coins and collecting is the rarity of the coin. Every day, on late night TV or in the papers, you can see ads for buying coins that are $99 or whatever price. Don’t waste your time. These coins are not rare. They are sold in bulk and will probably never have any value other than the metal content. In general, rare coins above $5,000 will have much higher multiples at auctions than smaller coins. The key here is to play off the emotion of the auction when you plan on selling them. People tend to pay a lot more for coins that are unique and have a story, or documented provenance.

Keep in mind, again, that your coin dealer is a critical player in this situation. A dealer must have the knowledge and experience to know when is a good time to sell. It is easy to buy coins; the trick is knowing the timing of when to sell.

Advantages of Rare Coins as an Investment

The following summarizes some of the main advantages of rare coin investments:

Guidelines for Rare Coin Investors

The following are basic guidelines for prospective investors in rare coins:

• Have clear objectives in mind when buying rare coins as an investment. Decide what types of rare coins you should acquire, the total amount you wish to invest in rare coins, and the circumstances under which you will consider selling your coins.
• Keep in mind that the market for rare coins can be particularly volatile. Further, the difference or spread between dealer buy and sell prices is normally much higher than the commissions charged by brokers for equity investments. Consequently, for an investor to sell rare coins at a gain, rare coin prices must appreciate at a higher rate than may be the case for other investments.
• Only buy rare coins graded and authenticated by the leading independent grading services, whose standards are accepted industry-wide.
• Buy coins as a long-term investment only. Do not expect short-term profits from rare coin investments. Expect to hold the coins for two to five years or longer.
• Only buy rare coins that are popular with collectors and are actively traded.
• Never buy very expensive rare coins by mail-order. When representing coins, the coin dealer’s credentials are vital. How long have they been in numismatics? To which associations do they belong, and can you confirm? Do they have experience selling coins at auction, and most importantly, do they have references?

Many collectors have come across a particular coin from time to time and wondered whether they had something of great value in their possession. This feature describes the main factors influencing a coin’s value and provides some guidance in obtaining an estimate of such value. Remember, however, that the mere fact that a coin does not have significant monetary value does not mean that it is not interesting or that it should not form part of your collection.

Factors Influencing Value

The value of a particular coin is influenced or determined primarily by the following four factors:

Determining a Coin’s Approximate Value

Accurately and properly identify the coin. Is there a summary page describing the history? How much did the value go up and down during the past cycles, for instance during either the 1979 or 1987 run-ups? Any properly graded coin will come with this information.

Online, you can go to Professional Coin Grading Service at www.PCGS.com. You can find many coins and see scale values at different grades.

A firm I’ve used and have found to be exceptional is Farmington Rare Valley Coin & Investment Co., in New Hartford, Connecticut. They follow our philosophy of “Education first,” a mantra to which any coin dealer you work with should adhere.

Other means to confirm general prices is to look up the coin in a coin catalog to find listed retail selling prices or estimated retail values for your coin. For U.S. coins, use A Guide Book of United States Coins by R.S. Yeoman, commonly called The Red Book by collectors and dealers. It provides retail prices for U.S. coins. For world coins, the most widely used guide is a series of volumes called The Standard Catalog of World Coins by Krause and Mishler.

For more current prices, based on what dealers are actually selling a particular coin for, you should check coin newspapers and magazines or online auction sites such as Coin World, Coin Prices, or Teletrade. These sites provide price guides for many U.S. coins and some world coins.

Lastly, you should buy coins that have been sealed and bar-coded. An example show in Figure B.1 is from the Numismatic Guaranty Corporation (NGC).

Figure B.1 1912 $20 Saint-Gaudens PF-67

Oil/Gas Investments

State of domicile suitability and accredited investor rules apply—not suitable for all investors.

Oil and Natural Gas investments are any type of investment that focuses on the production of petroleum products. These investments can be offshore based, but for most, they are from domestic sources. I feel that sticking within our borders or Canada will help reduce political risk. Political risk includes the threat to an investment’s ownership from someone nationalizing the resource, such as Hugo Chavez did within Venezuela.

Oil and natural gas investments come in three varieties, including everything from exploratory to developmental to royalty programs.

Exploratory—New wells in uncharted areas. In general, these were the majority of the programs in the 1980s, which everyone remembers as losing most investors’ money. These programs generally have very low success rates, yet when they hit, they have the potential for a large return.

Developmental—New or reconditioned wells in existing fields around existing producing wells. Think oil/gas fields with lots of wells already producing, and these programs are putting more straws in the dirt.

Royalty—Buying land with mineral rights and letting the developmental or exploratory drillers do all the hard work. For their hard work, they generally get 75 percent of the production. Royalty owners sit back and do nothing but collect up to 25 percent of the production coming from their lands. This is generally the most conservative form of energy investment when discussing direct participation programs.

Following is a list of many common questions we have seen over the years with oil/gas direct ownership investments:

Is Investing in Oil and Gas Profitable?

Yes, it can be very profitable, and it can also be a complete loss of your principal. However, I tend to think about which are the largest companies in the world. Chances are a good number of these are oil companies. This could mean that they are making big profits.

There are several areas where you can make oil and gas investments, and all of them have profit potential. You will need to determine which areas to get into by analyzing their risks versus their rewards.

The potential rate of return is also a consideration. A rate of return between 25 percent and 40 percent is considered great. Of course, many exploratory oil/gas programs return 0 percent, not counting a tax benefit. Who cares about a tax benefit when you just lost all your money? All programs have pros and cons and need to be analyzed.

What is your investing goal with oil and gas? This will play a part in determining how profitable it can be because it will affect your choices. You may also want to determine what your desired rate of return is.

One option for investing that may help with your profits is to focus on investing with what are called Independent Operating Companies. One of the benefits of this is that they can help reduce risk by investing in oil companies that are located in several different geographic areas. The companies tend to share the cost of development, which also can reduce risk.

Investing in the oil and gas industry can be very profitable but it’s not for everyone. Some invest for the potential tax benefits, and some invest because they enjoy speculating. In order to make it as successful as possible, you need to understand your investing options, as well as learn how to analyze the potential risks and benefits.

Top Four Reasons to Invest in Oil and Gas Ventures

There are several reasons why you may want to invest in oil and gas.

Investing in hard assets, such as oil and gas, in my opinion, is important to avoid some of the volatility of the traditional markets and investments today. Another important quality is the relationship of the dollar to commodities like oil and gas. Since the U.S. Dollar is the world exchange currency, the further the dollar falls, the more dollars it takes to purchase a barrel of oil. Therefore, commodities tend to be a great inflation hedge. Unless of course, the Chinese Yuan becomes the world exchange currency, then we better all learn to speak Mandarin.

Tax benefits are usually one of the most talked about qualities of these types of investments. Below is a basic example of some of the benefits you may realize from investing in an oil and gas program based on current tax laws. Remember to work with your financial advisor and tax professional regarding your potential benefits and risks prior to investing.

According to Worth Magazines April 2010, drilling is one of the best tax-advantaged investments. Oil and gas investments are generally 100 percent tax deductible. You can usually write off 65 percent to 90 percent in the first year of certain investments.

