What to Do when Traditional Diversification Strategies Fail – Revisited

Reduced costs of trading commissions are a welcome new benefit of using ETFs as portfolio building blocks, but the cost of the bid-ask spread can be significant if low-volume ETFs are mixed into a diversified portfolio.

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/fall2010/dilellio-diversification.mp3]

Online investments going down

The market events of 2008 stressed the ability of diversification to protect against loss due to rapidly changing correlation amongst assets. But, as demonstrated in the initial article, “What to Do When Traditional Diversification Strategies Fail,” there is still a simple, repeatable approach based on utilizing previous year correlation coefficients to construct a diversified portfolio that reduces loss of principle.[1] The significant market gains of 2009 further challenge the benefits of diversification. So, the question now is: Does this approach to diversification also provide opportunity for significant positive gains? To answer this question, we revisit the simple diversification strategy featured in the previous article, which exploits correlation to reduce risk, to see if opportunities for gains exist.

Furthermore, a recent competition between brokers has been driving down commissions for online trades. In addition to lower commissions, some brokers have selected a subset of ETFs from a single provider, such as iShares’ affiliation with Fidelity, and waived all commissions when trading these financial products within their online platform. These reduced costs are important and may have a direct influence on the optimal reallocation frequency. So, a new question now is: With the reduction or elimination of trade commissions, is a more active strategy optimal? This article also examines this practical issue, and quantifies the overall benefits from $0 ETF commissions currently in the marketplace.

Hypothesis Revisited

This study revisits many of the hypotheses established in the previous study. The correlation coefficient threshold is validated from an updated illustration containing four asset classes: U.S. Large Caps, U.S. Small Caps, International, and Bonds. As seen in Table 1, correlations observed over 2008 suggest the same allocations against U.S. Large Caps (SPDR S&P 500 fund, symbol: SPY) and Bonds (iShares Aggregate Bond Fund, symbol: AGG) as suggested from correlations observed over 2007.[1] But, because of the continuing trend of lower commission costs, consideration must also be given to volume in the process of identifying uncorrelated assets. Volume is known to be inversely related to costs from bid-ask spreads and is empirically modeled in the following section. So, to provide a preference to higher volume funds that minimize the resulting bid-ask spread, the correlation matrix rows are generated in order of decreasing volume before eliminating highly correlated investment options. The result to the right of the arrow illustrates the result, applying this process to a four-asset class example.


Table 1- DiLellio

Table 1: Correlation Coefficients from Daily Returns Adjusted for Dividends in 2008, sorted by Average Daily Volume.


Table 2 shows the associated 2009 performance, based on holding both the four-asset portfolio as well as the suggested two asset portfolio based on the 80 percent correlation threshold. The diversification effect observed in 2008 reduced the 2009 portfolio gain from 21 percent to 14.3 percent. Reviewing the 2008 portfolio returns (illustrated in the previous article), we observe a loss of 27 percent and 15 percent, respectively, where the smaller loss occurrs when we apply the correlation threshold to portfolio construction. Thus, the two-year cumulative return from this simple illustration is -12 percent when no correlation threshold is applied, versus -3 percent when it is applied.


Table 2- DiLellio

Table 2: 2009 Performance of Naïve Allocation with and without use of 2008 Correlation Coefficients.


This updated simple illustration continues to suggest a benefit of multi-asset diversification or wide diversification, consistent with other research.[2][11] While these studies use longer history market indices, we show a more pragmatic view in the following sections, since the ETFs examined are easily traded by individuals, investment advisors, hedge funds, and institutional investors. Furthermore, ETF transaction costs can be accurately modeled, as shown in the next section. Unfortunately, ETFs are still fairly new investment products, so they do not offer the long histories available for many asset allocation studies employing equity, bond, and commodity-based indices used in the aforementioned studies.

Analysis Assumptions and Methodology

Continuing with the nine asset classes identified in the previous article, including the 136 unique ETFs available since January 2004, we have added an analysis of new zero-commission ETFs now being offered by Schwab, Fidelity, and Vanguard. Six of the asset classes are equity-based and consist of large cap domestic, large cap foreign, emerging markets, midcap domestic, small cap domestic, and domestic sectors. The three non-equity classes include commodities, bonds, and real estate. A summary of the nine asset classes represented by these ETFs appears in Table 3, where sector and large cap domestic assets have the largest representation, while bonds and real estate assets have the smallest.


Table 3 - DiLellio

Table 3: Asset Classes represented by 136 Exchange Traded Funds available since January 2004 (values are rounded to the nearest percent).


Based on the updated simple illustration from above, we continue to define uncorrelated assets using a correlation matrix generated by volume. We then eliminate lower volume assets that are more than 80 percent correlated with higher volume assets. All correlation coefficients were calculated based upon 12 months of daily historical returns developed from adjusted closing prices that included dividends and splits. For consistency, volume was also estimated using a 12-month average daily volume. This methodology follows the same rationale established in the initial paper.

Revisiting the existing assumption regarding switching costs, we have updated our methodology to address the practice of investment managers seeking “most liquid” ETFs.[4] To further improve the fidelity of the back-testing, we have also incorporated a nonlinear regression model for a bid-ask spread that grows rapidly with low volume. The model parameters are based on empirical data provided by Pankaj Agrrawal and John M. Clark in their 2009 article, “Determinants of ETF Liquidity in the Secondary Market: A Five-Factor Ranking Algorithm.”[3] This data is represented in Figure 1. The value of R2 = 94 percent obtained from the power-law model suggests that a significant amount of the variation has been explained between the bid-ask spread and the trailing volume, providing high confidence in the model’s ability to accurately reflect bid-ask costs based on volume.


Figure 1 - DiLellio

Figure 1: Bid-Ask Spread, in Basis Points (BP) versus Average Volume, with Power Law Regression model and Goodness of Fit Measure.


The model in Figure 1 is applied against hypothetical trades using month-end adjusted closing price and volume. Returns were calculated based on a naïve allocation approach that evenly spreads assets across uncorrelated ETFs. The purpose is to examine the data’s sensitivity to annual, biannual, and quarterly rebalances. To reflect the latest updates in commissions from discount brokerages such as Vanguard, trade commission are reduced from $10 to $5 per trade against a portfolio starting with $100,000 in a tax-free account.[7]

Empirical Results

Figure 2 appears to have a very similar downward trend, but contains a full five years of history. Once again, the increased correlation amongst assets classes increases over time, yielding fewer uncorrelated funds. Also note that including volume as part of the process to determine uncorrelated funds has had a marginal effect on the total number of uncorrelated funds, but the downward trend from 2005-2009 remains.


