With the stock market somewhat volatile, many people are looking for ways to make more money outside “traditional” means.
Alternative investments like real estate, tax liens, private mortgages and others might be the way to go. You might even be able to enjoy a tax advantage with a self-directed IRA.
But are these investments right for you?
Kirk Chisholm of Innovative Advisory Group (http://www.innovativewealth.com) joins us to talk about some of the alternative investments his clients choose, and what you need to know before you risk your hard-earned cash on the next big trend.
[0:00:02] ANNOUNCER: Welcome to the Money Mastermind Show. Let’s Talk Money.
[0:00:18] GC: Welcome to the Money Mastermind Show. When we think of investing, we tend to think of your typical Wall Street. I think of the movie Trading Places where they were all in the floor, throwing tickets in the air, sell, buy, sell, buy and I think we tend to think of stocks generally as what we invest in but there are a number of things or alternatives to that, that we could be investing with and that’s what we’re going to discuss today. We have Kirk Chisholm of InnovativeWealth.com and he’s going to help talk about alternative investments. Welcome to our show Kirk.
[0:00:57] KC: Great, well thanks for having me on.
[0:00:59] GC: Thanks for being here. If anybody is out there watching live on our event page and you have any questions on alternative investments, please go to the event page and feel free to use the app there and ask us any questions. Also from the Money Mastermind Show we have Kyle Prevost of youngandthrifty.ca, Miranda Marquit of Planting Money Seeds, Peter Anderson of Bible Money Matters, Tom Drake of the Canadian Finance Blog. He is usually with us, he can’t make it tonight and I’m Glen Craig of Free from Broke.
Alternative investments, I’m sure that it is broad subject but there is probably a smaller handful of items that we would generally include in that. What type of things would be an alternative investment and where would we use these? I think would we put this in IRA or what would we use this for?
[0:02:00] KC: Well, I think the terminal return of investments in itself is a little hard to define. Recently, Wall Street has made this a trendy term. In the past, it was used to define hedge funds or private equity funds and now that 2008 happened and investors are deathly afraid of the stock market, Wall Street has seen that and taken advantage of it and many mutual funds call themselves alternative. I’m not sure why or how but they managed to do it.
I would characterize alternatives as non-traded securities. Anything outside of the stock market, the bond market, anything that’s traded you can look at it from the perspective of the investors as well. Some people might look at options as an alternative investment or NLP’s or business development companies because they’re not widely known. I would still consider all of those traditional assets or traded assets.
The alternative investments that I would characterize is things like physical real estate or tax liens, private mortgages, a private business perhaps. Anything that you can invest in without having to go to broker to buy it. I think that is probably the best definition I can come up with to define alternative investments.
[0:03:24] GC: Fair enough and I think the question maybe is the alternative to what? You’re saying that everybody is afraid of the stock market a little bit, so I guess it’s the alternative to that these days but you’ll never know how that alternative starts switching up and then the alternative to the alternative. And ends up you start investing in stocks again. The investments that you mentioned, they seemed a little heady for the average person. What type of people go into those types of investments?
[0:03:54] KC: Well, I think any alternative really it’s important for people to invest in what they know, as Peter Lynch said, “You shouldn’t just invest in an alternative because you read about it in an article or saw it on TV.” If you’re to invest in something like tax liens, they are very complex in rules but in my opinion, they’re also one of the best investments when you measure it from a risk to reward perspective, they’re easily one of my favorites but it’s not something you can go into lightly. It requires you to do your homework, it requires you to do reading, to actually understand the ins and outs of the process.
The thing with alternative investments are it’s not like you’re investing in a stock. You can’t just go to your local broker and click a button and buy a hundred chairs of Microsoft. You have to actually do the work. It’s just like buying a piece of real estate. Most people who have gone through the process of buying real estate before understanding it, it’s not easy. You have a lot of contracts to sign, you have to buy it from somebody, you have to find the property, you have to do due diligence, inspections and all of these different things. It’s a lot more work, but you also can find a lot better opportunities.
See, the downside of alternatives is many of them are illiquid, with the stock market, you can buy and sell right away. With a piece of real estate, it takes you a while to buy it, it takes you a while to sell it and if you do it right, that can work to your advantage because there are people who need to sell right away and will take lower prices. Liquidity can work both ways depending on which side of the coin you’re on.
[0:05:41] GC: That was exactly the question I was going to ask about it being liquid there because it seems like not only are some of these things, at least to me, they seem somewhat esoteric but I’m guessing that if you have to do so much research to get into, you’re not going to turn these things around very quickly unless you know the industry. Like you said, if you find opportunities where people are trying to get out of one thing and you can jump on that. For these kinds of investments, how does a person even start to get some sort of expertise in this? How do you find that and then get your head around it if you’re not part of the industry itself?
[0:06:19] KC: Assuming someone’s not working with a professional, we have actually developed a network of different investments that we can access for clients, but assuming that you are not working with a professional, I think it’s really important that people go with their strengths. If you have a background in real estate, you’re an agent or you’re a developer, real estate rehab or things like that, you should not be focused on investing in diamonds or investing in rare paintings. You should be focused on investing in real estate. And I think that’s the most important thing. This is true for the stock market as well. In the late 90’s everybody thought they were an expert in technology companies. Nobody had the foggiest clue, but everybody was making money so they just assumed that’s okay.
[0:07:05] GC: It’s just like the mid-odds, everybody thought that they can handle real estate too.
