Based on Arixa Capital’s Sept. 14, 2016 webinar: an interview with Don Plotsky, private investor and featured guest speaker.
Don Plotsky has 32 years of experience in the bond markets, starting as a portfolio manager on mortgage-backed and other structured securities. During his career at Western Asset Management, he worked closely with investors to help them define both their investment objectives and solutions — for mostly large institutional investors. Now retired, he’s faced with the challenge of turning accumulated wealth into income, and dedicates his personal and professional time to this end.
The interview was led by Jan Brzeski, managing director and chief investment officer of Arixa Capital. He has participated in more than 500 real estate transactions, ranging in value from $100,000 to more than $20 million per transaction, including virtually every aspect of sourcing, structuring, financing, and acquiring investment properties.
One of California’s leading private real estate investment and lending fund managers since 2006, Arixa Capital provides investors with attractive current income and total returns while focusing on capital preservation and above-market returns, year after year. Arixa strives to maintain a healthy margin of safety on every investment it makes. Arixa’s private lending business secured by real estate, or first trust deed investing, comprises a full-service loan servicing platform to ensure a steady flow of investments. Arixa provides outstanding customer service to its borrowers: primarily, private real estate developers of single-family home projects in the western United States.
What kind of return — net of inflation — could an above-average investor expect in a well-performing bond fund over the next 5–10 year period?
Investors always have to start with: where is the 10-year treasury? Today it is at 1.7%. Assuming he or she diversifies across corporates, mortgages, some high yield, and maybe some other fixed income opportunities, investors can achieve a portfolio that yields 3 or 3.5%. We are at what CNBC has called “generational lows” in interest rates. Interest rates will be likely to rise over the next 5–10 year period, resulting in some negative performance.
So for a top-performing bond fund over the next 5–10 years, investors should expect no more than 2–4% total return per annum. We know the Federal Reserve is aiming for at least 2% — their stated objective is 2–2.5%. Therefore, an investor will be pretty close to zero net real return on bond investments over that period of time.
What investment advice would you give a wealthy individual who isn’t a seasoned, experienced real estate investor?
The most important thing that the markets have taken away from investors is income. Traditionally, when one looks back at the long-term numbers from both equities and bonds, income has been the primary driver of return. Over the long term, dividends have averaged about 5%. Bond yields have been between 5–6%, which accounted for at least 50% of total returns in the market, if not 2/3 of the total returns. Today investors are looking at 2% dividends on stocks, less than 2% yields in treasuries, and slightly more than 2% in a diversified portfolio.
What I advise investors is what I have done personally: look for real assets with high income and tax advantages. Real assets provide investors with some degree of inflation protection. Which is critical, given that the central bank is aiming for higher levels of inflation than what we have seen. High income should be the primary source of liquidity in an investment portfolio.
When investors make long-term investment decisions, the ability to withdraw money at any given time should never be a primary factor: it should not top the list of concerns. Tax considerations, however, are critical. Most investors do not thoroughly think through the tax consequences of their investments. There are two factors to consider: 1) what asset to invest in — asset allocation, and 2) where to put those assets — asset location. By combining those two, investors can increase their tax efficiency and therefore increase their net income without dramatically increasing their risk.
How did you determine and prioritize your personal objectives when you retired recently?
The top priority is capital preservation. My primary engine for accumulating capital came to an end the day that I retired. So I have to think about alternate ways of generating new capital, largely through my activities as an investor, either working with people or investing on my own. Total return drives capital growth, but income is of equal importance.
With my background in bonds, I have been confronted with these questions over the years — whether to invest in high-yield or junk bonds, and get a high income, but not a desirable target total return. Investors must pick when to invest in some of these options. But considering the landscape of investments today, most of the better opportunities are in the private markets as opposed to the public markets. The public markets have been negatively impacted by the actions of the Federal Reserve, which has driven rates down. This has driven up the price of bonds and driven down the income. It has driven up the price of equities, and driven down the income.