Figure 2 - DiLellio

Figure 2: Number of ETFs that are less than 80 percent correlated over previous year with higher volume ETFs (2005 – 2009).


Tables 4, 5, and 6 list the portfolio allocations against each of the nine asset classes for the annual, biannual, and quarterly rebalancing periods. In each case, the allocations begin in 2005 with a majority of holdings in large foreign equities, emerging markets, and domestic sectors. By 2009, large domestic equity increases significantly, while large foreign equities and emerging market allocations shrink drastically, as highlighted in orange. Highlighted in yellow, bond funds continue to grow to become 43 percent of the allocation, one of the largest percentages seen over the five-year study. Lastly, domestic sectors remain a significant percentage of the allocation throughout the five-year study, suggesting a cyclical pattern between the range of approximately 25 percent and 45 percent. In summary, these results indicate that the naïve allocation strategy appears to be achieving wide diversification, based on the portfolio containing between five and eight asset classes throughout the five-year testing period.[2] Furthermore, the strategy appears to have a dynamic component that, in times such as early 2009, approaches the classic allocation of 50/50 bond-equity allocation.


Table 4 - DiLellio

Table 4: Annual Portfolio Allocation Percentages with Naïve Allocation Approach and 80-Percent Correlation Threshold



Table 5 - DiLellio

Table 5: Biannual Portfolio Allocation Percentages with Naïve Allocation Approach and 80-Percent Correlation Threshold.



Table 6 - DiLellio

Table 6: Quarterly Portfolio Allocation Percentages with Naïve Allocation Approach and 80-Percent Correlation Threshold.


Table 7 summarizes the net returns based on the three reallocation intervals and includes the effect of modified and new positions incurring a bid-ask spread cost and the flat-rate $5 commission cost. Once again, the annual reallocation period appears optimal. Also, the commission costs do not appear to be driving the lower performance. When set to $0, returns increase by 0.6 percent, 1 percent, and 1.9 percent over the five-year period for annual, bi-annual, and quarterly reallocations, respectively. But, this increase is not sufficient to offset the larger gross returns provided by the annual reallocation frequency.


Table 7 - DiLellio

Table 7: Net Returns with Naïve Allocation



Table 8 - DiLellio

Table 8: Sharpe Ratio with Naïve Allocation


Alternatively, Table 8 shows the risk adjusted returns using data from Ibbotson & Associates’ one-month T-bill for the risk-free rate and William F. Sharpe’s methodology based on excess return and standard deviations.[5] Once again, annual reallocation provides the greatest risk-adjusted returns.

The cost impact on the portfolio due to the bid-ask spread is somewhat more complex than the flat-rate commission discussed above. While the the aim was to select higher volume uncorrelated funds, it is likely that a few of the uncorrelated funds had significantly lower volume. To examine the relative effect of the portfolio’s bid-ask spread against number of positions in the allocation, a scatter plot appears in Figure 3 from the quarterly allocation data. Interestingly, the lowest bid-ask spread cost incurred for a given allocation is achieved when 20 to 30 uncorrelated funds are identified. Alternatively, when only a dozen or so funds are available, the resulting bid-ask spread becomes significant. The larger bid-ask spread is also seen for portfolios with more than 40 uncorrelated funds, but to a lesser degree. The larger portfolio bid-ask spread is the result of a few low-volume ETFs needed to provide portfolio diversification, which were not available from higher volume alternatives. And because of the rapid growth of the bid-ask spread for low volume, a small fraction of the allocation towards low-volume ETFs can increase the portfolio bid-ask spread substantially.


Figure 3 - DiLellio

Figure 3: Portfolio Bid-ask spread (basis points) vs. number of uncorrelated funds is nonlinear.


Observations and Current Market Offerings

Revisiting the simple methodology previously established, we see that using correlation coefficients continues to provide a practical approach to obtaining the benefits of diversification. Reduced costs of trading commissions are a welcome new benefit of using ETFs as portfolio building blocks, but the cost of the bid-ask spread can be significant if low-volume ETFs are mixed into a diversified portfolio. Furthermore, based on a correlation threshold, the methodology applied here can include these low-volume ETFs in portfolios with smaller and larger numbers of uncorrelated funds.

These are important observations because, as of May 2010, Fidelity, Vanguard, and Schwab all offer $0 commissions on trades. These brokerage firms appear to be using this offer along with lower expense ratios, better exposure to asset classes, and lower tracking error as a discriminator.[8][9] But, expense ratios and bid-ask spreads are important costs to consider, particularly for lower volume $0 commission ETFs.[10] Table 9 summarizes the median cost for the 6 ETFs from Schwab, 26 from Fidelity, and 46 from Vanguard that are currently offered with $0 commissions when traded online. The costs are based on buying and selling the median ETF over a one-year holding period, and the bid-ask spread is based on the model in Figure 1 using average volume from February to April 2010.

Table 9 suggests that annual transaction costs associated with buying and selling $0 commission ETFs can quickly exceed 100 basis points, or 1 percent, when traded quarterly. While such evidence still may not deter day-trading of ETFs, one broker has announced limitations on trading their $0 commission ETFs. Vanguard incorporates a limit of 25 buys/sells of its $0 commission ETFs per year.[6] This announcement is clearly associated with Vanguard’s founder, John Bogle, and his belief in keeping costs low for long-term investments. Investors would be wise to consider this fundamental philosophy.


Table 9 - DiLellio

Table 9: Annual Median Transaction Cost of Reallocation using $0 Commission ETFs


DISCLAIMER: The exchange trade products analyzed in this article were chosen from those publicly available. They do not represent the author’s recommendations and were only used to support observations. Investment advice is neither implied, nor suggested.

[1] DiLellio, James, “What to Do When Traditional Diversification Strategies Fail,” The Graziadio Business Report, 12, no. 4 (2009).

[2] Mulvey, John M., Cenk Ural and Zhoujuan Zhang. “Improving Performance for Long-Term Investors: Wide Diversification, Leverage, and Overlay Strategies,” Quantitative Finance, 7.2 (2007): 175-187.

[3] Agrrawal, Pankaj and John M. Clark, “Determinants of ETF Liquidity in the Secondary Market: A Five-Factor Ranking Algorithm,” Institutional Investor Journals. Fall: 59-66.

[4] Hight, Gregory N., “Diversification Effect: Isolating the Effect of Correlationon Portfolio Risk,” Journal of Financial Planning, October (2010).