Risks

• Interests in these types of programs are speculative and involve a high degree of risk; investors should be able to bear the complete loss of their investment.
• There may be restrictions in transferring the Interests, and some Interests are not liquid investments.
• The performance of the investment could be volatile as a result of commodity pricing, the depletion nature of oil and gas investments, and operation of the oil and gas wells.
• There are a number of significant tax risks and tax issues involved with the purchase of energy programs; investors should consult their own tax advisors and legal counsel.
• The direct or indirect purchase of oil wells and/or royalties involves significant risks, including market risk and commodity pricing and risks specific to a given oil field.
• Cash distributed to you may constitute a return of your own capital and may be paid from proceeds of the offering.
• Energy programs involve the risk that the mineral production will not provide enough revenue to return the amount of your investment.
• The revenues are directly related to the ability to market gas and oil and to its price, which is volatile and cannot be predicted. If oil and/or gas prices decrease, then your investment return will decrease.
• There is a potential for lack of liquidity or a market for the units.

How is a standard oil & gas transaction structured?

Summary: For Every 100 BBLS of Oil

What is the difference between working & royalty interests?

Working Interests

• Responsible for all expenses
• Takes active role in development
• Less expensive to acquire than royalty interests due to market availability
• Working interests programs have the potential to generate payout in three to five years or longer. Remember this could be a return of capital.

Royalty Interests

• No expenses/No liabilities
• No role in development
• Generally more expensive to acquire than working interests due to limited market availability

I’ve heard U.S. domestic production is heavily funded by direct Investments.

How long before I receive income from my investment?

This depends on a number of factors, but the type of investment: Royalty Interest or Drilling Program has a bearing on the investment timeframe. The Royalty programs typically will have a three to six-month window. Payments will generally start small and progressively build to the final amount, which depends and fluctuates based on current oil/gas prices. The reason for the buildup is that once the lands (Mineral Rights) are bought, the oil/gas that comes from the ground from that point in time is payable to the new owners. The oil/gas that is currently in the system (pipes, trucks, so forth) is the property of the previous owner.

With a drilling program, the timelines can vary depending on the ability of the sponsor to drill the wells, establish potential production, get the oil/gas sold and transported, collect the revenues, and disperse the payments to both the royalty (land) owners and drilling investors. Typically, once a well is drilled, there is a 90-day (or more) lag to receipt of the revenues for that well. Then the payment can be made to the investors. Some drilling programs are designed to generate payments very quickly, in two to four months; others are much longer terms of one to three years. Make sure you understand the anticipated timeline for potential payments before investing in any oil/gas partnership.

How long are these investments?

Although some energy-direct investments have seven- to 10-year terms, it’s not unusual for these investments to be open-ended. A well produces oil or gas on a diminishing basis over time, but its duration or rate of depletion can only be estimated. When the well stops producing, the income stream of the investment ends too. So there is no single event that results in a final cash distribution or capital gain.

In my opinion, going into an oil/gas program with 20 or more wells or more helps mitigate the possibility of one or two or more dry or poorly-producing wells significantly affecting a program’s distribution potential.

What does “a barrel of oil” mean anyway?

According to the Energy Information Administration of the U.S. Government, “One barrel (42 gallons) of crude oil, when refined, produces approximately 19.6 gallons of finished motor gasoline, as well as other petroleum products” (See Figure B.2).

Figure B.2 Products from a Barrel of Oil

What are the products and uses of petroleum?

There are many ways that petroleum (oil) is used. Oil is refined into useable petroleum products, most of which are used to produce energy. Other products made from petroleum include: ink, crayons, bubble gum, dishwashing liquids, deodorant, eyeglasses, records, tires, ammonia, and heart valves. From a barrel of oil, 47 percent is refined into gasoline for use in automobiles; 23 percent is refined into heating oil and diesel fuel; 18 percent is refined into other products, which includes petrochemical feedstock such as polypropylene; 4 percent is refined into propane; 10 percent is refined into jet fuel; and 3 percent is refined into asphalt. Percentages equal more than 100 percent because there is approximately a 5 percent processing gain in refining.

Won’t electric cars reduce the need for gas?

A client of mine drove up in his new 100 percent electric car. He steps out and asks my opinion of his electric car.

My response, “What electric car? I see a natural gas and coal burning car, with tires made from six barrels of oil each along with plastics, fibers, paint and dyes all made from petroleum products. I see parts made of metal, mined using diesel-powered equipment. For sure, though, the welders were indeed electric.”

Where does the electricity come from to recharge the batteries in his “fully” electric car? Do a little research and see how lithium is produced—a major component of today’s battery technology. Almost all the electricity used to recharge his car comes from burning fossil fuels!

The point being, everything we use today, from cosmetics to dyes to plastics to rubber, comes from petroleum products. I believe it is impossible for us to get away from the use of oil and gas in our modern lives.

Tax Benefits of Oil/Gas Programs—2012 tax year

The Basic Tax Considerations Involved in an Oil & Gas Investment

• Intangible drilling Costs (IDC) are any costs associated with the drilling prospect that cannot be re-sold. These costs may be deducted against active, passive, or portfolio income in the year incurred. Consult with your tax advisor.
• Tangible drilling costs include all items associated with the drilling of the prospect that can be re-sold, such as tanks, wellhead equipment, and so on. These costs may be depreciated over seven years, currently 20 percent the first year and the balance over the next six years.
• Depletion allowance allows you to receive the first 15 percent to 24 percent of your revenue income tax-free. This means you are paying income taxes on only 76 percent to 85 percent of your potential well income.

Example of Tax Benefits (Hypothetical Illustration of $100,000 investment)

What are the current oil and gas tax incentives from Congress?

The United States is still heavily dependent on foreign oil and gas reserves. In order to help minimize this, the U.S. Congress has historically been devoted to encouraging the use of domestic reserves. To help do this, they create tax laws which offer tax incentives and benefits to people who are investing in oil and gas. These benefits are listed in the official tax codes put out by Congress, which are listed here.

What are the current tax deductions for intangible drilling costs?

Intangible drilling costs include such expenses as the cost of labor, grease, chemicals, and so on. These costs are usually 65 to 85 percent of total drilling costs. All of these drilling-related expenses are completely deductible in the first year. The first year is considered to be the year that the investment was first started (Section 263 of Tax Code).

What are the current tax deductions for tangible drilling costs?

The tangible costs for drilling consist of the remaining percentage of the total drilling costs and are deducted over a five year time span.

Active Versus Passive Income

The Tax Reform Act of 1986 introduced into the Tax Code the concepts of passive income and active income. The Act prohibits the offsetting of losses from Passive activities against income from Active businesses. The Tax Code specifically states that a working interest in an oil and gas well is not a passive activity; therefore, deductions can be offset against income from active stock trades, business income, salaries, and so on (Section 469(c)(3) of the Tax Code).

Self-Employment Tax Exemption Information

This section has to do with the self-employment tax exemption and the concept of converting a general partner to a limited partner.

The net income or net loss of the investments is considered “earnings from self employment.” It is likely that there will be a loss taken the year that the initial well is drilled. This loss can be used to offset any employment income that was generated.

Once a general partner becomes a limited partner, self-employment tax does not apply (IRC Section 1402, Rev. Rul. 84-52, 1984-1 C.B. 157).

Tax Exemption for Small Producers

This section relates to the 1990 Tax Act, which allows certain tax advantages (called the Percentage Depletion Allowance) for individuals and smaller companies. This tax benefit exists to encourage their participation in oil and gas.

Who is not eligible:

• Large oil companies
• Petroleum marketers
• Large refiners (more than 50,000 barrels a day)

Alternative Minimum Tax

Prior to the 1992 Tax Act, working interest participants in oil and gas ventures were subject to the normal Alternative Minimum Tax, to the extent that this tax exceeded their regular tax. This Tax Act specifically exempted intangible drilling costs as a tax preference item.

