Other Equity Investment Vehicles

What are “Other Equity Investment Vehicles”?   

Investment vehicles refer to an array of investment products, such as bonds, stocks, mutual funds, certificates of deposits, etc. that are offered to investors for the purpose of investing, earning a rate of return or profit, and building wealth. In addition to these most common investment vehicles, there are “Other Equity Investment Vehicles” such as i.e. Separate Managed Accounts (SMA), Real Estate Investment Trust (REIT), and Master Limited Partnership (MLP). 

SMA’s are “Individually Managed” investment accounts managed for individuals or institutions (with substantial assets) by a professional money manager. Further, REIT is a company that owns or finances real estate and more specifically income-producing real estate, and MLP’s are structures that invest in energy infrastructure (pipelines, storage tanks, and processing facilities). 

Other Equity Investment Vehicles – Types

SMA: can be very similar in strategy to a mutual fund or even a hedge fund. However, in the former, assets are not held in a pool. Instead, they are held in a segregated account for each investor. The key difference between a mutual fund and SMA is that in the case of the latter, assets are owned directly by the individual or institution and not held by a fund or a trust structure. While mutual funds have low minimums, in the case of SMAs, the minimum can be as high as US$100,000 to US$500,000 if not more. Further, SMAs can be more tax-efficient than mutual funds. 

REIT: were first introduced in the US in the 1960s to provide access for retail investors to larger and more diversified portfolios of commercial and residential real estate. Originally REITs were designed as passive investment vehicles. Over time, REITs have transitioned to more actively managed portfolios.  

REITs can be private entities or traded on a major stock exchange. A key advantage of REIT is that it can sidestep corporate tax by passing on 90% or greater of its taxable income to shareholders. Therefore, unlike a typical equity holding where both a company and an investor pay taxes on income, in a REIT only the shareholders pay taxes. REITs are typically high-yielding investments, as they pass on 90% or more of the income to holders. REITs tend not to reinvest income – historically, over 60% of the total return from REITs has been from dividends. Broadly, there are two different types of REITs – Equity REIT and Mortgage REIT.

MLPs: unlike most partnerships, Master Limited Partnerships are public companies, and their shares (called units) trade on the major stock exchanges. Similar to REITs, MLPs also benefit from favorable tax rules and they do not pay taxes at the company level by passing on income to investors.

There are generally four categories within the MLP universe: transportation (transportation MLPs move energy commodities such as oil and natural gas from one place to the other), processing (this includes any business that transforms the raw product into a usable form), storage (which involves the storing of the underlying commodity) and lastly production and mining (which is less common and this includes both the exploration, which is searching for energy and the production, which is bringing it to the surface like crude oil, natural gas, coal, etc.     

REITs – Estimating Value: Funds from Operations 

In order to estimate the value of a REIT, investors cannot apply the usual metrics of earnings-per-share or price-to-earnings ratio. There is a more reliable measure to estimate the value of a REIT known as Funds from Operations (FFO). 

Calculation of FFO and Adjusted FFO

Given below is an example of a residential REIT, whose Funds from Operations (FFO) and Adjusted FFO are calculated for year 1 and year 2. 

To arrive at FFO for years 1 and 2, depreciation is added back to net income, gains on depreciable real estate sales are deducted (we assume that these gains do not reoccur) and other depreciation items and gains are also added. 

Analysts prefer the adjusted funds from operations (calculated above) measure to estimate the residential REITs value. This measure deducts from FFO the capital expenditure that is required to maintain the existing portfolio of real estate. Adjusted FFO is therefore viewed as a more accurate measure of the residual cash flow available to shareholders.