[5] Sharpe, William F. “The Sharpe Ratio,” Journal of Portfolio Management, Fall (1994): 49-59.

[6] Wiener, Dan, “Free Trading Vanguard’s Shotguns,” Forbes.com, May 4, 2010.

[7] Maxey, Daisy, “Vanguard Joins Cuts of ETF-Trading Fees,” The Wall Street Journal, May 5, 2010.

[8] Spence, John, “BlackRock, Vanguard Battle for ETF Assets – Being First Mover isn’t So Advantageous,” The Wall Street Journal, April 27, 2010.

[9] Kapadia, Reshma, “Identical Twins? Nope.” WSJ.com, April 5, 2010.

[10] Randall, David K., “Why Bargain Trades Are No Bargain“, Forbes, March 15, 2010.

[11] Gibson, Roger C., “The Rewards of Multiple-Asset-Class Investing,” Journal of Financial Planning, July (2004):58-71.

[14] Vanguard.com, Vanguard ETFs® https://personal.vanguard.com/us/funds/etf.


[i]Expense ratios and volumes were obtained from Brokerage Web sites in April 2010, including Fidelity.com, Vanguard.com, ishares.com, as well as finance.yahoo.com, SeekingAlpha.com, and are subject to change.

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Investing for Income in a Down Economy

As equity markets fall and a recession develops, investors are faced with the “What do I do now?” question. At this point in the business cycle, it is common for investors to move all their resources into cash and cash-equivalent investments while other investors who desire higher rates of return without exposure to equity markets turn to income-generating securities, like bonds, and suffer the low yields. Still others, who seek to minimize the risk of loss, turn to blue-chip-type equities with high-dividend yields and some potential for capital appreciation. However, there are other alternatives that share characteristics with these strategies and may provide better long-term portfolio performance through high-dividend yields and favorable diversification characteristics.





Photo: MBPhoto





Traditionally, investing for income means investing in fixed-income securities such as treasury securities (T-bills and T-bonds), agency debt, municipal bonds, corporate debt, annuities, money market accounts, and CDs or simply allocating resources to interest-bearing bank accounts. While this is one way to preserve capital, these fixed-income securities currently offer very little in the way of yield or long-term capital appreciation.[1] Moreover, when deflation ends and inflation reignites the market, interest rates will head higher, which means the real value of bonds and other fixed interest-bearing securities will fall. Investors in these securities will run the risk of significant loss of purchasing power, due to inflation and material resource shortfalls, when it is time to retire. Annuity investors also face these risks and may feel somewhat secure knowing that top-rated insurance companies have their backs. However, a bankrupt insurance company means that its annuity holders are likely to get much less than they had planned.[2] [3]

Alternatively, investors with higher risk tolerances and with goals of generating high rates of return may consider common stock with high-dividend yields. Currently, it is uncommon for the yields on Fortune 500-type companies to be in the 3 to 4 percent range or higher, and to receive these dividends, investors need to be able to bear the turbulence of the markets and the possibility that the dividends will be cut. Since the beginning of 2008, many publicly traded companies in the United States, Europe, and the Far East have cut their dividends and more cuts are expected. Furthermore, some analysts have observed that if we go into a prolonged recession, a depression, stagflation, or just an extended period of equity markets moving sideways, then buy-and-hold equity investors may experience little, if any, capital appreciation.

So, what are the securities that offer an alternative to fixed-income securities and common stock? They include real estate investment trusts, master limited partnerships, closed-end mutual funds, business development companies, royalty trusts, and shippers.

These securities often include equity claims on assets like real estate, gas and oil wells, pipelines, mines, timberland, and tankers and dry-bulk shippers or may be funds that hold a portfolio of debt and equity claims of companies operating in related industries. While these securities are subject to the same volatility as common equities (particularly those with low-volume trading and market capitalizations below $250 million), they typically offer large dividend payouts that help cushion an often bumpy ride through the downturn and subsequent recovery. Alternatively, these investments offer a superior return relative to fixed-income investments because of the potential for capital appreciation. A brief discussion on each of these investment opportunities follows.

Real Estate Investment Trusts (REITs)

Real estate has come into its own as an asset class, and REITs are probably the best known and most popular way to get exposure to the real estate market outside of owning a personal residence. Since 1960, when the U.S. Congress created REITs to make investing in income-producing real estate available to all investors, the market capitalization of these publicly traded partnerships has reached $300 billion.[4]

REITs come in three general types:

  • Equity (owns and manages commercial, office, industrial, storage, medical, and multi-family properties)
  • Mortgage (facilitates real estate ownership by investing in mortgages and mortgage-backed securities)
  • Hybrid (invests in both property and mortgages)

Because much of a REIT’s return is in the form of a dividend that is taxed in the year in which it is received, the ability to defer taxes is somewhat diminished, when compared to a long-term investment in non-dividend paying equities.

Over the last three decades, REITs have offered returns and diversification benefits not available from traditional equity and equity index investing. Currently, there are over 150 publicly traded REITs on U.S. exchanges, and according to the National Association of Real Estate Investment Trusts (NAREIT), the total return on these REITs is superior to that of all the major stock indexes for the period March 1978 to March 2008.[5] They also note that the annual dividend growth rate for REITs from 1993 to 2007 averaged just below 6 percent, with a high of 8 percent in 1998 and a low of just less than 2 percent in 2002.[6] In 2005, Michael C. Henkel, president of Ibbotson Associates, observed, “because of their declining correlations with other types of investments, REITs offer a significant source of portfolio diversification.”[7]

However, recent REIT performance indicates they offer little diversification benefit in the face of the current credit crisis. The latest returns on REIT indexes indicate one-year and three-year rates of return of approximately -50 percent and -22 percent, respectively.[8] Returns on the S&P 500 over the same periods were approximately -38 percent and -27 percent, respectively.

So does this mean that the diversification benefit has evaporated? Not exactly. Over the short run, various asset classes can be highly correlated; however, over longer periods, these correlations will decline and the diversification benefits will return. This is likely the case for REITs. Also, note that the REIT sector is an important factor in determining relative performance. For example, REITs that invest in industrial, office, and retail space are likely to continue to suffer in the near-term, while REITs that invest in healthcare-related assets may have less exposure to the current economic difficulties.