Alternative Minimum Taxable Income generally consists of adjusted gross income, minus allowable Alternative Minimum Tax itemized deductions, plus the sum of tax preference items and adjustments. Tax preference items are preferences existing in the Code to greatly reduce or eliminate regular income taxation. Included within this group are deductions for excess intangible drilling and development costs and the deduction for depletion allowable for a taxable year over the adjusted basis in the drilling acreage and the wells thereon.

Equipment Leases

In general, State investor suitability rules apply for this type of investment and they are not suitable for all investors.

Leasing offers businesses an alternative to purchasing hard assets vital to the operation of their business, especially items that are extremely expensive or those that become obsolete within a relatively short period of time. An Equipment Leasing Trust gives the investor an opportunity to invest in the operational equipment that a company may need to operate. This type of program creates income from the lease payments, which is potentially paid out to the investor as dividends. Remember that dividends are not fixed and can be increased or decreased as the advisor to the lease trust deems necessary for operations.

Leasing gives a company greater flexibility by freeing up capital because lease payments are less than purchase payments. A company leasing its operational equipment also has the tax advantages that come with lease payments. Unlike bank loans taken out to purchase equipment, lease obligations don’t appear as debt on a company’s financial statements. This can be helpful, as major debt can make a company less attractive to investors. Additionally, because lease payments are typically less than purchase payments, this frees up capital to be dedicated elsewhere.

Equipment Leasing programs offer an alternative that is not as prone to the volatility of the stock market. This is generally due to the equipment values themselves not fluctuating with the broader equities market. For example, the aircraft that FedEx leases to fly packages around the world didn’t necessarily decrease in value during the most recent recession. FedEx still needed to pay their lease obligations or risk losing the aircraft. Equipment leasing programs are typically an illiquid investment that requires a longer time commitment, but that commitment may potentially provide a platform for greater stability.

What Is the Leasing Business?

The terms of a leasing deal are spelled out in a contract signed by the equipment provider, called the lessor, and the equipment user, called the lessee. The contract generally provides that the leased item will be returned in good condition. Then the lessor either sells it or re-leases it to a different lessee. Some contracts, though, give the lessee an option to purchase the equipment, usually when the lease ends, or to renew the lease at a residual value and at a favorable rate.

Companies lease equipment instead of buying it for several reasons. Capital intensive industries—airlines, utilities, railroads, transit authorities, factories, shipping, and healthcare facilities—may find that purchase prices are prohibitive, even though they need the equipment. Or they may own some of the equipment they need and lease the rest to conserve cash.

Leasing also gives a company greater flexibility in meeting its capital commitments in times when it’s difficult to forecast business volume.

What are the benefits of this type of investment?

One of the appeals of a direct leasing program is that you and other participants potentially collect a stream of rental income from the leased equipment. In most cases, you may also realize additional income from re-leasing or selling the equipment at the end of the lease term. These residual values may vary from estimations, so I don’t usually include any upside in my financial plans. If it happens, then I just consider it gravy.

In addition, you can take advantage of accelerated depreciation and the tax benefit it provides. Usually, you can write off your share of the cost of the equipment at a relatively fast rate, offsetting income you receive in the early years of the program, thus potentially reducing your tax bill. That situation changes, however, as the leases mature and the equipment is sold. While you may continue to collect income, an increasingly larger percentage of that income is taxed at your regular rate. You must plan for this tapering effect.

A diversified leasing program can be an attractive investment because it is long-term, and because it’s not traded, it can help insulate your portfolio from market volatility. Further, because hard assets underlie the return, investment risk is generally reduced. In instances where a lessee can’t pay, the equipment can be reclaimed and leased again or sold.

Equipment leasing can also serve as a hedge against both inflation and recession. In inflationary periods, the hard assets may sell at a higher price and exceed expected yields. During recessions, companies typically defer new equipment purchases in favor of holding onto leased equipment, so lease renewals may increase. In addition, when interest rates are low as they are now, equipment leasing programs may be an attractive substitute for fixed-income securities, though they are likely to be significantly more difficult to liquidate than bonds or other interest-bearing investments.

What Happens in the Beginning of a Leasing Trust?

As the leasing company begins operations, it pools investments from hundreds or thousands of participants and uses the money to buy the equipment it will lease. Be aware that any dividends or distributions will come from infused capital until the trust begins buying and leasing out equipment.

When you invest, you generally don’t know in advance exactly what equipment the company will be offering. But most equipment leasing DPPs invest in a wide range of equipment types to achieve the greatest possible diversification and help reduce the risk of concentrating in a limited number of sectors or industries.

I’ve Never Heard of These Investments. Are They New?

Among the earliest equipment leases were those for Phoenician merchant ships, the first example of the now-common practice of leased transportation equipment. Today, the list includes not only ships but airplanes, trucks, container ships, trailers, train and subway cars, and buses. Many of the pieces of equipment in your office building could very well be leased. The computers and large copiers you use daily all could be leased from an equipment leasing trust.

My personal experience with a large copier I purchased used for my business taught me the value of leasing equipment. I paid more than $6,000 for a copier which was previously sold brand new for $12,000. After only 18 months my copier was broken and unrepairable. I thought I was getting a good deal when in fact I was paying $6,000 for a giant doorstop. My bad luck, but again it taught me an important lesson on equipment leasing.

It is better for my firm to lease a $12,000 copier for $500 per month, ($6,000 per year), than to buy it out right. Why would anyone pay 50 percent per year? Simple, after the firm deducts the expense for the payment, in reality I’m only paying $250 per month and I free up the use of the other capital I didn’t spend. The best part, the equipment is warranted and serviced by the owner for my benefit.

It is not a bad deal for the owner either. They receive over two years 100 percent of their purchase price of the equipment and their goal is to sell it at the end of the second year for about 30 percent of what they paid. In this case around $4,000, which is their profit on the copier. If they are able to do this, they would have made approximately 15 percent per year return on their initial investment.

Institutional Grade Real Estate

In general, State investor suitability rules apply for this type of investment and they are not suitable for all investors.

This is generally real estate valued at $10 million or more, including either single or portfolio properties, Tenant-in-Common, Delaware Statutory Trusts (DST), or non-traded REITs. The key to the REITs in this category is that they are not traded on the stock market. The REITs that trade on the stock market are classified as static mutual funds. Though they are real estate, since they trade on the markets, they tend to follow the markets in general and lose much of their non-correlation status.

A Real Estate Investment Trust (REIT) is a tax designation for a corporation investing in real estate that reduces or eliminates corporate income taxes. In return, REITs are required to distribute 90 percent of their income to the investor, of which a portion may be taxable. These earnings are distributed to the REIT shareholders as dividends. The REIT structure was designed to provide a vehicle for investment in real estate much as mutual funds provide for investment in stocks. REITs can invest in real estate, mortgages (loans), or both (hybrid). A REIT pools money from investors to purchase real estate investments. A REIT has a management team that is responsible for overseeing the day-to-day operations and investment process.

The overall goal of a REIT is to manage and build a portfolio of income producing buildings in order to generate income and potential appreciation when the assets are divested at some point in the future. REITs allow smaller investors to own small pieces of large, institutional grade income properties. They also allow for geographic and building-type diversification.

There are three different types of REITs: publicly traded, public non-exchange traded, and private.

Publicly traded REITs file with the SEC and trade on one of the national stock exchanges. Private REITs are not available on any exchanges and are not registered with the SEC. I primarily work with public non-exchange traded REITs that are registered with the SEC but not traded on a national exchange.