To make matters worse, our tax system today discourages companies from making adequate distributions to investors. For example, the earnings rate on Apple is just over 8%, but the dividend yield is right around 2%. Meaning they are distributing only about a quarter of their profits. This is part of the problem for income-oriented investors: an ownership stake in an income-generating company does not mean the investor is getting cash flow from it. It would be a different landscape if investors could invest in a company like Apple and know that they’re getting a pro rata share of the earnings. But that is not what is available in the market today.
Does U.S. federal tax policy cause companies to keep their assets overseas to avoid distributing them in the U.S. and paying more in taxes?
Yes. I always talk to investors about the Apple equation. Which is, Apple designs its products in California, manufactures them in Asia, and sells them all over the world. Where does Apple book the profits? Ireland. Why? Favorable tax regimes. At least, until recently when the EU got involved.
How much income can you realistically expect from your portfolio without taking on too much risk of losing principal, and how would you quantify that risk?
The first thing is to retreat from the traditional 60/40 model of investing. When 60% of one’s wealth is invested in the stock market, the market essentially determine the value of that portfolio every day and therefore limits the amount of income. Taking a step back from this conventional model means rethinking one’s portfolio allocation and focusing on higher income opportunities which do incur risk. The alternative is public equities. In my case, I’ve segregated a portion of my portfolio to allocate largely to equity real estate–type opportunities.
Why equity real estate?
It is a real asset which offers some degree of inflation protection, high income and the ability to participate directly in the profitability of the buildings. It’s got tax advantages, in that assets can be depreciated over time (i.e., a non-cash event) and excess income can be gained, which is a cash event. While taking in cash, losses are written down as paper losses. Current income tax liability is reduced and deferred until later, but it accrues as long-term capital gains. So effectively, taxes can be deferred and the ultimate rate paid on equity real estate can be reduced.
What are the potential risks for investors making these types of real estate investments?
Concerns common to investors that are new to this type of equity include: which type of real estate investment to make, while avoiding critical errors that would cause them to lose principal. For someone who has not been investing in real estate for the long term, getting involved with the wrong manager can be a real concern despite all the reasons it makes sense to go into real estate. Not having come from a real estate background myself, it is safe to say there are highly regarded investment managers in the real estate world, such as Blackstone and Arixa Capital.
However, the No. 1 obligation of any potential investor is due diligence. Conducting adequate due diligence is absolutely critical to being able to invest effectively in this market. It’s important to seek out firms that have pooled vehicles that enable investors to participate, as well as contacts who are able to make capital available in exchange for a fee. I personally do not directly invest in equity real estate nor do I manage any buildings. My investments go through a syndicate or a fund.
What is the recommended ratio of private and public investment in an investment portfolio?
I hold at least 50% of my portfolio in private investments. At 56 years old, I took early retirement. So to me, the private portion of my portfolio is targeted to provide me with income that I use to live day-to-day. The income from the private side of my portfolio covers my expenses without having to sell assets. Were the income on the public side, then I would hold a larger percentage of my portfolio there. The public portion does not generate income: but the private side does.
What kind of yield can you expect from the private portion of your portfolio as a percent of your principal investment amount, blended?
Right now the average yield on that part of my portfolio is close to 9%. It ranges from roughly 7 to 14% depending on the deal that’s in there. What I am trying to do now is diversify away from purely equity real estate into other things. That is how I met Jan Brzeski and his firm, Arixa Capital. One of his partners, Greg Hebner, was giving a presentation on their business of making mortgage loans. Even though it’s tax-inefficient, for a tax-deferred account, it makes a lot of sense.
How would you advise a potential investor who would like to replicate your strategy?
How does one go about allocating 50% of assets to private? When maybe right now, they are at 10% private and 90% public? How do they find the “real deal” people? For example, Blackstone is great, but I don’t know if one can even get into their funds unless they are an institutional investor.
A reputable financial advisor is be a good place to start. A sophisticated financial advisor, through a private bank, will have access to these types of opportunities, as will a registered investment advisor (RIA). Financial planners, accountants, lawyers, RIAs and private banks can access these investment options. In short, consult with trusted advisors.
Do you foresee a real estate downturn? How does the cyclical nature of the real estate market affect your portfolio investments?