REIT investors have the option of investing directly in partnerships or investing in Exchange Traded Funds (ETFs). An ETF is similar to a mutual fund, with a couple of notable exceptions. First, ETFs are traded just like stocks throughout the day, so they offer a liquidity advantage over mutual funds. Second, ETFs are passively managed, unlike most mutual funds. This means that, once ETFs are created, the portfolios do not change very often. Some notable ETFs offering the benefits of a diversified REIT portfolio include Vanguard’s REIT Vipers (VNQ), iShares Dow Jones U.S. Real Estate Index Fund (IYR), and streetTRACKS Wilshire REIT Index Fund (RWR).

Master Limited Partnerships (MLPs)

The United States has a natural gas pipeline network stretching almost 300,000 miles; its crude oil pipeline network runs approximately 100,000 miles. These networks move over 60 billion cubic feet of natural gas and 20 million barrels of crude daily. Some 50 exchange-traded MLPs control 25 percent and 70 percent of the ownership of these networks, respectively.[9] Ownership is traded in the form of “units” rather than shares, to reflect the nature of the business’ legal structure investors are essentially limited partners when they acquire ownership. While most MLPs are in natural gas and oil-related businesses, there are other MLPs operating in the real estate, mining, and coal and timber industries.

The limited partner status will result in an investor’s receiving a form K-1 for tax purposes. The form K-1 indicates how much of the earnings and depreciation are passed through to unit holders. It also indicates how much of the total distribution to unit holders is return of capital as opposed to return on capital (i.e., dividends) which is not taxable. Because unit holders are taxed as partners rather than as shareholders, the depreciation and return of capital result in lower current taxes and allow unit holders to effectively defer some of their tax obligations into the future. Finally, if an MLP is held in a tax-sheltered account, such as an IRA, the portion of the distribution designated as income may be subject to unrelated business tax income (UBTI). If an investor has UBTI of less than $1,000, then the income from the MLP is not subject to the tax. However, if UBTI exceeds $1,000, then the income from the MLP is subject to the tax as well in effect, it becomes part of the UBTI measure.

Another way to take advantage of the rich yields offered by MLPs and avoid all the tax issues associated with K-1s is to hold an exchange-traded fund (ETF) or a closed-end fund (CEF). Kayne Anderson MLP Investment Company (KYN) is an example of a CEF that converts K-1 income into dividend income and provides some diversification across the North American natural gas and oil infrastructure. Kinder Morgan Energy Partners (KMP) is another way to invest in pipelines and receive mostly dividend income. Currently, these securities offer yields of 8 to 10 percent.

Closed-End Funds (CEFs)

A closed-end fund is similar to a mutual fund, but with some notable differences: CEFs issue a fixed number of shares in their IPOs, can be bought and sold throughout the trading day, do not require minimum investments, and have market prices that can deviate from their net asset values (i.e., CEFs trade at discounts and premiums).

CEFs are also similar to ETFs; however, CEFs are actively managed and have higher management and expense ratios. Current CEF offerings break down into the following asset classes:

  • Tax-exempt bond funds (42 percent)
  • Domestic equity funds (25 percent)
  • Domestic taxable bonds funds (20 percent)
  • World equity funds (9 percent)
  • World bond funds (4 percent)

The Closed-End Fund Association provides a website that allows for searches by asset class and offers news related to the CEFs and advisors they follow. [10]

Of particular interest in this business cycle are CEFs that invest in convertible securities and preferred stock. Convertible security CEFs will offer investors a small yield with upside potential, once the stock market resumes its climb. This is because convertible securities are debt instruments until they convert, so the investor “gets paid to wait” until conversion.

Due to the recent market decline, it is likely that most existing convertible securities will not convert for some time. However, with yields ranging from 2.5 to over 11 percent, these investments are a reasonable alternative to other fixed-income securities, with the bonus of a claim to the upside potential of the firms in the portfolio. However, because there is no such thing as a free lunch in financial markets, the values of these securities are more volatile than their non-convertible counterparts.

Preferred stock CEFs are another possibility for generating income. Preferred stock is typically issued by financial concerns and utilities, but can be issued by firms from all industries. Preferred shares are often called hybrid securities, because even though they are equity securities, they behave like fixed-income securities due to their high yields. Currently, there are approximately 30 CEFs that include preferred stock in their portfolios. When selecting a CEF with preferred stock, one must pay careful attention to the contents of the portfolio and avoid those with exposure to companies that are financially distressed or may become financially distressed, as we move further into the recession. For example, firms likely to be able to meet preferred dividend obligations include banking concerns that are supported by regulators and the government, such as J.P. Morgan, Bank of America, Wells Fargo, Freddie Mac, and Fannie Mae. Most other banks are in a more precarious position. Utility issues are also another subset of preferred stock likely to avoid default. A good example of a fund with minimal exposure to the banking crisis is the DNP Select Income Fund (DNP), which is 75 percent invested in interest-bearing securities issued by utilities and currently yields over 10 percent.

Business Development Companies (BDCs)

BDCs offer individual investors the opportunity to enter the private equity markets, with all the potential returns and risks facing professional private equity firms and venture capitalist. However, BDC investors do not have to worry about capital calls and minimum income or net worth requirements and their shares are quite liquid.

The Small Business Investment Incentive Act of 1980 facilitated the establishment of BDCs, which are closed-end funds that provide financing to small- and middle-market companies that are often not large enough, or obscured by too much uncertainty, for larger financial institutions’ tastes. They also receive tax-preferred treatment that is, there are no taxes levied on the entity because BDCs are regulated investment companies (RICs) and are required to distribute a minimum of 90 percent of investment company taxable income to shareholders by the end of each tax year.

BDCs investment strategies can be focused on:

  • Growth (majority of capital allocated to start-ups or smaller companies with high growth opportunities),
  • Value (majority of capital allocated to established and less speculative companies), or
  • Income production (majority of capital allocated to established and less speculative companies).

Typically, publicly traded BDCs will allocate capital to all of these opportunities using various financial instruments, including secured debt, unsecured debt, convertible notes and bonds, preferred stock, common stock, and warrants.

Because BDCs invest in small companies with subordinated positions, the investment risk in these entities can be substantial. This risk is somewhat mitigated by regulations that limit leverage to a one-to-one ratio that is, for every dollar borrowed by the BDC, they have to raise at least one dollar in equity. Furthermore, BDCs must also be diversified no more than 25 percent of a BDCs assets may be invested in a single issuer. The upside to this significant risk is that small companies tend to do well once a new expansion begins, so well-managed and well-positioned BDCs will also do well.