[0:07:10] KC: Right and there are plenty of people who should have not been anywhere near real estate that were owning five or six properties. I think it’s important for people to focus on the areas that they know, that they can get their head around and grasp. For instance, if you happen to live in a town and you know the local dry cleaner, they do very well but they’re looking to expand in a neighboring town. You know the person running the shop very well, you know the business reasonably well and he’s looking for capital. That might be reasonable investment to make.
If you know nothing about the business, you don’t know the person, somebody just said, “Hey, I need some money”, it’s probably not the best strategy. I think with any investment, the same rules hold true. You need to know what you’re investing in, you need to do your research. If you’re not going to do your research, then you shouldn’t invest in it. You should find someone else to do it for you.
[0:08:03] GC: Yeah, I think we’ve kind of touched on that in this show in various different ways. There’s no real shortcut to getting to that golden pot at the end of the rainbow. You really have to put the elbow grease into it no matter what you’re doing, right? What are the advantages to somebody? Let’s say I’m willing to put in the work, I’m willing to put in the research, I really want to learn about whatever this one particular alternative investment is, be it tax liens or a type of real estate, what are the advantages in investing in something like that over just keeping something in the market?
[0:08:41] KC: Well, I think…
[0:08:44] GC: And I’ll use air quotes “in the market” because that can really mean anything also.
[0:08:48] KC: I mean if you’re investing in let’s say tax liens for instance, one of the benefits is you do have predictable income streams. The reason why I like tax liens is actually for multiple reasons. Every single State in the US has it in their state legislation that they can sell their tax liens to investors, so every state has it.
[0:09:15] GC: If I could just interrupt just for a second, for our listeners out there, what exactly is a tax lien and how was that something that’s sellable?
[0:09:25] KC: Okay, thank you for correcting me. So what a tax lien is, is if you want a piece of property, you’ve probably encountered this before, presumably every quarter you pay your taxes. If you don’t pay your taxes, then you get assessed a late fee or an interest rate. Every state has a different interest rate. In my state, I believe it is 14%. I don’t know because I’m never been late for my taxes but every state has this. Not every state will sell their liens to investors but the legislation allows them to do this.
So let’s take a state like Florida and you’re probably asking yourself why would a state do this? A state like Florida is out with a 16% interest rate let’s say and around the time the taxes are due, there are a lot of people who own real estate in Florida that may live up north so they don’t pay their taxes on time necessarily but the municipalities in Florida need to run their operations. They need to pay people like police officers, they need to pay the people in City Hall, all these people require tax dollars to pay their salaries.
So what a state like Florida does where they have quite a large amount of people who don’t pay on time, the state could say, “Well, we’re going to take our 16% and wait a year,” but they need it now. So what they do is they actually will sell these liens to investors who will get that 16% and the municipalities will get their money right away. It’s a win-win for both sides. The tax payer’s paying anyway. and one of the best parts about the liens in a State like Florida is the people will actually collect the taxes for you. As an investor, you don’t have to worry about collecting the taxes. The municipality will collect the taxes and then pay you when they pay you off. It’s really a good situation for investors.
Now a process you have to go through to get the liens would be you actually have to go through an auction process. Some counties are online, some you actually have to show up in person and every state is different with their process but depending on the year, sometimes the liens are up in the 16% range. In a time period like 2007, they’re actually down to 25 basis points which is lowest allowable amount that you can bid for a lien. There is a process that you have to understand, but now that the technology has increased quite a bit, it allows investors to take advantage of these places without actually having to go to visit and because of things like Google Maps and other technology, people don’t actually have to show up at the property to check it out, they can look in various ways.
If somebody was to get into the tax lien investing process, then they can learn. There are a lot of resources available.
[0:12:33] KP: That is really interesting Kirk. I am not used to learning what new investing concepts on the show. I frankly had no idea that you can invest in tax liens. What sort of risk profile do these things carry though?
[0:12:45] KC: Well, this is actually the best part. If you own a piece of real estate in the US, you have a certain seniority of liens on a property. If you take out a mortgage on your property and you are the first mortgage, you have first right of collection. If they don’t pay their mortgage bill, you can foreclose and you will get back all of your money for what the property sells for. Any second mortgage will get second dibs on any remaining equity in there after.
Now above that surprisingly, if you don’t pay the IRS and they attach your house, they actually have seniority over any sort of mortgage and they are the most senior person on that list. After that becomes tax liens. So tax liens takes over the seniority over any mortgage. They take seniority over condo liens, which are actually next in the process. So tax liens and condo liens are above any sort of mortgage, which is interesting. Not a lot of places have the ability to do condo liens but those are also a nice source of investment if it’s possible but tax liens have the superior position.
So what many people will do is they’ll buy a tax lien, so a state like Florida for instance, you can bid for as low as 25 basis points interest per year on the note. But Florida has a minimum amount of 5% that they allow. So even if you bid 25 basis points in the first year, you will get 5% flat rate. There is some incentive for people to bid even lower than 5%. Now what typically will happen is if somebody wants to get paid right away, what they will do is they have a certain period of time that they can foreclose, so there are time limits.I think you have to wait two years before you can foreclose and within a certain period of time, you have to foreclose. So if you don’t, you lose your right too.
But what a lot of people would do is they will as soon as possible they will initiate foreclosure. They will notify the bank and the bank will pay them off because the bank is not going to lose their position to a $100 lien when the bank has a $200,000 mortgage.