Public non-traded REITs typically require a longer time commitment, but are generally not correlated to the stock market like their publicly traded counterparts. They may provide the investor an opportunity to invest in a type of REIT that is not subject to the volatility of the stock market. As a result, they may potentially be more stable than a publicly traded REIT. Because the public non-traded REIT does not sell on a national exchange, it may be a more illiquid investment. It is important to note that Public non-traded REITs qualify for IRA funds and offer a diversifying alternative to traditional stocks and mutual fund portfolios. Bear in mind, however, that global economic meltdowns and panics that impact the US Economy as a whole, will potentially effect the valuations of the assets held within these REIT’s.

Here are the common questions asked about REITs:

What’s the Difference Between Traded or Non-Traded?

Most REITs are publicly traded. Their shareholders range from individuals to large institutions, such as pension funds, insurance companies, and mutual funds. And there’s an active secondary market, where REIT shares trade at a discount or premium to—that is, for less than or more than—their net asset value (NAV), or worth on paper.

Non-traded REITs are available to investors who meet certain suitability standards. Here too, the list may include both institutions and individuals. But there is no formal secondary market for these REITs, and shares trade infrequently, though most programs have a mechanism for selling shares to other buyers. These REITs tend to be non-correlated with traditional investments, which means that they don’t tend to be affected by the forces that affect other securities, such as changing interest rates or corporate earnings reports. The valuation of the underlying assets don’t generally change every second of the trading day.

When REITs are publicly traded, however, they are subject to the pressure of meeting short-term Wall-Street analyst expectations, just as other listed investments are. If these REITs seem to be providing stronger returns than other securities, they may attract added attention and their share price might rise. But if their returns are weaker than those of other securities, they face the risk that investors will sell—even if it means taking a loss—or put pressure on management to make changes.

Because the price fluctuations affecting publicly traded REITs tend to be driven by changing economic conditions and investor emotional sentiments rather than changing real estate values, these REITs tend to rise and fall with other equities in the marketplace, rather than providing a hedge against volatility.

Do REITs Pay Income?

REIT income flows to its investors in the form of monthly or quarterly distributions based on rent or mortgage payments from the REIT’s investments. Equity REIT distributions often increase as rent payments increase, which can provide a hedge against inflation, though the distributions can drop in a market downturn or if the properties lose value. Bear in mind that as these programs start up, dividends or distributions may be a return of capital until such a time as all the funds raised have been deployed into assets which may potentially add to the overall net operating income of the REIT and thus may flow to the investor.

If you’re interested in potential income investments to supplement your annual earnings, REITs may be able to provide a relatively stable cash flow. Similarly, you can use REIT income to fund college expenses or charitable remainder trusts. And, of course, you can use REIT income to make additional investments.

What Are the Tax Benefits?

REITs don’t have to pay corporate income tax. Instead, they are subject to an IRS rule that requires these corporations to pay out 90 percent of their taxable income as distributions. As a result, REITs can provide higher returns than other corporations because once stabilized, they may have more cash available for distribution. That, in part, is what makes them attractive investments.

A special benefit of investing in REITs is that you can claim depreciation of real estate assets against your dividend income. As a result, you may not have to pay tax on the income until no depreciation value is left, at some date in the future, when your income tax rate may be lower. Or you may be able to defer payment until the REIT holdings are sold. Then the income is taxed at the lower long-term capital gains rates.

Another advantage of REITs is that they don’t generate unrelated business taxable income (UBTI), an important consideration for investors who own these investments in a tax-deferred or tax-exempt account, such as an IRA or 401K, or in a charitable remainder trust. (UBTI results when an otherwise tax-exempt organization realizes any income from a taxable subsidiary or if substantial leverage (debt) is used to generate potential distributions and profit.)

Because a REIT does not pay corporate taxes, taxable REIT dividends don’t usually qualify for the low rate that applies to most equity dividends, currently a maximum of 15 percent. Rather, when tax is due, it’s at your current rate for regular income, up to 35 percent at the federal level. Long-term capital gains distributions, on the other hand, are taxed at the lower rate.

How Diversified Are REITs?

The majority of REITs own property and often specialize in a particular type of real estate, such as apartment buildings, hotels, shopping centers, self-storage units, office buildings, hospitals and other healthcare facilities, data centers, timber, student housing, or low-income housing developments. Some equity REITs are geographically focused while others are national or global.

You can diversify your REIT investments by buying REITs concentrating in different geographic regions, different areas of real estate, or different industries or market sectors.

What Kind of Due Diligence Should I Be Doing?

Before you invest in a REIT, you and your advisor should review the quality and depth of the management team and the company’s business plan. You’ll want to consider the managers’ experience in overseeing the types of properties the REIT owns, as well as their experience in the industry, market sector, and geographic region where the REIT does business.

Because so much of a REIT’s cash goes to pay dividends, the business generally needs access to outside sources of capital. Therefore, in evaluating a REIT’s business plan, you’ll want to consider the provisions it has made for growth, specifically how it plans to raise new money.

The options are:

• The sale of additional shares
• Mortgage debt secured by its real estate assets
• Corporate debt dependent on the company’s overall creditworthiness

The REIT’s overall debt level is another factor to consider. As the debt level increases, so does the business risk, and hence, the risk to your investment.

Debt service reduces the amount of net operating income, or funds from operations. The higher the level of debt, the more drag is placed on any income available for distributions. You should check to see if a REIT’s debt is at the portfolio level or at the individual asset level. Portfolio-level debt can be riskier than asset-specific debt because when debt is linked to a particular asset, the lender doesn’t have any recourse beyond that asset if the tenant defaults.

How Do the Surrender Charges Work Within a Non-Traded REIT?

Most (but NOT all) non-traded REITs follow the following surrender charge schedule from Date of investment (DOI):

Non-traded REITs, at the discretion of their board of advisors, may suspend redemptions in any year, or even permanently, based on how well their properties are performing or whether or not they are able to deploy capital as quickly as it can be raised. Generally, this does not happen in normal times but only in periods of economic uncertainty, when investors are panicking and trying to sell everything. I have seen the suspension of redemptions in 2009–2011 for several of the non-traded REITs. In most cases, the REIT’s Private Placement Memorandum (PPM) discloses quarterly or annual redemption limits. These limitations allow the REIT management to plan on maintaining access to at least 95% of the trust’s funds each year. When investors pulled out 5 percent of the total value of the REIT in any given year, they will shut off the redemptions until the upcoming January or longer, a cooling off period, so to speak. The board of advisors for a non-traded REIT will not allow panicking investors to force them to take actions in unfavorable times.

A risk to these investments, as any non-exchange listed investment, is the inability to sell your shares if you need to in the above situation. In the REITs which suspended their distributions, though the rent was still being paid to investors, they did not have a means to sell their shares for a return of principal. These REITs are waiting for better economic times before they list the shares to provide liquidity. Just as one would not want to sell a house at the bottom of a real estate cycle if one was not forced to, the non-traded REITs which have suspended redemptions are following the same logic. Protect the principal, collect rents and pay out or suspend distributions, and wait for a better day to eventually sell.

Looking at the surrender charges another way. Even an investor who had an unforeseen event in their life needing money and did not have sufficient liquid reserves to meet the immediate need, if they redeem their shares in a non-traded REIT—which redemptions are still possible—depending on how long they have been in the REIT, they still may potentially come out ahead of a typical CD or bond.