Finally, it is important to determine whether the BDC is internally or externally managed. Externally managed BDCs may be exposed to conflicts of interest, which could have adverse consequences on shareholders. Some examples of self-managed BDCs include American Capital Strategies (ACAS), MCG Capital Corporation (MGC), and Gladstone Capital Corporation (GCC). Examples of externally managed BDCs include Apollo Investment Corporation (AINV), Technology Investment Capital Corporation (TICC), and NGP Capital Resources Company (NGPC). It is also important to note that some BDCs are broadly diversified across many sectors and industries, while others specialize within market sectors or industries.





Photo: Alptraum





Royalty Trusts

Royalty trusts are corporations typically established to engage in natural resource extraction, such as mining and natural gas or oil production. Most are based in Canada or the United States. They are financing vehicles without management, employees, or operations of their own. They offer investors the ability to gain direct exposure to energy and commodity prices and markets. Similar to the other securities discussed in this paper, royalty trusts are currently not taxed at the corporate level, if they distribute 90 percent or more of their profits each year.

While all trusts may look similar, investors need to be aware of some important differences between Canadian and U.S. royalty trusts. For example, Canadian royalty trusts, or CanRoys, are able to replenish or perpetuate their activities through continuing investment by the same entity. In the United States, royalty trusts are established to own a specific asset or assets, and once those assets are depleted, the trust is effectively out of business and dissolved. Therefore, investors in U.S. royalty trusts can expect payouts to diminish over time, whereas investors in CanRoy trusts can expect payouts to increase.

Another important difference relates to tax status.[12] Recently, Canada decided to tax CanRoys at the maximum corporate rate of 31.5 percent, beginning in 2011. However, political opposition is seeking to overturn the change and keep the old maximum tax rate of 10 percent. Investors seeking income through CanRoys should carefully consider the impact of the tax change on the units’ values and the future expected dividends.

Because royalty trusts incur huge depreciation and depletion charges, most of the income distributed to unit holders is not taxed in the period the dividend is received. Instead, the cost basis of the purchased units is adjusted downward, and at the time of sale, the unit holder will pay capital gains taxes on the difference between the purchase price and the reduced cost basis. A list of publicly traded royalty trusts can be found here. Examples of U.S. royalty trusts and their accompanying dividend yield include BP Prudhoe Bay RT (BPT) yielding 9.7 percent, Permian Basin RT (PBT) yielding 7.9 percent, and Sabine RT (SBR) yielding 7.4 percent. Examples of Canadian trusts include Harvest Energy Trust (HTE) yielding 38 percent, Precision Drilling Trust (PDS) yielding 10.8 percent, and Provident Energy Trust (PVX) yielding 19.2 percent. Investors should expect dividend decreases in many of these issues until oil prices firm up.

Dry-Bulk Shipping and Oil Tanker Companies

There are several exchange-listed oil tanker companies and dry-bulk carriers for investors who seek high but volatile yields and who can handle relatively volatile stock price movements. During the recent expansion in the U.S., these companies provided both high yields and handsome capital appreciation. However, in the market downturn, the capital gains quickly turned into capital losses. The meaningful gains will likely return, when China and India begin buying commodities again. This turn should be reflected when spot rates incorporated in the Baltic Index begin to rise. The signals produced by this index, which is related to market turns in shipping, tend to be more reliable than typical leading and coincident indicators used in equity markets because of the way they are constructed. There is little speculation built into shipping rates.[13] Therefore, the time to start buying is when spot rates firm up. Current and historical shipping rates can be found on the DryShips Inc. Web site (DRY).[14]

Currently, several shippers are offering what appear to be extraordinarily high-dividend yields. For example, at the time of writing, Nordic American Tankers (NAT), Frontline LTD. (FRO), and Diana Shipping (DSX) are yielding 15.62 percent, 37.88 percent, and 20.37 percent, respectively. But these yields reflect past shipping rates that are not available in today’s markets. The dividend yield based on next year’s profits will most assuredly be lower. While it is difficult to determine which shippers will be able to operate their fleets profitably in a downturn, a good starting point in identifying the most likely survivors is to find the shippers with relatively little debt, relatively less exposure to spot rates, and no commitments to purchase new tankers.[15] These are also the tanker companies that will be well positioned when the next expansion cycle begins.

Conclusion

Before investing in these securities, weigh the following:

  1. Assess your own risk tolerance and how these securities might change the volatility of your portfolio;
  2. Understand the tax consequences related to each of the discussed securities, particularly as they relate to tax-deferred investment accounts; and
  3. Make sure that inclusion of these securities, and the associated expected returns, are consistent with your portfolio return objectives especially as they relate to a trade-off between desired capital gains and current income.

Minimize your risk by selecting companies with proven management teams (especially recession proven), modest debt levels relative to cash flow, and histories of increasing distributions for an extended period of time. Also, avoid companies that are required to retire debt unless you are confident that they can refinance in this credit tight environment.

[1] Some bonds currently trading at discounts offer the potential for capital appreciation.

[2] Ron Lieber, “What Happens When Your Insurer Goes Under?” The New York Times, November, 14, 2008.

[3] Aldo Svaldi, “AIG Shows Annuities Aren’t Fail-Safe,” The Denver Post, September, 26, 2008.

[4] For more information on REITs, see REIT.com.

[5] REIT.com, REIT Performance, http://www.reit.com/AllAboutREITs/REITInvestmentBenefits/Performance/tabid/142/Default.aspx. (no longer accessible).

[6] REIT.com, Dividends, http://www.reit.com/AllAboutREITs/REITInvestmentBenefits/Dividends/tabid/143/Default.aspx. (no longer accessible).

[7] REIT.com, Diversification Benefits of REITs, http://www.reit.com/AllAboutREITs/REITInvestmentBenefits/Diversification/tabid/144/Default.aspx. (no longer accessible).

[8] DowJonesIndexes.com, Dow Jones Wilshire Real Estate Indexes, http://www.djindexes.com/wilshire/realestate/index.cfm?go=index-data.

[9] Zack O’Malley Greenberg, “Pipeline to Profits,” Forbes Magazine, June 2, 2008, 144 146.

[10] Closed-EndFunds.com.

[11] For more information on BDCs, see ValueForum.com.

[12] Reuters.com, Canada’s Liberals Get Trust Plan Election-Ready, http://www.reuters.com/article/bondsNews/idUSN0443978220070904.

[13] Wikipedia.org, Baltic Dry Index, http://en.wikipedia.org/wiki/Baltic_Dry_Index.

[14] DryShips.com, Welcome to DryShips Inc., http://www.dryships.com/index.cfm?get=report.

[15] Ruthie Ackerman, “High and Dry in Dry Bulk,” Forbes.com, October 27, 2008.