[0:15:08] GC: Let me interrupt you just one second and I apologize to stop you there. So when you’re holding a lien, you’re holding somebody else’s — they didn’t pay taxes or whatever lien is put onto their home so they can’t basically get another type of loan without first paying that off, if I’m correct there right?
[0:15:27] KC: Right, so the lien holders and there are many different types of liens. There is also mechanics liens and other liens that go onto the property. If you have somebody fixing your roof, you don’t pay them. They typically put a contractors or a mechanics lien on your house. What that means is that you cannot sell your property without paying them off.
[0:15:47] GC: Right. I remember when I bought my home like they had to do a big check to make sure that there were no liens outstanding on it so this way that everything would go through. So as a lien holder, you can initiate a foreclosure on their home?
[0:16:01] KC: It depends on the legislation per state. You think of it this way. If you live in a state like Florida and you didn’t pay your taxes for two years, the municipality is going to foreclose on you at some point. They’re not going to sit on it forever. At some point, they will foreclose on it. Most states will do this. Like I said, every state has their guidelines for what they can and are willing to do but if they want, they can foreclose anyway.
Whether it’s the investor or the municipality, the home owner is not going to know because the investor doesn’t actually participate in the process except for the foreclosure procedures, which depending on the state, they may or may not have to be involved in. When it comes to the home owner, the investor is not putting them out in the street. This is something that would happen anyway.
[0:17:04] GC: They’ve already gone through the process of not paying something long enough that this is the expected consequence.
[0:17:11] KC: Correct, right.
[0:17:11] GC: This isn’t like a guy with a crooked nose coming over to you as a lone shark going to you, “I just bought your loan, now you owe me everything,” like that feel, right? “Now, I own you, instead of Vinnie down there now it’s me that you owe everything to,” right?
[0:17:29] KC: States are very careful to protect the home owners as well. I mean not every state will sell their liens. The state like Massachusetts is where I live, I found it very hard to actually find a lien to purchase and they’re usually on pieces of property that nobody would ever want to own for any reason whatsoever. So it’s very challenging and I don’t want to speak poorly about my state but I think they have the friends and family plan for the lien auction business.
Some states, there are quite a few like Florida, Colorado and in some states, there are so many that it’s full access. There are websites you can go to that will show you past auctions and what they’ve gone for but in the grand scheme of things, it’s a process. The state does want to protect the home owners but that’s one of the reasons why they manage it as well, which makes it so much easier for investors.
[0:18:32] GC: I imagine just even like buying a home as an investment property, it really depends on where you’re living and what state you’re in because different laws apply better to the owners than they do to the people who are living there so yeah, you really have to do your research as to where you’re buying it then.
[0:18:55] KC: Right and I’ll mention a little known fact that there used to be six large US banks that own 200 to $300 million dollars in these liens. JP Morgan actually recently got out in the last two years. Apparently, they didn’t want to be seen in the front page of the paper foreclosing on granny’s home. But to my knowledge, five other big banks do own enormous portfolios of these liens because they understand that they are getting a good yield with relatively low risk.
I met one of these people who managed these properties and when JP Morgan got out, he actually called me up and said, “Hey, I want to start running a portfolio like this,” and I said, “What experience do you have?” He said, “Feet on the ground,” like yeah, I know but that doesn’t equate to running a portfolio. It’s a totally different skill set. But here is the guy for the right person that would have been a perfect data on for somebody who wants to run a portfolio of $200 million.
I think in general it’s one of my favorite asset classes and from a portfolio perspective, there are very few people who actually managing tax lien portfolios. We’ve considered doing that ourselves but the logistics are extremely complicated. There are a lot of $100 price range liens so you could probably go to Florida any day of the week and find a hundred dollar lien for 16%. If they don’t get auctioned off, they will pretty much — they will give them to you for 16%.
[0:20:39] GC: So a lay person could get their fee with a relatively lower cost maybe low risk type of — like if it was a hundred bucks, and nobody wants to lose a hundred bucks but like what type of — I mean you floated a number before, something like $250 million. I think most of us aren’t really going to touch that range. If I did, I would have a whole bunch of different…
[0:21:05] MM: You wouldn’t be doing this right?
[0:21:06] GC: Maybe but right, we would have a whole bunch of different problems to deal with. For a person, is that something that then that can be an entry point for them or?
[0:21:21] KC: I think there are a lot of alternative investments such as private mortgages or real estate which are very challenging for people to get introduction to without taking a lot of risk. Tax liens is also one of those areas where it is very easy to get involved with, with a very little amount of money. You could contact the municipality, look through the liens and say, “I want this hundred lien”, you give them a $100 and they give you the rights to the lien.
From my perspective, that is a very easy entrée, a low risk way for most people to get into the tax lien investing business. So if they lose $100, it’s not the end of the world. I know people that will buy quite a number of $100 liens because they’re paying 16% and they’ll do virtually no due diligence on the property. So if they happen to find a piece of swamp land, they’re okay with that because out of all the liens, they’re losing one, they’re getting 16%, it’s the cost to doing business.
[0:22:25] GC: Like if you get enough of them maybe you mitigate the risk amongst all the different loans?
[0:22:30] KC: Correct, diversification effectively. It does work from that perspective and quite frankly even if you’re investing in a number of liens, your biggest risk is if you do foreclose. If you’re doing this in a grand scale, approximately 5% of the liens you will be able to foreclose on actually on the property. You could own a $100,000 property for a $100 in 5% of the cases.