I personally try to diversify geographically and minimize my exposure to the more highly leveraged markets. My exposure to New York, Los Angeles, Chicago, and Boston is highly limited. My exposure is more focused in the Midwest, and I’m looking to expand that into the Southeast.
In terms of how that impacts my portfolio, I’m not terribly concerned about it. Because if I am generating on average, 9 or 10% on these investments, and if there is a contraction in the real estate market, then yes: the properties may decline in value. And yes: cash flows may be reduced, ultimately reducing the yield on any particular property, or even on the entire portfolio. But I still own the asset. What have we seen time and time again? That these things are cyclical. Downturns represent an opportunity to accumulate a larger position rather than run from existing positions.
Which of the four real estate “food groups” or asset classes are you most invested in: office, apartments, industrial or shopping centers?
Mostly multifamily apartments. One of the things I love about multifamily is the diversification of the tenants. I was actually just considering a single-office opportunity outside of Milwaukee. It is one tenant with a 10-year lease. But there is a huge risk of that tenant walking away, leaving me with an empty building at the end of the lease. With a multifamily, 100–150 apartment building, it would take multitude of adverse occurrences to result in a serious decline in revenue.
Where are the apartments that you are buying located, geographically?
I target a very high concentration in the greater Kansas City region. Again, it is my relationship with a particular accountant there who services a number of clients. Those clients are always in need of capital. That accountant put me in touch with some of them.
One of the people has a particularly good business model. He is buying Type B and C apartments that are undervalued. Coming in, when we do a purchase, we contribute an extra $500,000 or $1,000,000 into that pool to improve the property. So we are not just sharing in the income associated there. We are also working on improving the value of the property as we move forward.
What about the Southern California apartment market for small, medium and large complexes?
Southern California apartments used to be viewed as an income-generating asset, similar to the apartments in the central part of the country. But increasingly, apartments here in Los Angeles are viewed more like gold — a store of value, not an income-generating asset. So it is hard to get a lot of income from apartments, after the initial cost to purchase them. There is inflation protection, as well as pride of ownership, but not significant current income, at least not at first. The income materializes over time.
For my own portfolio goals, Southern California is quite highly valued. Therefore, it does not generate the kind of income that I am looking for, as it relies more on capital gains as a primary source of return. So, if I’m looking for diversifiers and income opportunities, then I am less inclined to invest in multifamily in California. However, I do like the type of lending that Arixa Capital is doing in Southern California. As an income-oriented investment manager, Arixa focuses on lending to borrowers and generating more income, rather than apartment ownership.
Does the daily quotation of publicly traded securities actually matter in the long term?
As Warren Buffet has said, if you are going to hold an investment forever, then you don’t really care what the price is today. Meaning, the notion that you have to worry about daily fluctuations is largely unfounded. But just because something is not valued daily does not mean the price does not fluctuate. What it does mean, however, is that in a private deal, the investor generally has a substantial — if not a pro rata — share of the income that is being generated.
Considering the public stock market, earnings yield vs. the dividend yield of the S&P, the trend shows it is heading: down. Dividend income as a percentage of earnings has been nearly halved over the past generation. This is because corporations don’t have to pay out the income. As an example, as previously mentioned, Apple earns 8+ percent on the market cap but only pays out 2+ percent. One perception is that the investor is being compensated through stock buybacks. But on any given day, the value can fall substantially. It requires either great market timing to realize the benefits of those stock buybacks, or else they won’t be realized. Whereas, given a pro rata share of the income, investors would just have to decide whether to reinvest in that company or take that capital elsewhere each quarter.
This very interesting idea can be investigated further on Don Plotsky’s LinkedIn page. His white paper found there, entitled “Unconstrained Bonds” is available for download at https://www.linkedin.com/in/don-plotsky-2882b282.
Why are publicly traded companies paying much less in dividends than they used to?
After having peaked in the 1990s, publicly traded companies now pay roughly half the income they used to, when looking at dividend payout ratio as percentage of the income they generate. Today, on average, the payout ratio is approximately 35–45% but it used to be about 60%, almost double that. That is a huge change.