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Owner-Occupied Commercial Real Estate for the Entrepreneur

Many entrepreneurs have proven that owning the real estate used by their closely held businesses can provide them the advantages of stable rents for their businesses and appreciation for themselves. Many other benefits accrue to the owner of single-tenant commercial real estate, including the ability to employ advantageous tax strategies, an income stream in perpetuity, asset diversification, and control of the property’s tenancy.

This article provides an overview of how business owners can benefit from owner-occupied, single-tenant commercial real estate, and offers practical advice on how to enter this potentially lucrative investment.





Photo: Cezars




Case Study: M & G Consulting

Introduction

M & G Consulting is an engineering firm located in Southern California. They have rented space in a business park for many years and each year they have observed that their rent has increased by at least the rate of inflation. Although their business is successful, they have come to realize that their landlord has made just as much profit in the form of rents and appreciation on the building as they have in their business. They vowed to take control of their situation and began the search for their own building.

Identifying the Building

First, M & G identified the building size and amenities that suited their needs. They planned for the growth they expected over the next 10 years. In addition, they planned for future technology needs in terms of communications facilities, the image they wished to portray to clients, the proximity and ease of access to transportation hubs, and not least importantly, the geographic area. Their specifications were shared with trusted employees, and modifications were made based on ideas generated in group discussions. The owners then began their search and quickly settled on a building in a business park about 10 miles from their current site.

Negotiating the Terms

M & G negotiated with the owner of the identified building regarding his price, terms, willingness to carry back secondary financing, and willingness to complete necessary repairs and tenant improvements. The owner was flexible because he had held the building unsold for some time. The buyer and seller settled on a set of mutually acceptable terms and signed a contract.

Structuring the Entity to Hold the Building

M & G soon discovered that they could hold title to the building in a variety of ways, each of which had its own advantages and downfalls in terms of liability and tax treatment. M & G discussed the legal implications with their attorney and the tax implications with their CPA of the following methods:

Limited Liability Company (LLC)

M & G’s attorney advised them that they could structure building ownership as an LLC, the major advantage being that it would be a legal entity separate from either M or G, and therefore limit personal liability from claims arising from the property. However, M & G’s accountant pointed out four disadvantages of an LLC holding the property:

  1. The cost of establishing an LLC, largely attorney fees, is significantly greater than for some other forms of ownership.
  2. If an LLC has two or more owners, they must file partnership federal and state tax returns,[1] which require most taxpayers to seek professional (i.e., costly) tax preparation assistance.
  3. In some states (e.g., California), an LLC, including a single-member LLC, is required to file a tax return and pay an annual fee based on gross revenue the fee, which is $800 if the building makes no net income, can go as high as $11,790.[2]
  4. Not only is the owner taxed on his or her portion of the net profits of the LLC, losses may have limited deductibility depending on the cash the owner has invested in the LLC.

Sole or Joint Ownership

M & G’s attorney advised them that the property could also be held under sole ownership (one owner), or as a tenancy in common or as joint tenants with right of survivorship (multiple owners). Under any of these structures, the attorney opined, unlimited liability falls on the owner of the building for any potential claims against the property.[3]

M & G’s accountant told them that the attractiveness of sole ownership or joint ownership versus an LLC is that it requires only one additional form on a personal tax return. Net rental income or loss on the property is taxed at ordinary income tax rates on the owner’s tax return. He also pointed out that these entrepreneurs can mitigate personal liability risks through the establishment of a comprehensive insurance policy. That said, the decision of which way to structure the entity holding the property should be based on the LLC fees and costs versus the cost of any extra insurance required because the property is held in the owner’s name.

Formal General Partnership

Essentially, a formal general partnership is a tenancy in common that is required to file a partnership tax return (usually form 1065), which is usually prepared by the partnership’s accountant. Very often, establishing the partnership also requires an attorney to prepare the partnership agreement. M & G’s accountant strongly urged them to have a formal partnership agreement if they chose to enter into any form of partnership; in his experience, many problems are avoided if they are anticipated, which is what the partnership agreement formalizes.

The partnership is not required to pay income taxes and each partner’s share of net rental income or loss on the property is taxed at ordinary income tax rates on his or her tax return. The general partners have unlimited liability for the partnership’s acts, and they will often opt to insure against loss from those activities.

Formal Limited Partnership

A formal limited partnership is another type of tenancy in common required to file a form 1065 partnership tax return. However, while the limited partners’ liability is generally restricted to the amount they contributed to the partnership, the general partner’s liability is unlimited. There must be at least one general partner and most often it will be a corporate entity established for that sole purpose. If so, that corporate owner must file a form 1120 tax return to report its share of the income from the property.

Again, establishing the partnership often requires the services of an attorney to prepare the partnership agreement. The partnership is not required to pay income taxes. Each partner’s share of net rental income or loss is taxed at ordinary income tax rates on his or her tax return.

C-Corporation (Regular Corporation)

It is rare that a property is owned by a corporation and leased out to others; doing so usually means losing tax advantages such as favorable capital gains treatment on the property at sale, the ability to deduct operating losses from the property, and the ability to take tax-sheltered cash from the property. In addition, any cash taken from the corporation would be double taxed (if taken as dividends) and subject to payroll taxes (if taken as management fees) neither scenario is tax efficient.

The only advantage of corporate ownership is the limitation of liability; however, this can also be achieved by holding the property in an LLC or a limited partnership.

Method Liability Costs/Taxation
Limited Liability Company (LLC)
  • Limited
  • Legal fees for establishing LLC
  • Partnership tax returns if two or more owners
Sole Ownership / Joint Ownership
  • Unlimited but potentially mitigated by purchasing insurance
  • Insurance policy (if purchased)
  • Taxed at the personal level
Formal General Partnership
  • Unlimited but potentially mitigated by purchasing insurance
  • Partnership fees
  • Insurance policy (if purchased)
  • Taxed at the personal level
Formal Limited Partnership
  • Limited partner’s liability is limited to initial equity capital
  • General partner’s liability is unlimited but potentially mitigated by purchasing insurance
  • Partnership fees
  • Insurance policy to mitigate general partner’s liability (if purchased)
  • Taxed at the personal level
C-corporation (regular corporation) Ownership
  • Limited
  • Incorporation costs
  • Double taxation at the corporate and personal level

Lease Agreements

Regardless of the form of ownership, M & G’s attorney and accountant strongly urged them to have a written lease between the entity and M & G Consulting. A lease protects both the firm and the landlord by spelling out the rights and duties of each, and would provide uninterrupted tenancy for M & G Consulting in the event the landlords sell the building.