Now, I’m not suggesting that that’s going to happen all that often but that’s statistically is what the odds say. You could make a lot of money, the down side to that is, if you foreclose and you don’t realize that it’s on a toxic waste dump, then that would be an issue but the worst case scenario is, you foreclose, spend a little money. Instead of a $100, maybe spend $500 or $1,000 on attorneys and you own it but if you find that out, you can easily just not pay the taxes and someone else will buy that lien.
[0:23:34] KP: Wow.
[0:23:36] GC: It’s interesting, you meant this and it sounds so interesting but like I think you said in the beginning of the show, you really do need to know what you’re doing. This isn’t something to play around with in your spare time in the hopes to get rich.
[0:23:51] KC: This is not a get rich quick scheme by any means. You need to do your homework. There are a few books written about this, there are people who specialize in this, it’s really a great thing for people to break their teeth on with a small amount of money but in general, like any alternative investment, you need to know what you’re investing in. If you want to gain with your money, go to the casino. It’s easier, at least you’ll get some free drinks.
[0:24:21] PA: Talking about diversifying earlier, really is that part of the draw to alternative investments, is that you’re diversifying against stocks. And bonds and normally what people buy in the stock market, you’re maybe buying some assets that aren’t necessarily as closely tied to the rise and the fall of the stock market?
[0:24:43] KC: That is actually a great point. If you look at some of the top of some of the Ivy League Universities in US, you will realize that over 50% of their assets are invested in alternative investments and that amount is actually increasing. The reason is, is because, just like you stated, that diversification is an important tool. We actually did a study back about seven or eight years ago about correlations in the stock-bond market, publicly traded markets you could say and what we found is very interesting.
What we found is that when stock markets — and when I say stock markets, I mean stock market, bond market, any sort of publicly traded markets. When they go up everything, you know, diversification is important because you’ll never know what’s going to do best. So you moderate your return and you find an equilibrium in many different markets. But when the markets crash, they all crash together. The correlations become really close.
Diversification within the publicly traded markets are not actually doing you much good. There are times where it does help. In 2008, if you look at the numbers and we’d looked at commodities, stocks, withstanding treasuries, gold and cash, you are more or less down around 38.5% give or take 5% in 2008. It’s crazy and that should not happen, but apparently within their markets, that tends to happen in other periods of time as well. A lot of people are comfortable in the fact that they’re diversified but they’re not as protected as they believe that they are.
[0:26:29] MM: Right so that — oh sorry. I was going to say that kind of goes back to, I’ve talked to a few hard core people that say that modern portfolio is dead and if you’re just doing stocks and bonds are not truly diversified. Would you stand on that or like where are you at there?
[0:26:45] KC: I think if you look prior to 2000, there are a lot of studies done and they show certain things. Modern portfolio theory, we ascribe to that to some degree. I think in a large part that that is true. Unfortunately, another study that we’ve done which we haven’t published yet is even more interesting. If you want to know why the correlations have become so close, it’s a lot more interesting. The reason is, is it’s because institutions get into a market, they’re the ones that correlate it.
So stocks, bonds, anything publicly traded, institutions are in those markets so those are correlated. Real estate, a lot of the large pension funds and institutions and endowments started investing in real estate in the mid-2000’s. All of a sudden, real estate became highly correlated with everything else, that also includes timberland. So back in early 2000-2001, a read a study that timberland had a correlation to all publicly traded markets so close to zero, it’s negative .02 which is as close to zero as I’ve ever seen.
Now, timberland is highly correlated to the stock market. It should have absolutely no bearing on it but yet it does because institutional money flows push the markets where the institutions want it to go. This has happened with Manage Futures in 2003, they’re almost non-existent. They were probably the best non-correlated asset you could find in terms of how they worked because it was a traded portfolio. They were just trading and wasn’t buying whole. They were a great asset and a lot of institutions started putting money there and now, they’re also highly correlated. The culprit of all these is institutional money flow and they’re the ones that cause it to be correlated.
[0:28:44] GC: Now again just definition wise for those out there who maybe this is getting a little heady for them. I think I could follow what you’re saying here, but what do you mean by the institutions? Are you talking about the big banks and brokerage houses?
[0:28:57] MM: Like college funds and pensions?
[0:29:01] KC: Yeah, pension funds like CalPERS, Harvard University, Yale University, endowments, large institutional managers like hedge funds. People who are managing billions and billions of dollars, those are the people who can push a market at a click of a button because they have a huge amount of money to place.
I mean CalPERS is a perfect example. They invested at real estate at the peak of the market and at the bottom of their market they pulled out and they moved so slowly because they have so much money but if they want to get into an asset class, they’re going to get it because for allocation purposes, or however they see best fits what they’re doing.
What a lot of people don’t realize is money flows is one of the more important aspects of how investments perform. If you could look at the Federal Reserve’s effective quantitative easing, that has pushed money flows into stocks. All the big institutions or many of them were pushing money into stocks which of course, pushes the stock market up.
It’s not always just what with companies are growing then their stock price should go up. We are now more influenced by institutional money flows than any sort of rational thought which is unfortunate but that seems to be the trend.
[0:30:31] GC: The market theory itself is being [inaudible] by the fact that it’s not really the pure market that’s driving it. It’s these other factors that have so much money in there that when they act, it moves the market more than should be natural maybe.