Let’s work on a hypothetical example. An investor puts $10,000 into a non-traded REIT and needs to pull out the money between year two and year three. This particular REIT had been distributing 7 percent in dividends.

The investor has earned a combined 14 percent over the last two years and now must surrender with a 5 percent penalty.

The net return is 9 percent, or roughly 4.5 percent per year.

Keep in mind, the investor is potentially giving up something much greater by selling the non-traded REIT before the sponsor has determined it to be the right time to sell. The appreciation of the buildings, growing inside the REIT, is forfeited by an investor selling early. This can be substantial if the investor has been in the REIT for more than four years and sees it as an easy exit since the surrender penalty is now 0 percent. The real penalty for leaving early may be internal appreciation which will be realized as soon as the sponsor sells the portfolio.

Co-Ownership Real Estate (CORE)

The Co-Ownership Real Estate (CORE) structure is an increasingly popular choice among real estate investors. Whether you are seeking a replacement property to satisfy a 1031 Tax Deferred Exchange or looking for a suitable “turn-key” passive real estate investment alternative, the CORE structure provides a host of options that should be researched.

CORE investment properties employ a professional asset and onsite property manager, guided by an owner agreement, which sets forth the management of the overall investment as well as the decisions that would require a vote by the property owners.

The CORE structure provides an opportunity for smaller investors to potentially own institutional-grade, class-A real estate, with national credit tenants and professional property management. These types of properties have typically been available only to the larger institutional grade investors like Real Estate Investment Trusts (REITS) and Pension Funds and Life Insurance Companies. CORE Investments generally offer the same rights and benefits of individual ownership but without the headaches of day-to-day property management.

A CORE Investment strategy combined with a 1031 Tax Deferred Exchange can potentially provide an opportunity for an individual owner to exit one property and step up into multiple properties, thereby diversifying their real estate portfolio by location and property type.

Example CORE Property Types

• Triple Net (NNN) Lease Properties
• Multi-Family Apartment Communities
• Self Storage Facilities
• Internet Data Centers
• National Single Credit Tenants and Franchises
• Multi- and Single-tenant Office Buildings and Corporate Centers
• Industrial Complexes, Warehouses, and Manufacturing Facilities
• Retail Shopping Centers and Malls
• Medical Office Buildings
• Hotel and Hospitality Properties
• Restaurant and Food Service Facilities

CORE investment properties are assembled by real estate investment companies referred to as Sponsors. I employ an extensive due diligence process to evaluate each Sponsor according to its track record, management team and expertise, financial strength, property selection, industry access to properties, and essential business relationships (i.e., financing).

Reasons for CORE Ownership

• May be suitable for those who realize the importance of real estate as an investment tool but who are dedicated to a career that may not allow them to dedicate the time required to building a successful real estate portfolio. This type of investment allows a part-time real estate investor to purchase and build a portfolio of properties. Through the repeated use of the 1031 exchange process, the portfolio can potentially grow tax deferred while providing passive income and tax advantages.
• Eliminates the headaches associated with day-to-day property management. May be a viable solution for those rental property owners looking for relief from active property management and the burdens that come with being a landlord.
• For estate planning purposes, the heirs of a CORE investment get a stepped-up basis in the inherited property, thereby wiping out the built-up tax liability resulting from one or many prior 1031 Exchanges.
• In some cases, properties that are available for co-ownership are institutional grade, class-A properties that typically would not be available to the smaller investor. By pooling funds and aligning with a Sponsor, the smaller investor has access to properties, management resources, and financing that would not normally be available to them.
• You may be searching to purchase a new investment property outright or looking to trade-up via a 1031 Exchange. A CORE property will allow you to expand your consideration pool and offer more opportunities to find property that has a favorable return on investment. Additionally, you may currently own a property with a significant amount of equity but with an income stream that is maxed out. CORE properties may offer a better cash-on-cash return than your current options. Depending on the properties you select, you may have the potential for greater cash flow and/or appreciation, combined with renewed tax benefits.

CORE Risks

A CORE investment is a real estate investment and shares similar risks inherent to the overall asset class of real estate investing. These risks include loss of tenants and rents, possible need for additional capital for unforeseen expenditures, and lack of liquidity or formal secondary market to sell you ownership stake.

As always, work with an experienced adviser well versed in CORE properties as well as 1031 exchanges. Ask lots of questions and get other opinions.

1031 Exchanges

In my opinion, the 1031 tax-deferred exchange is one of the most powerful wealth-building tools currently available to U.S. taxpayers. It is the IRS-approved method that allows you to sell an investment property and defer capital gains and depreciation recapture taxes, providing you reinvest 100 percent of your equity into “like kind” property of equal or greater value within a specifically defined timeframe.

Any property held for investment purposes or for productive use in a trade or business generally qualifies as “like kind” property for 1031 exchange purposes. A 1031 exchange is also referred to as a tax-free exchange, tax-deferred exchange, tax exchange, or Starker exchange, named for T.J. Starker, an Oregon timber man and Oregon Agricultural College forestry professor who taught my grandfather and who first used this exchange mechanism and won its approval in the courts, including delayed exchanges, in the late 1970s.

To read more about this powerful deferral of taxes on real estate, please see Appendix D.

Collateralized Notes

In general, State investor suitability rules apply for this type of investment and they are not suitable for all investors.

There are three basic types of collateralized note programs: mortgage notes, business development corporations (BDCs), and life settlement notes.

Mortgage Notes

The types of First Trust Deed Investments I generally work with are geared toward building a portfolio of many loans, as opposed to investing in individual notes. They are structured as a fund with pooled money from investors. The portfolio provides a collateralized note investment vehicle, which is diversified in an effort to balance risk and provide consistent returns. The types of mortgages that are in the fund are acquired through a defined process, using conservative acquisition criteria. They are generally hand-picked, first positions only, that can be purchased at a potential discount to loan value, have low Loan-to-Value (LTV) ratios, include borrowers with excellent track records, and a seasoned successful payment history.

These funds seek to provide investors with a consistent monthly income and attempts to achieve this by investing in a managed portfolio comprised of mortgage notes secured by real estate. These investments are typically not available directly to individual investors. The funds invest in fully collateralized first deeds of trust for residential, commercial, and land mortgages, thereby providing the investors with collateralized hard assets.

It is essential that the fund acquire good notes with good collateral. A good note has a track record of making payments on time. The borrower has been making the payments on a reliable basis; it must be a seasoned note by its successful payment history. This is important because a note is purchased for the payments, not for the collateral. The function of collateral is to secure the principal investment. The function of getting payments each and every month is to receive the interest.

A reliable payment stream helps bring the return on the investment; the collateral helps guard the principal of the investment.

Good collateral does not refer so much to the specific secured property as it does to the degree of certainty that the property can be readily converted to cash to prepay the debt.

The fund’s acquisition and operation criteria are generally as follows:

• Select a note with a good payment history to secure the stream of payments
• Select a note with a healthy collateral margin to secure the principal investment in the note
• Buy the note at a discount to secure an attractive yield on the note
• Monitor the note collections, to assure realizing all the benefits that were negotiated when the note was purchased
• Share the benefits with the investors

These, in a nutshell, are debt instruments collateralized by real estate. They can be first, second, or greater positions.

Business Development Corporation (BDC)

Investor portfolios often include investments in the stocks and bonds of public companies. But did you know that, like institutional and high net worth investors, individuals can invest in privately owned companies as well?

There are 5,000 publicly traded companies in the United States, but more than 300,000 privately owned companies. Using a BDC greatly expands the potential investment landscape. The privately held companies are in recognizable industries, ranging from major retailers and food stores to health service, utilities, and beyond.