The Decision

M & G decided to hold their building as a tenancy in common. Each partner (and his wife) owns a one-half interest in the building. Because California (and eight other states[4]) is a community property state, each co-tenant holds a community property interest in the building.[5]

Loan or Cash?

This question is probably one that every entrepreneur looks at with disbelief after all, paying cash is not something an entrepreneur does willingly. Perhaps the question is better rephrased: How much cash will M & G have to pay for the building, and how much of a loan they can get?

One of the most attractive attributes of commercial real estate is the ability to leverage (or encumber) the property. Historically, commercial banks have loaned (debt capital) up to 80 percent of the appraised value of the real property, depending on the quality of the tenant and in-place rental rates compared to current market rental rates.[6] So, if a commercial property is valued at $1 million, the acquirer would need a $200,000 down payment with the remainder of the purchase price provided by a bank loan.

The amount of leverage a commercial property can sustain is much greater than on a typical business balance sheet because real estate is tangible, stationary, and can be utilized in multiple contexts. High leverage is generally desired by commercial real estate owners because the greater the amount of leverage a real estate asset can sustain, the greater the return the entrepreneur will earn on his or her invested equity.[7]

Getting the Loan

M & G found that acquiring a loan on an owner-occupied commercial real property was fairly straightforward because they met the five main criteria that banks require:

  1. Loan-to-value ratio that does not exceed 80 percent.
  2. Debt-service-coverage ratio of at least 1.20x.
  3. History of the business’s profitable operating performance.
  4. Business’s stable and recurring cash flows.
  5. Guaranty or recourse clause from the borrower.

A bank loan will be secured by a first deed of trust on the real property, and thus a bank must be certain that the value of the property is sufficient to repay the loan. In the event that the investor defaults, the bank assumes control of the property and sells it to repay its loan.

Another important step in acquiring property is obtaining an appraised value sufficient to satisfy the bank’s requirement that the property be appropriately priced. Appraisers base the value of a commercial property on its rental value (i.e., the cash flows that the building provides to cover its operating costs, including debt service). A commercial building is only worth the value of what it provides its owners in cash flow no matter how pretty it is or how much it cost to build and the bank will base the loan amount on that value. For example, if the appraised value of a commercial property is $5 million, the bank’s lending standards might support a loan amount up to $4 million as long as the income stream of the property can service the mortgage payment.

Banks typically require debt service coverage of at least 1.20x, which allows a cushion in case the property’s net operating income (NOI) were to decline slightly. The debt-service-coverage ratio (DCR) is the ratio of the property’s NOI to the monthly mortgage payment. In an owner-occupied scenario, a decline in the DCR is usually directly related to the deterioration in the business’s performance; when the business’s operating performance begins to falter, the owner decreases the amount of rental expense to the level of the mortgage payment. That is one reason that banks generally require the entrepreneur to sign a personal guaranty for the amount of the loan granted.

Another Advantage: Asset Diversification

The addition of real estate to a typical “stock-and-bond” portfolio often provides a reduction in portfolio risk without the sacrifice of return. This is because of the negative correlation of returns between real estate investment and financial securities. The U.S. National Council of Real Estate Investment Fiduciaries (NCREIF), which calculates quarterly rates of return for all commercial properties based on NOI and changes in market value, studied the correlation of real estate, stocks, and bond returns from 1978 to 2006. The following table details the result of that study and shows that real estate returns over the period are negatively correlated with the S&P 500 and 10-year bonds.

Return Correlation* NCREIF Index
S&P 500 -0.0302
10-Year Bonds -0.1600

*Years 1978 to 2006 [8]

The combination of negatively correlated assets in a portfolio provides enhanced diversification of systematic risk and makes a portfolio more efficient it achieves a greater amount of return for the same level of risk. The graph below details the improvement in return of a stock-and-bond portfolio when real estate assets are added.

The red line represents a typical stock-and-bond portfolio’s efficient frontier espoused by Harry Markowitz, the father of efficient portfolio theory. When real estate assets are combined, the portfolio’s efficient frontier moves to the green curve representing lowered risk at each level of return. The improvement in the portfolio’s risk-adjusted return is due to the negative correlation between real estate and equity and debt securities.

The Creation of Value and Net Worth

There are many innovative and legal ways of creating and capturing value in property. M & G will find that as its business and its building mature they will want to do serious planning to assure that their investments, including their newly acquired building, continue to meet their needs. Clearly, the building will be a major asset on the balance sheets of both owners.

Hopefully, M & G will continue a successful growth track that assures the company can pay the individual owners a fair and increasing rent from the building’s strong cash flows. But M & G should also anticipate other needs, for example, they may want to monetize the equity value in their commercial property for personal uses (acquiring a second home, taking a three-month vacation in Europe, providing for a child’s education, or investing in outside investments) while keeping ownership control of their property. In the future, they may even want to sell the building and purchase others, or they may simply want to assure a revenue stream with no management problems. M & G might consider the following options for achieving those goals:

Sale-Leaseback Transaction

This is the process of selling a commercial property to a finance company and then continuing to lease the building for an extended period of time (a minimum of 5 to 10 years). This transaction is popular when the mortgage on the property has been amortized for a number of years and market activity has increased the value of the property.

The advantage of a sale-leaseback transaction is that it provides a large infusion of cash to the owner of the building while allowing the user of the building to continue leasing on appropriate terms. Such transactions typically contain a repurchase clause that allows the partners to buy the property at the end of the lease.

Cash-Out Refinance

This is simply re-leveraging the commercial property to optimal debt-to-equity (80 percent) and debt-service-coverage (1.20x) ratios. This strategy would allow M & G to get non-taxable cash from their building without having to sell it. However, it is likely that the new loan on the building will generate non-deductible interest depending how M & G use the funds received.

Rooftop Lease

If an owner cannot create additional space inside a building to lease, how about leasing the outside of the building? Parts of the building can be leased to cell phone companies for antenna space and to utility companies for the installation of solar panels. Roof leasing for solar panels has been gaining popularity because of government green initiatives and the tax subsidies that go along with it. Currently, solar energy for real estate is economically feasible because of tax subsidies that are slated to expire in 2016.[9]

Exchanging the Building for Like-Kind Property

It may be that a firm like M & G outgrows its space or decides that it wants to have additional buildings. U.S. Internal Revenue Code section 1031 provides the opportunity to do a tax-free exchange of a property for a like-kind property. Tax law is generous in defining like-kind in the case of real estate. For example, an exchange of a commercial building for an apartment house, or even raw land, usually can be structured to qualify as a tax-free exchange.