[0:30:48] KC: Correct. If you look at it right now, many markets around the world are dropping. Emerging markets, Europe, bond markets in these countries as well, they’re all dropping for many different reasons and the US economy is doing well but yet it’s highly priced. One of the reasons that it is highly priced is because all of these international investors are looking for, “Where is my money safe?” Well right now, it is safe in the US.
But if you looked back in August about a month ago when the US markets crashed, if you look at what did well, it was the German bond and the Yen that did really well during that time period. What that tells me is people from those countries pulled their money out of the US and brought it back home. So you see a lot of international investors pulling their money out, that’s really going to be, in my opinion, one of the triggers for the US to perform more poorly. It’s not because our economy is doing well, our economy is doing fine but as I said many times in the past that the economy is not the stock market. I don’t think that a lot of people realize that.
[0:32:05] KP: What I’ve read a lot about this Kirk and the correlation, like you hinted at, was relatively reason between a lot of these liquid asset classes, a lot of the people that I read were speculating that, a lot of these guys that are pushing these money or these billion dollar guys. When they’re losing money in one asset class either on a margin call or to cover their loses and keep cash flow consistent, they often have to sell things that have no adhering to fundamental weaknesses and that’s why a lot of these things are correlating. Do you have any insights on that or they are full of crap basically?
[0:32:38] KC: That is actually a great point and I actually believe that to be 100% true. If you look at 2008, that is a perfect example of this. In 2008, the banks effectively were, I don’t want to call them insolvent, but they were effectively insolvent and they held a lot of assets. And the hedge funds as well, they held a lot of assets. But what happened was the liquidity of the markets froze up which means that there wasn’t a lot of money to buy. Everybody was stuck, a lot of people were stuck in assets or leveraged assets.
So if you own an illiquid asset and the market is dropping, you need to get out or around the time at the end of September, hedge funds, that’s when they have had calls. That’s when investors pulled their money out. If they need to pull their money out, these people need to raise for capital but what are they going to sell? Are they going to sell a position that is liquid, that is easy to liquidate and they can actually make money on it or are they going to sell a poor position that will take them five weeks to get out of without pushing the stock price?
What ends up happening is they sell their good positions instead of their poor ones. Then it brings everything down to the same degree. That comes back to the same argument of money flows. It’s not necessarily a rational thought, it’s correlated because of the money flows, not necessarily because they’re bad investments. In 2008, there are a lot of great buys you could have had not because they were bad stocks but because people mean to dump them because they needed cash and no one had cash.
[0:34:17] GC: It’s really, really interesting in talking to you and listening to this because like you said, the market isn’t the economy and I think we watch the news and you hear all this unsteadiness about the market. But then you hear about companies that are making record profits and it’s hard to get your head around how that’s possible. How could the market be kind of wishy-washy when Apple is selling a quadrillion iPhones over the weekend? But the way you’re talking, you get a fundamental feel for how the market is really influenced and it is very interesting how finicky it could be.
[0:35:01] KC: I think there’s one point I’ll make because I think you’ve kind of eluded to another point. Right now, entry trades are effectively at zero around the world. If you’re investing in bonds you’re making no money. A lot of these investors feel they need to make money and this goes back to a more elaborate concept, which I won’t get into now, but a lot of this is all based around the theory of inflation.
For the last 60 years, people have assumed that inflation was the norm. If you go prior to 1950, inflation-deflation were natural forces. They came and they went and they balanced out the markets. We haven’t had deflation for a long time so people forget about it. They forget what it feels like. But what people assume is that they need to make a return in order to outpace inflation but we don’t have very much inflation right now.
People still have this psychological thing built into them that they feel they need to beat inflation. If you have zero percent interest rates. If you’re not making money, you’ll feel like you’re losing in the long term. So they feel like they need to take more risk. They need to buy dividend stocks that are paying more than a zero. They’ll but something paying a 1% dividend which is really not great but they’ll chase yields, they’ll chase anything they can.
So I think it was a year ago high yield bonds reached the lowest yield they ever reached. It was around 5%. Historically speaking, high yield bonds default at 7% and you’re getting 5% a year. It’s ridiculous! You’re effectively loosing 2% over long periods of time and that assumes you’re not going to have a big crash in the high yield bond market, which a lot of people suspect.
[0:36:56] GC: It’s crazy that you say high yield bonds at 5% when I remember it wasn’t long ago that my savings account gave 5%.
[0:37:04] MM: Yeah, I remember those days. Those days are long gone.
[0:37:07] KP: I actually don’t remember those days.
[0:37:10] GC: I’m a little older than you Kyle but it wasn’t that much long, that wasn’t that far ago. Can you tell us something about self-directed IRA’s and how those can be beneficial?
[0:37:23] KC: The term self-directed RIA doesn’t actually have legitimate meaning, which is interesting, but people use it.
[0:37:32] GC: Like we’re really just going off of that.
[0:37:35] MM: It’s sort of what they call a spousal RIA right? It doesn’t have a real meaning.
[0:37:42] KC: No.
[0:37:43] MM: RIA that your spouse contributes to.