The very simple reason why this changed, was because these companies got away with it. In the 1990s, the internet revolution in technology resulted in a lot of companies going public who paid no divided whatsoever. Many of them ultimately failed, but some of them succeeded. Intel, Microsoft, Apple, and Google are now some of the largest companies in America. What these technology firms learned through that cycle in the 1990s was twofold. First, they did not have to pay out large dividends to attract investors. Growth was the appeal. And second, the tax code actually discourages companies from paying dividends because they are taxed twice: once to the company when they realize a profit, and again to the investors when they get paid. This is why companies have sought to avoid repatriating and booking profits in the U.S. in order to avoid that taxation.
What kinds of private investment timeframe for lockups are required to match underlying assets with structured liquidity?
For the timeframe of a private investment, investors should be thinking 5–10 years. Not all investments are necessarily that long, but when committing capital to what is, in effect, a business rather than a security, investors should have a long-term attitude. An investor in a business would not go out and buy a store or a factory with the idea of getting out in
6–12 months! A long-term commitment involves thinking critically about the areas in which to invest. The reward for that is percentage of the profits, which is what I personally want as an investor.
What are your thoughts on gold or other commodities? Any concerns about inflation over the medium term?
Gold does not keep one warm at night nor can it feed you. It does not have a lot of utility and it generates no income. I think there are better ways to hedge inflation risk than by dedicating capital to something that throws off no income.
However, the markets do value it as a store of value over the long term. Again, the market has denied us the ability to reap the tax benefits that accrued to futures contracts versus ETFs. Most people who invest in gold will do so through an ETF, which is subject to the same treatment as a stock. That is, if held for less than 12 months, the ETF is treated as short-term capital gains. If held longer, it’s treated as long-term capital gains. Investing through futures means an automatic 60% long-term capital gains treatment and 40% short-term capital gains treatment. So if choosing to invest in gold, I would do it through futures rather than through an ETF.
Where do you see moderate to longer-term interest rates going for the next 2–5 years?
I think interest rates will stay low. I don’t know if they will stay as low as they are now. But I think we are going to remain in a largely low interest rate environment. My reason for saying that, is that we really don’t see the sources of inflation out there. We saw commodity prices, oil prices spike up, then come way down to more moderate levels. We’ve seen real estate go up. I certainly think there are some aspects of bubble-like behavior in New York and maybe in some other real estate markets.
But in general, the nation as a whole is still pretty much mired in a slow growth–type environment. The developed world as a whole is in a slow growth–type environment, namely Europe and Japan. Developing economies like China, who is struggling to maintain the growth rates that have propelled them to the second-largest GDP on the planet, are also in a slowed growth mode. So I think what we are going to see — largely because of demographics and secondarily because of fiscal policy — is continued slow growth, and therefore subdued inflation.
What are the main takeaways for investors from today’s discussion with Don Plotsky about bridging the gap between wealth and income?
First of all, bonds will deliver fairly low returns. Predictions are in the 3% range, just slightly above inflation. But we will be treading water over the next 5–10 years, and that’s for a well-performing fund. Don’s personal strategy is half his assets in public and half in private investments. The private portion is designed to generate income and his target is a 9% yield from private. Payout ratios for public companies have dramatically changed. The equation used to be: own shares and get the income generated by these companies, but no longer is this the case. That is why public stocks are not going to give investors the income they want anytime soon, just appreciation only.
Finally, finding a private manager and private investments, means going to a trusted advisor, tax advisor, registered investment advisor, lawyer, and other trustworthy individuals. It’s vitally important to ask around to avoid going with the next Madoff-style pyramid scheme, because that can happen in the private world. At that point, all bets are off with whatever income has been derived if it’s through someone unscrupulous. The investor’s No. 1 concern is due diligence.
For more about Don Plotsky, please visit http://www.importanceofincome.com
Arixa Capital Corporation is licensed under the California Bureau of Real Estate (CABRE) license number 02001940.
Copyright 2016 Arixa Capital Corporation.