Private companies contribute significantly to the American economy. In fact, the 200 largest private companies alone employ more than 4 million people and have combined revenues in excess of $1 Trillion. Cargill, Chrysler, Toys “R” Us, Enterprise Rent-A-Car, Fidelity Investments, Publix Super Markets, and Hilton Hotels are just some of the recognizable private companies that do not trade their debt and equity on the public stock exchanges.

Investors can invest in either traded or non-traded BDCs. Unlike exchange-traded BDCs, non-traded BDCs are illiquid investments and are not directly tied to fluctuations in the stock market.

What is a BDC?

A BDC is a category of investment company created by Congress in 1980 under the Investment Company Act of 1940 to facilitate the flow of capital to private companies. The investor essentially “owns” small pieces of each loan made to the private companies by the BDC. Basically a BDC allows an investor to act like a bank and loan money to a private company. These companies use the proceeds for any number of reasons such as growing the business, buying manufacturing plants, managing cash flow, and so forth.

A BDC provides investors with exposure to the private equity and private debt investment markets, which typically have been dominated by institutional investors, such as pension funds and endowments. These institutional investors have been able to meet the high minimum requirements imposed by private equity firms and private debt investment funds, and have had specialized investment expertise at hand to evaluate these types of investments. I believe that institutional investors participate in these funds for a number of reasons, including their use as a potential source of risk diversification within a portfolio and for their inflation-hedged return potential over the long term (Figure B.3).

Figure B.3 BDC versus Private Equity Capital Flow

Until recently, if you didn’t have a billion in your pocket, you were excluded from these sought-after investments. With the economy in turmoil over the last several years, the traditional sources of capital for private companies have become much tighter. This paved the way for other groups to gain access into these types of deals, and allow smaller investors the ability to participate.

How do they work?

A non-traded business development company (BDC) allows individuals to invest in privately owned companies, similar to using stocks and bonds to invest in public companies (Figure B.4). Investors are able to pool their capital to invest in the private debt of companies. These companies seek to make earnings or pay interest back to the BDC. The BDCs objective is to pass the earnings or interest to the investors primarily and to a lesser extent capital appreciation.

Figure B.4 BDC Flow of Funds

Private debt positions the investor as a lender to the company. It provides a contractual return and repayment back to the investor with priority over the equity investors in the company.

BDC Investment Focus

The primary area of focus is first lien senior secured loans, second lien secured loans, and to a lesser extent, subordinated loans, of private U.S. companies. These investments are part of a typical company’s capital structure whereby senior secured loans represent the senior-most obligations of a company and have the first claim on its assets and cash flows. As such, first lien senior secured loans carry the least risk among all investments in a firm. This is in contrast to preferred stockholders and bond holders, who generally get paid last, or in the case of GM bondholders, paid at all.

First lien senior secured loans are followed in priority by second lien secured loans, subordinated debt, preferred equity, and finally, common equity.

Senior secured loans carry the least risk among all investments within a company’s capital structure.

Due to this priority of cash flows and claims on assets, an investment’s risk increases as it moves further down the capital structure. Investors are usually compensated for the risk associated with this sliding scale of cash flows, or junior status, in the form of higher returns, either through higher interest payments or potentially higher capital appreciation. As depicted in the chart in Figure B.5, you should look for BDCs which focus on components of the capital structure with higher priority of cash flows, and therefore potentially less risk.

Figure B.5 Typical Capital Structure of a Company

Many of the BDCs during times of economic distress will weight their portfolios heavily toward senior secured debt, where investments are secured by collateral and recovery rates (i.e., the amount of principal a lender recovers after a default) are strongest among all types of corporate securities in the event of default. However, when the economic outlook is strong and corporate profits are expected to grow, many BDCs may broaden their focus to include more junior forms of debt, such as subordinated loans, which offer less downside protection but generally offer more attractive total returns. Subordinated loans offer returns both through high interest rates and potential equity appreciation in the borrower (they often award lenders equity interests at little or no cost).

Understanding First and Second Lien Senior Secured Loans

The goal of most BDCs is to maintain significant exposure to first lien senior secured debt and second lien secured debt, which represent the senior-most obligations in the capital structures that they occupy. These loans generally pay variable rates (a natural hedge against rising interest rates and inflation), are secured by the company’s assets, and are generally entitled to receive payment in full before all other security-holders of a company, including public bondholders. Senior secured loans are marked by strict investor protections in the form of loan covenants and enjoy the highest recovery rates (i.e., the percentage of principal recovered in a company defaults) among all classes of debt securities. Institutional investors have traditionally accessed senior secured loans both through approximately $1+ trillion secondary market and through active origination channels.

Understanding Subordinated Loans

In addition to first lien senior secured and second lien secured loans, BDCs may invest a portion of their assets in subordinated loans if the views on the economy or other factors suggest it is in the interest of the BDC stockholders to do so. Subordinated loans usually rank junior in priority of payment to first lien senior secured and second lien secured loans and are often unsecured, but are situated above equity and common stock in the capital structure. In return for their junior status, compared to first lien senior secured and second lien secured loans, subordinated loans generally offer higher returns through both higher interest rates and possibly equity ownership in the form of warrants, enabling the lender to participate in the potential capital appreciation of the borrower. Due to these attributes, subordinated loans tend to outperform senior secured loans and other forms of corporate debt in a growing economy.

The warrants typically require only a nominal cost to exercise and are used as a loan sweetener for the BDC.

An example of the potential protection of secured loans is the bankruptcy of General Motors in June of 2009. Shares of GM common stock, which peaked in 2000 at $90 per share, became worthless. Holders of GM unsecured bonds did not fare much better than the stock holders, ultimately losing almost 90 percent of their investment. The only bright spot in GM’s capital structure, the secured loans, which had a first priority security interest in its assembly lines, robotic welders, paint systems, other equipment, fixtures, documents, general intangibles, all books and records, and their proceeds, were ruled in the bankruptcy court proceedings to be paid in full, nearly $6 billion in all. The nice part of being the highest in the pecking order of a company backed by real assets is that most of the time you will be paid back in full. At least you will be paid first before anyone else gets a penny.

Is a Non-Traded BDC Similar to a Non-Traded Real Estate Investment Trust (REIT)?

A BDC is a pooled investment vehicle that invests in equity or debt of private companies, whereas a REIT invests in real estate. Nonetheless, a REIT and a BDC share many characteristics. From a regulatory standpoint, they both must file periodic SEC reports such as Forms 10-K and 10-Q, and comply with the Sarbanes-Oxley Act of 2002. Non-traded varieties are also both subject to state and FINRA regulations.

From a tax perspective, most BDCs and REITs are structured to provide tax-advantaged, pass-through treatment of ordinary income and long-term capital gains directly to stockholders. No corporate tax is paid if at least 90 percent of taxable income is distributed in a timely manner and applicable tax rules are complied with. In addition, a BDC is a highly accountable and transparent form of investment. It is required to place assets with a qualified independent custodian—employees and managers do not handle company funds.

Finally, both BDCs and REITs are governed by an Independent Board of Directors to ensure the proper alignment of interests. Here is a list of these and other characteristics shared by both non-listed structures in Table B.1.

Table B.1 Common Characteristics Shared by BDCs and REITs

As you can see, the only significant difference between REITs and BDCs is foundation for the investment, that being private debt/equity or real estate. Since the BDCs are passing interest earned from loans, they generally do not have any tax advantages whereas the REITs are able to pass through property depreciation and other real estate tax advantages.