[0:37:47] KC: If you look in the tax code, there is no word self-directed RIA and technically, every RIA is self-directed. If you go back to the basics, that’s really what an RIA is. It’s something that you’re directing yourself. The term self-directed RIA, I don’t know when it was actually coined, but I believe it to be probably about 20 years ago and they use it to define an RIA that will hold non-publicly traded securities. So if you wanted to own a horse in your RIA or a piece of real estate or tax liens or gold or whatever you might want to own.
[0:38:31] GC: Baseball cards?
[0:38:32] KC: You cannot own baseball cards. You could potentially own a company that trades and invest in baseball cards but baseball cards are considered a collectible. There are a few things that you cannot invest in inside of a self-directed RIA. One is collectibles, which includes wines, certain coins, baseball cards and things like that. You cannot invest in life insurance on yourself or an escort. Virtually, anything else you can invest in.
People get very creative around this but what it really does is it allows investors to invest in what they know. A perfect example is real estate investors. If you ever met one, you know all they want to own is real estate. Every nickel they earn goes back into real estate, they do not believe in anything else. If you tell them they have to put money in a mutual fund, they want to strangle you. They hate that and many of them will not even contribute to their IRA or 401(k) because they don’t want it going into something else. So really it benefits people to understand that they can do these things because they can truly invest in what they know and not have to put money away into investments that they’re not familiar with.
[0:39:49] MM: Pretty much like you said, the only things you can’t put in your RIA are like you said collectibles, life insurance and then they’re even in some derivative positions but almost anything else you can and you eluded to the fact that some coins you can’t hold in your RIA?
[0:40:11] KC: There are certain sovereign coins which are allowed to be held if they’re printed by the sovereign and they are gold, silver or certain materials. Those can be held inside of a retirement plan, an IFA or a 401(k) but not all of them. The IRS clearly outlines which ones are allowed and the purities and there’s a lengthy thing but if you wanted to invest in a collectible coin or a rare coin, you couldn’t do that.
[0:40:45] GC: Very, very interesting and what are the advantages of putting it in this self-directed IRA? You said something about I could put a race horse in there.
[0:40:54] KC: We actually have a client who has a farm and he trains dressage horses. If you’re like everybody else and you don’t know what a dressage horse is, I didn’t know it prior to this either.
[0:41:10] GC: They sound expensive.
[0:41:11] KC: They are. You can ask George Soros about what dressage horses are. They are effectively horses that dance. They compete but they’re dancing horses.
[0:41:23] MM: The Romney’s have one.
[0:41:24] KC: I’ll bet they do.
[0:41:27] MM: I remember this from the campaign and she was talking about the horse, okay go on.
[0:41:36] GC: They might be a part of the reason why people might have said he was a little out of touch with the people.
[0:41:40] MM: I can’t imagine.
[0:41:41] KC: It wasn’t because he left the dog on top of the car?
[0:41:50] MM: Anyway, sorry. I’m sorry I interrupted your awesome explanation of how you keep your Dressage Horse in your IRA so let’s go.
[0:41:58] KC: Alright. What this person did was he buys horses from Europe and he brings them over, and he trains them and he sells them to people like George Soros type and he makes a very good return on doing that. He did that within his Roth IRA. He made a 100% plus returns in a Roth IRA, which is effectively tax-free for him.
Believe it or not, you mentioned Mitt Romney, he has a $100 million IRA because of tactics just like this. Not because he’s a great investor but because he had some great investment scenarios that he knew well and they happen to do really well. If you’re investing in investments that are getting you 10% per year, you will probably not get to a $100 million. But if you’re doing certain things like this individual who’s investing horses, he’s getting a 100% return on investment. I’ve seen many people make many thousands for that return of investments but they are investments that they know.
For instance, if they wanted to flip a piece of real estate, I will give you one creative little tidbit for you. Some people flip properties. They will find a good deal, they’ll lock it up for $100 or $1,000 and they’ll flip it to somebody for $10,000 or $20,000 and make a quick profit. A lot of people do this. However, let’s say you decided to do that in your Roth IRA. You just turned a $1,000 into $10,000 and you did that maybe within a month’s time. That’s a pretty good return for a short period of time and not to say that you could do every week but you don’t have to do that too many times to get a decent return of your money.
So there are many creative ways that you can use your self-directed IRA to continue to make good returns on your tax deferred or tax free money. The best part I like about working with self-directed IRA’s is not only the creativity that you can use to keep this money sheltered and to get good returns, but more importantly, we see some incredible investments out there that I’m astounded constantly by things that people bring to us that are just absolutely amazing.
[0:44:21] MM: If you’re going to use this technique, you can’t go to your bank for the most part and just open it up because most of them have specific custodial guidelines, isn’t that right? You have to go to a specialist to be able to do this?
[0:44:36] KC: So what is required, what the IRS requires for an RIA or a 401(k) is a qualified custodian. Now, they have a very specific definition of this but if you go to your local broker dealer like Fidelity or TD Ameritrade or E-Trade or Schwab, they are custodians, they could invest, they could help you with this. However, they have chosen not to for the most part. They’ve chosen to specialize in publicly traded securities.
You not only have to find a qualified custodian but you have to find one that actually can and wants to do these types of investments. Quite frankly, even if one of those brokers did want your business, I wouldn’t use them because they’re not equipped to deal with this. It’s more complicated than most people realize to deal with this on the custodian side. We’ve actually compiled a list of all of the self-directed IRA custodians and administrators that are legitimate that people can choose from.