Donating the Property to a Charity

Some highly appreciated property may generate large taxes when sold. However, if the property is donated to a qualified charity, those taxes can be avoided, and the former owner will generate a tax deduction for his or her charitable contribution. Often, the charity will also arrange for an annuity of payments to the former owner, which will give him or her an income for a specified period of time.[10]

Over time, M & G will likely use one or more of the above strategies to create more wealth for themselves. It is also possible that their creative accountants and attorneys could find additional ways to meet M & G’s financial needs using the building.

Tax Preparation

The U.S. Internal Revenue Code defines rental real estate, regardless of the level of participation, as a passive business activity.[11] As such, real estate income and loss are treated differently on an individual’s tax return: While profits must be fully reported, losses may be limited in dollar amount. Rental income and loss are reported on the first page of Schedule E of an individual income tax return.

In general, passive losses can only offset passive gains: If an individual invests in a partnership that generates $5,000 in passive losses, he will need passive income of at least $5,000 from some other activity to be able to take those losses. However, real estate passive losses are subject to more kindly tax rules than other passive losses. Current tax laws allow an investor to deduct net rental losses of up to $25,000 per year, if two criteria are met:

  1. Minimum of 10 percent ownership in the real estate and
  2. Active participation in the property, which typically consists of approval of capital expenditures and tenants.

The $25,000 loss phases out based on income: For modified adjusted gross incomes (MAGI)[12] of $100,000 or less, the allowable net loss is $25,000; for MAGI above $150,000, the allowable net loss is zero; and for MAGI between $100,000 and $150,000, the $25,000 allowable loss is reduced by $1 for every extra $2 of adjusted gross income (e.g., a $110,000 MAGI allows for a deduction of $20,000 of net rental loss).

Any “unused” loss is carried forward until one of three conditions is met:

  1. The owner uses the carry-forward loss in a future year,
  2. The owner sells the property, in which case the untaken losses reduce the gain or increase the loss from the property, or
  3. The owner dies.

There are some exceptions to the passive-loss rules that bear notice. If an individual is designated as a real estate professional, he or she is allowed to have unlimited deductions. To be a real estate professional, the individual must spend a majority of his or her time in real property business,[13] thus meeting two critical requirements:

  1. The individual must work a minimum of 750 hours in the real estate industry annually and
  2. Number of hours in real estate has to be more than 50 percent of total hours worked in the year.[14]

It is possible to do very sophisticated tax planning with real property, taking expenses and income in the years when it is most advantageous for the owner. The ability to shift income between years is in itself a sufficient reason for the entrepreneur to purchase real property.

Conclusion

Owner-occupied commercial real estate provides an opportunity for large value creation in a variety of industries by providing an entrepreneur the ability to extract additional cash from his or her business in a way that is tax advantageous. A sophisticated entrepreneur can utilize real estate as a specialized vehicle to provide asset diversification, reduce tax liability, offset taxes from other investment sources, and provide the opportunity to leverage and acquire other assets. It is recommended that business owners work towards the goal of owning the real estate associated with their business and rent from themselves.

[1] A single-owner LLC is not required to file an LLC return for federal purposes. Instead, all of the income or loss is reported directly on his or her income tax return, as it would be in sole ownership of the property.

[2] California Revenue and Tax Code Sections 17941 and 17942.

[3] Richard A. Mann and Barry S. Roberts, Business Law and the Regulation of Business (5th. ed.), (Ohio: Thomson/South-Western, 2005).

[4] The nine states allowing community property are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In addition, Puerto Rico is a community property jurisdiction.

[5] The title is held in the name John and Martha Mays, husband and wife as community property, tenants in common with Jack and Jill Gomez, husband and wife as community property. In that way, should a spouse die, his or her surviving spouse would continue to own the property and would, under current law, get a step-up in basis on the property, leading to a lower capital gain at sale. (The estate planning aspects of this transaction are beyond the scope of this article.)

[6] The amount of leverage real property can sustain is directly related to the quality of the net operating income stream generated by the property as well as the variability in the historical occupancy rate. If the property can consistently attract high occupancy while charging market-average rental rates the demand for the property reduces the risk of owning the property. Lower risk levels contribute to the ability of the asset to sustain higher leverage. In owner-occupied scenarios, entrepreneurs need to be confident they can favorably forecast their company’s operating future, based on historic profitability and projected growth in demand.

In depressed economic environments, such as today’s commercial real estate market, an 80 percent loan-to-value ratio will not be advanced by a bank. Declines in commercial real estate assets happen rapidly and the result is a disconnect between sellers and buyers.  Sellers have acquired the properties at over-market values and have the potential of being “under water.” Buyers anticipate a continuing decline in the price of commercial real estate. As a consequence, sales do not take place in the market.

In addition, appraisers rely on current sales market activity to determine the capitalization rates that are used to value the cash flows from the commercial properties. If there is a lack of current sales activity, an appraiser has to use dated capitalization rates to value a property. The end result is a value that is not representative of the current market. Because of an appraiser’s inability to identify the true current market value of a commercial asset in a recessionary economy, along with the prospect of the declining performance of tenants, banks will advance less than a 60 percent loan-to-value ratio on performing commercial assets that have quality credit tenants.

[7] Of course, if real estate values decline, higher leverage means that a larger negative return will accrue to the owners of the real estate.

[8] William B. Brueggeman and Jeffrey Risher, Real Estate Finance & Investments (13th. ed.), (New York: McGraw-Hill/Irwin, 2008).

[9] Prologies, a REIT based in Denver that focuses on commercial warehouse real estate, recently signed an eight-year lease with Southern California Edison to lease the roof on one of its buildings, for example.

[10] The present value of any such payments received by the owner of the property will reduce the amount of his or her charitable contribution.

[11] U.S. Internal Revenue Code [Tax Information For Businesses].

[12] Modified Adjusted Gross Income is Adjusted Gross Income (the bottom number on the first page of the form 1040 tax return) minus taxable social security or railroad retirement benefits, deductions for IRA and pension contributions, deduction for half of self-employment tax, and certain other items of income and deduction that are more unusual. For details, please consult an accountant. CCH U.S. Master Tax Guide paragraph 2063 has a good summary of this information.

[13] Broadly defined, a real property trade or business is a business with respect to which real property is developed or redeveloped, constructed or reconstructed, acquired, converted, rented or leased, operated or managed, or brokered. Internal Revenue Code section 469(c)(7)(C).

[14] U.S. Internal Revenue Code [Tax Information For Businesses].

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