There is one important difference, however. Unlike REITs, BDCs are restricted in the amount of leverage they can employ to 50 percent of the BDC’s asset value. REITs, which are not governed by the Investment Company Act of 1940 as BDCs are, may employ substantially more leverage than BDCs.

Life Settlement Notes

According to the American Council of Life Insurers, individual consumers in the United States owned $10.3 trillion in life insurance policy benefits in 2009. In that same year, consumers lapsed and surrendered 7.52 percent ($752 billion) in life insurance policy benefits back to the insurance companies.

Think about that. How many premium payments did these consumers make keeping their life policies in force, only to wind up with nothing at the end? The number is staggering.

Years back, investment groups realized there was a significant opportunity in these policies that the original buyers no longer wanted. If they bought the life policy from a consumer who was going to get rid of it anyways, the investment group could continue to pay the policy, keeping it in force, and eventually, when the insured (consumer) dies, the investment group collects the death benefits as the named beneficiary on the policy.

They always say the only two things in life guaranteed are death and taxes. I’m not so sure about taxes but the other, I’m pretty darn sure. That is the logic behind these investments. They are called life settlements.

Life Policy Analysis

When an investment group is analyzing whether or not they want to buy a particular insurance policy, they are mainly concerned with two pieces of information. How much the policy costs each year and how long do they expect the insured to keep getting out of bed?

A simple example goes as follows. Suppose you have an 80-year-old man who owns a $1M life insurance policy which he no longer wants to keep, thus alleviating him from the monthly premiums due. The investment group will perform a medical examination and profile on the man to determine what his life expectancy is. Say in this example eight years. Looking at the costs to maintain the policy, in this example, $40,000 per year, the investment group makes an offer to the man of $200,000 to purchase his life insurance.

The investment group will buy the policy becoming the new owner, change the beneficiary to become themselves, and continue to pay the premiums, keeping the policy in force. The man is still the insured, that is, the policy will pay out the death benefit to the investment group on his death.

The amount the investment group is willing to pay is based on their expected return with the assumed life expectancy, in this case eight years (Table B.2).

Table B.2 Life Insurance Policy Expected Return Analysis

As you can see, death can be profitable. A bit of a morbid investment, but consider the 80-year-old man’s alternative choice. He could lapse his insurance policy and get nothing. In this case he is walking away with $200,000.

Two Common Versions of Life Settlements

Looking at the above example you will start to recognize potential problems with the investment group’s analysis for their return potential.

The main one is life expectancy. That is the wild card in the analysis. If the person lives too long, longer than the original expected time frame, the investment group has to continue paying the premiums until the insured eventually kicks the bucket. The longer they have to pay beyond their expected time frame, the lower their return will be. In the above example, if the man lives for 16 years, the investment groups return is now only 1.79 percent per year. Hardly worth the headache factor and effort.

On the flip side, if the man gets hit by a steam roller in year three, the results are far different. Their return is now 58.48 percent per year in the above hypothetical example. Makes you think they would want to go and hire cousin Vinnie to take care of business. Thankfully there are rules and structures these life settlements have to follow. Blind trusts and other entity structures hopefully prevent the nefarious situation of an investment group speeding along their investment returns.

There are various versions of these being pitched to the general public. The most common ones investors will hear about on the radio or TV are either the single policy purchase or fractional policy purchase.

The single policy purchase investment is the previous example. One insured and one policy. These carry the most risk as the statistical life expectancy variance for any one individual is boundless.

However, the actuarial results improve the more life policies you have in your investment pool, the more statistically accurate your payouts and return will potentially be.

Generally it works out that if an investment pool has more than 250 policies; their results will be +/– 2 percent of their projections.

Obviously the fewer policies in the pool the greater the risk and more random the results.

Fractional policy investments are simply spreading your investment over more insurance policies. Suppose you have $100,000 and are presented the ability to purchase a portion of 10 life policies. You would put $10,000 into each one and now participate in 10 different people’s lives. The statistical odds are still not any better, but at least you have 10 chances of the steam roller coming around versus just one.

I am not a fan of either of these investments for a few simple reasons.

First, the odds are great either your single policy or fractional policy life settlement will go much longer due to the limited number of policies the investment return is based on. The odds are good the insured(s) will live longer than expected.

Second, other than an occasional account statement reporting your ownership in one or more policies, you get nothing else. Until a policy pays out, you will receive no regular cash flow or distributions. It could be a month, it could be seven years. Not receiving anything for an undetermined amount of time is not the typical investment I try to place into our Wealth Code plans. Remember, I love the idea of checks in the mail.

Lastly, most of the life settlement groups will plan for five years of premium payments with either the single policy you purchase or the multiple policies you purchase. This means they have enough money to pay the premiums for five years and if none of your policies pay out, then they will send you a bill for your prorated portion of the premium payment due to keep the policies in force. How’s that for insult to injury. You buy and investment, see no returns, and five years later get a bill requesting more money. Instead of positive cash flow, we are dealing with a potential negative cash flow situation indefinitely until a policy pays out.

You can see the single policy purchase issue here being the high odds that the insured lives much longer than expected and you the investor keep getting a bill. This again reduces your expected return on investment year after year.

An Alternative—Life Settlement Notes

You might gather from the above descriptions of the single or multiple policy direct ownership, there are a lot of unknowns so why bother.

Yet, every TV and radio ad touting these investments discusses returns around 16 percent. It is true, that is the investment return most life settlement groups are targeting.

You will hear in the ads that Warren Buffett is a big buyer of life settlements. This is true. The difference with Warren Buffett and Berkshire Hathaway is they most likely have a lot more money than you do, and they don’t buy one or two policies, they buy hundreds at a time. By doing so, the statistical odds are in their favor.

An improved version of life settlement investments came out around 2010, and they are called Life Settlement Notes.

You were ascertaining from the name that they are notes of life settlements. That is, something collateralized by something real, in this case, the hundreds of life insurance policies.

Basically, what a few life settlement investment groups realized was that they could monetize their previously purchased life policies. Knowing they have hundreds and hundreds of policies and knowing their odds are very high, greater than 98 percent, that the payouts will happen consistently, they created a series of CD-like term notes with definitive time spans and cash flow potential.

For instance, if a group’s target return for an entire life settlement pool is 16 percent, they could offer a six month term note with a payout of approximately five percent per annum. Effectively they will pay out 2.5 percent in the six month window. Compared to current treasury prices and bank CDs this is a great return.

The six-month life note investor knows the exact term and how much they will be paid out, taking care of the second concern of cash flow and the unknown duration of your typical single or multiple policy direct ownership.

By the note being collateralized by hundreds of policies, an investor truly is participating like Warren Buffett. A particular settlement pool might be worth billions of dollars of life insurance face value, much more than the average Joe will have to invest. Therefore we are getting the proper diversification necessary to make these attractive investments.

Why would a group be willing to shave off five percent of their expected return? Simple, the money you invest in the six-month term note will allow them to buy additional longer-dated life policies in their investment pool and keep their program going. A problem with a life settlement pool is eventually all the insured will pass away and their 16 percent return comes to a halt. By adding longer-dated life expectancies into their pool, the investment group will keep collecting the difference between what they pay out to the life settlement note investors and the ultimate return of the larger life settlement pool.

In the above example, even though they pay out five percent per annum, assuming they are hitting their return target of 16 percent, the investment group is still making close to 11 percent per year.