We’ve put together a number of resources to help people out to do due diligence on them but there are many things that people have to consider. One is the fees, these are not fees as you would expect from one of these other broker dealers. They’re not $10 a trade. They, in some cases, charge per transaction, they might charge for wire transfer or they might even charge a percentage of assets that they manage. They have different fee structures based on the type of business that they’re writing custody for. Fees are an important part of the equation.
One of the more important parts of the equation is service. Some of these custodians are quite large and their service is not good. You might have problems and if you’re trying to buy a piece of real estate, you need somebody who’s on the ball. You need somebody who’s going to assign the documents, make sure they are done properly and get the ball rolling so you can meet your deadlines. If they drop the ball and lose paperwork and don’t get back to you and all these things happen, you could lose a deal.
So it’s very important when you’re working with a custodian or administrator, you need to make sure that they’re doing it properly and they provide really good customer service. That is a very important part of this process and that’s not something you can usually quantify. What they put on their marketing materials is not going to show up. You really have to have insider knowledge of whose good and who’s not.
Those are the more important factors that people have to consider and some of these factors will depend on what kind of business you do. If you’re buying one piece of real estate and you’re never going to sell it, then it doesn’t matter what the transaction fees are. You can look for custodians where you can find at a cheaper cost but if you’re turning over investments every week, you really don’t want to pay transaction cost because that will get very expensive. You want to make sure that the custodian you find is suitable for your needs, for what type of investments you’re trying to pursue.
[0:47:47] GC: Now, I’d imagine when you are using a self-directed IRA there are some limits on what you can do with the money, if you are selling an investment or moving it around?
[0:47:59] KC: You have to understand generally how it’s structured. You have to look at your IRA from a different lens. You have to look at your IRA as if it’s the neighbor on your street that you really hate. You wouldn’t lend that person money, you wouldn’t fix their roof for free and you have to look at it as a third party. You cannot do business with your IRA.
For instance, if you own real estate in your IRA, you can’t go fix the toilet, you can’t go fix the roof, you can’t take rent money and put it in your pocket and actually, the IRA owns the real estate. You don’t even do the transaction. The custodian actually will sign on all the documents not you because it’s not you and effectively, the IRA is like its own person.
[0:48:51] GC: It’s almost like a trust almost sounding.
[0:48:54] KC: Well IRA’s technically our trust, although nobody refers to them that way, they are technically a trust. You have to look at it as a completely separate type of entity in transaction. If you look at it that way, you’ll be fine and a lot of people get into trouble because they think that they can either outsmart the IRS or they’ve found a loophole.
Believe me, there are no loopholes. A lot of people come up with what they call a “Checkbook LLC IRA” which is a very commonly used term in some coordinators out there trying to sell that as, “Hey, we’re create an LLC for you and you can use it.” And people think they can somehow circumvent the rules of the IRS. The rules don’t differ because you have an LLC. All it means is it’s harder for people to see what you’re investing in and it makes it a little bit easier in some ways to do business but it doesn’t give you the right to break the rules.
People think they can beat the IRS. They can’t and we’ve seen so many instances where they — I’ll give you an example; there was a guy with an engineering background. He was investing in bus shelters and this guy knew the rules inside and out. He was very focused on the rules, not breaking them and he did everything right. This guy made a lot of money inside of his IRA and he had to use a qualified custodian. Well apparently, the person who said he was using said were qualified custodian, in actuality they weren’t.
The IRS when they found this person, they went through this guy’s client list and said, “Oh, look at all these people who think are using a qualified custodian”. Of course, the IRS has no qualms going after people even though they are innocent. They went after each single person and they contacted them and said, “You’ve created a prohibited transaction. You owe taxes as full distribution on this date,” and they don’t find you right away because if they find you right away, you can correct it. They find you six years later.
So that is six years of interest and penalties compounded overtime. This person virtually lost his entire IRA because of something he had no control over and didn’t deliberately do. Fortunately, the judge took pity on him and gave him a onetime transfer of money into his Roth IRA but it was a travesty. I think people have to really be weary that they are following the rules to the tee because it’s not the right away issues. It’s the down the road issues that hurt you.
[0:51:31] MM: Alright, so how do you find a qualified — how do you make sure your custodian is qualified because it sounds like this guy pick the wrong person to trust. How do you find that qualified custodian?
[0:51:43] KC: So we’ve classified these vendors if you will in different categories. There are qualified custodians and you can find these people. Many of them are registered and most of them are non-depository banks and we’ve created a list on our site that we update consistently and they’re not that many. I think there’s 22 of them out there. There are other ones that may do it but generally don’t want the business but if you went to your local bank, they would qualify. They may not want the business but a bank would qualify as a qualified custodian.
There are administrators. These are people who, if you’ve ever had a 401(k) plan, they are what you would call a TPA, a third party administrator and they would administer the plan and deal with certain tax issues and things like that. There are people like that and they would administer your IRA for you and what they would do is, they are not qualified custodians. They would find a bank or trust company and they will set up accounts and they will administer the process.
They could go to wherever your local bank is and they could set up an account and they would administer it and act as, you know, it would be as if you went to TD Ameritrade and somebody is administering the account for you. That would qualify. They are administrators that are legitimate out there and I think there’s probably about 22 of them as well. They will help you and they have track records and they’ve been around for a while.