16 percent Life settlement pool return – 5 percent investor note payout = 11 percent retained earnings.

As the saying goes, “It is better to make 50 percent on something rather than 100 percent on nothing.”

Things to Look for in a Life Settlement Note

The biggest risk to a life settlement note is the constant distributions to the investors whether they have policies paying out or not. The major way these investment groups will cover themselves in this situation is to have an established line of credit with a large bank to handle the withdrawals and interest payments.

As a general rule, I make sure our clients who meet the suitability requirements, only invest in life settlement notes with shorter maturation terms than the renewal date for the established line of credit. When the notes come due, reassess the line of credit. If the investment group has already elongated the term for the line of credit, then you can more confidently renew your life settlement note. Again, keep the life-note term shorter than the renewal period for the line of credit.

No matter how much we believe people will eventually kick the bucket, revolutionary changes in medical treatment, which are occurring every day, is serving to elongate our expected lives. We are living longer due to better healthcare.

This was always one of my greatest concerns with my background in biochemistry. We keep getting better and better at solving diseases and people by nature are living longer. Take AIDS for instance. Back in the 1980s it was a death sentence. Today it is manageable and individuals such as Magic Johnson have been living with the virus for more than 20 years and counting.

A sad reality though, even if the cure for cancer takes place, according to life insurance industry research, that miraculous event will only extend life expectancy rates by just more than two years.

Don’t get me wrong, if I had cancer, I would appreciate every second more I get to spend with the grandkids, but the overall impact on population life expectancy is not that great. Not enough to throw the life settlement notes into a tizzy.

To recap the biggest two things to look for with life-settlement note investments:

Strategy with Life Notes

Many of us are familiar with a bond or CD ladder. That is, buying varying dated maturities with different yields.

For instance you might put $100,000 into a bond ladder with $25,000 in four different maturation dates. Maybe three, four, five, and six years. Let’s presume the bonds don’t get called by their issuer, and the issuer remains solvent. As the bonds mature, you get back your principal and can invest it in potentially higher paying bonds if interest rates have risen by that point. Of course if rates have fallen further, you are stuck getting a lower yield than previously enjoyed.

Life settlement notes can be used the same way, sticking to the first rule for any investment slice, that being total invested cannot be more than 10 percent of investable net worth. And of course using a smaller allocation of five percent or less is potentially even more prudent.

For instance with an investable net worth of $1M and the size for your individual legs on your financial table being no more than five percent, than the most you can put into the life settlement note program is $50,000. You can apply the idea of creating a ladder with the investment by splitting the $50,000 into five different term notes of $10,000 apiece to achieve a blended return (Table B.3).

Table B.3 Hypothetical Example Life Settlement Note Yield Ladder

Always keeping money liquid in stages is the goal.

In this example, an investor will have $10,000 coming due every six months with larger amounts all coming due at the same time on the yearly anniversaries.

Certificates of Deposit

These are bank instruments that are FDIC insured. Most people know what a CD is. It’s a time deposit with a bank. A newer component of this category, which has come out in recent years, is called a structured CD. These are CDs with stock market indexes for determining the potential growth or interest earned in the CD.

For instance, I will use a five-year structured CD that is tied to the S&P 500. If you put $100,000 into this CD, it would be protected by FDIC, in case the issuing bank goes kaput. If the S&P 500 goes up during those five years, you would get the gains of the market as a percent of the growth, as determined by a formula established by the bank for that particular CD. If the S&P 500 tanks during the five years, you would be handed back your original $100,000 and not have any interest credited to the CD’s final value. Sounds too good to be true, right? Yes, there are drawbacks to these accounts, which have to do with the underlying securities protecting them, namely bonds. These investment vehicles are very similar to Index Fixed Annuities, and those are thoroughly described in Chapter 9.

The biggest issue with structured CDs is if interest rates move up quickly, the formula that determines how much interest you will earn in the CD as a factor of the growth of the S&P 500 is generally only a portion of the full market upside. You will not earn close to what the market makes in a rising interest rate environment.

Needless to say, these are very complicated investments that are sold as simple concepts. Nothing is simple when it involves complicated formulas tied to bonds or options that are tied to the markets. Also, be aware that structured CD’s may also be designed around the performance of a certain basket of stocks. Not the full S&P 500 mind you, but a small number of stocks—like Google, Microsoft, IBM, Yahoo, Apple, and Intel for example. The CD would earn interest based on a formula which only uses the small basket of stocks for upside/downside calculations.

Another version of structured CDs are bank notes. These allow an investor to play an individual stock, commodity, market index (such as S&P 500, INDU, Nasdaq, . . .), or other equity investment with a formula wrapper around the performance. Typically an investor will get a set amount of potential upside return over a time span as short as a couple of years. They will also get a floor, so they will not ultimately lose value if the underlying equity stays above that floor.

These protection levels are created by using equity options, such as puts and calls. The issuer is essentially using puts and calls to manage their returns on your money, and paying you the difference based on a formula they have devised.

For instance, an investor buys a structured note on gold. The issuer develops a formula that, over the course of the two-year term, this investor can participate up to 30 percent absolute return on the upside with a floor above negative 20 percent. That is, as long as gold does not lose more than 20 percent of its value on the day the structured note was purchased, the investor will not lose. Incidentally, some of the more interesting notes will actually give the negative 20 percent as a positive return on top of their principal.

If gold in this example falls below 20 percent of the value on the day the note is purchased, you the investor are no longer protected and when the invested structured note matures, whatever the price of gold is on that day is your positive or negative return.

When purchasing these investments, again, do your homework and ask lots of questions.

Underlying these products are sophisticated call and put options being placed on individual equities, commodities, or market indexes and are designed to simplify the ability of the average Joe to participate without them needing to understand complex stock option theory and application.

These products are potentially appropriate additional legs on the table for investors looking for stock market participation with some downside protection. You are giving up some of the upside in doing so but may be a fair tradeoff. The terms for the bank notes, the upside and downside protections, change frequently depending on the overall stock market volatility and other economic conditions. Take your time, educate yourself and see if they serve a purpose for your Wealth Code table.

Cash

“Cash is King,” the old saying goes. It gives the holder the power to buy and sell almost everything with total freedom. The main problem with cash is the issue of inflation. When you are liquid and you are protected, the tradeoff of course is you don’t earn anything or barely anything on your money. If you stuffed your mattress full of cash 20 years ago and took that money out today, how much purchasing power would you have you lost? If you had stashed away $1,000 in a tin can in 1913, you could only buy around 56 equivalent dollars’ worth of goods and services today according to The Privateer. That is, you would have lost more than 94 percent of your purchasing power on your $1,000.

The one point we want to make in this section is very basic. Cash does not necessarily have to be denominated in U.S. dollars. If inflation does become a significant problem, commodities will tend to move up in value from a falling U.S. dollar, and the currencies of oil-exporting countries such as New Zealand, Australia, and Canada might offer reasonable protection. The Switzerland Franc has generally been a safe haven but sadly, with the global competition to devalue all currencies, even the Swiss started printing money in early 2011 to keep their currency from appreciating too much. That being said, their currency may still be a good place to park excess cash.

Most of the citizens of Germany in the Weimar Republic lost everything because they didn’t realize the significance of exchanging their Deutsch Marks for any other currency during the hyperinflationary years of 1921 to 1923. The same thing goes for Rubles in Russia during 1998, Mexican pesos in 2002, and so on.

Realizing you do not have to keep cash sitting in any one particular countries currency is an important step in potentially protecting your purchasing power.