There are also people who refer to themselves as facilitators and this is a confusing category for people. I’ll actually label two other categories to you so it’s clear. There is also investment sponsors. These are people who sell product like they try to sell you some investment product of sorts and then there are licensed professionals. The facilitator category are people who don’t really fall in a category. They are trying to sell you something. They might be an investment sponsor trying to sell you a product, they might be trying to sell you an LLC or some sort of arrangement but they really don’t provide much value. It doesn’t mean that you shouldn’t work with them or they’re bad people but they’re not really required. You don’t need them.
And so we kind of refer to them as coordinators. They’re there to help people but you don’t need to use them. It’s an extra cost. The problem is, is that the industry itself is not well regulated and there’s not a lot of oversight. The qualified custodians do have oversight. They have oversight from OCC or the state banking regulations or other sorts. All of them have some sort of oversight. The administrators, some of them have oversight and some do not. Facilitators have no oversight and then there’s licensed professionals like myself, there are CPA’s and attorneys who also specialize in this area and they have some oversight.
There are some people who fall under this miscellaneous category and they might be good people, they might provide value but I think that’s the category that people have to be weary of because many of those people do not make clear on who they are and what they do. While some of them might be okay, people have to be really careful because there’s a lot of misleading advertising out there that say, “Hey you can invest real estate in your IRA and make X amount of returns,” and really they’re trying to sell you some real estate property they have that they’re trying to get rid of. That happens a lot and there’s a lot of bad players and every once in a while, we see somebody gets caught for doing something that they probably shouldn’t have done. So really people have to exercise a good bit of caution when they’re investing in this.
[0:55:57] GC: It sounds like you not only need to do your homework in the investments themselves but depending on what you’re going to do with that investment, you might have to really do a lot of homework on the broker as well.
[0:56:07] KC: Yeah, I mean the custodians — and we’ve done a lot of this due diligence. We actually are creating a thick report on each one because we have experience so people can actually figure this stuff out. We’ll have pretty thorough nature on some of them but to some degree, even some of the legitimate ones sometimes things happen and for instance, one of the larger ones a few months ago got implicated by the SCC for fraud.
Now they weren’t committing the fraud, it was one of the investment sponsors that was involved with them selling product to people. They were committing the fraud but the SCC doesn’t care. They said, “Well, you hosted the asset so you’re in trouble”. I don’t know if they’ll ultimately be in trouble because I don’t think they did anything seriously wrong but frauds happen because people see, “Hey, you can use your IRA money,” and they sell people on a dream. And there is no oversight. And then all of a sudden, they think, “Oh, I’ve got this great idea why invest in stock market?”
And there is a good amount of fraud that happens. The SCC has put out a notice a number years back of steps that people can do to be careful and to actually prevent these things from happening. I think there are steps people can take. I found that if people are actually using a licensed professional, they will protect themselves from a lot of problems. In many cases, you actually need one. You need an attorney to do you some sort of legal documents with the transaction. So I think it’s in people’s best interest to, at least initially, some people are experts and they can do it themselves but at least initially they should use some licensed professional that they know does it.
So if you’re in a small town and you have a local attorney or accountant, I can guess that’s the majority of people are going to have no knowledge of how to do this or how it works. There’s only a small percentage of people who specialize in this in those different fields because there aren’t that many people doing these transactions so there’s no reason for people to know the rules inside and out. But there are people who specialize. In each state, there are attorneys and accountants in each state that do this. There are ways to find these people and we’ll probably work on that as our next project as well as putting together a big list of those people.
[0:58:39] GC: Kirk, you’ve certainly dropped a lot of information on us. I know my head is spinning a little bit but at the same time, it is nice to know that there are some real alternatives out there that aren’t these blocky obscure things but there’s really things that if I wanted to get into and get my head around, it could open up a whole new world of opportunity for.
One thing we do in the Money Mastermind Show is at the end of the show, we sum up everything with a final word. We’ll go around and take everybody’s opinion here. So Peter, what’s your final word on alternative investments?
[0:59:16] PA: Well, my final word is that we always talk about diversifying when we’re investing in stocks and bonds and so forth but this something that I honestly hadn’t really thought about a lot. It sounds like this could be a good way to diversify even further across different types of assets and managing the risk even further and assets that aren’t necessarily as correlated or tied to the stock market.
So you definitely do your due diligence and make sure you’re sitting down and evaluating these investments and make sure they’re suitable for you. That they are something that you understand and figure out. You’re not just investing in the first thing that somebody brings to you after church on Sunday or something like that but it does seem like it could be a definitely very good thing.
[1:00:13] GC: Miranda, what’s your final word on alternative investments?
[1:00:16] MM: I don’t know, dido Peter?
[1:00:19] PA: I’m sorry but I am…
[1:00:19] MM: Okay, I’ll just echo that. Make sure you know what you’re investing in. It goes just beyond due diligence. It goes back to what Kirk was talking about earlier when he said that you need to understand what you’re investing in. One of the reasons why I am such a big indexer is because I’m so lazy and I don’t take the time to learn about these things and really get into it so I index. But if you’re going to do this, then yeah.
Make sure it’s something that you truly understand so that you can move forward and feel a little more confident and you don’t get taken advantage of and that you can follow up on whoever is advising you because even though, yeah you have an adviser for a reason, at the same time it’s sort of like my tax accountant. I usually double check what he’s done and obviously, he knows more about it than I do but I still look it over just to make sure because you really do have to. It’s like Larry Ludwig always says, “Nobody is going to take care of your money like you do so make sure to pay attention.”
[1:01:25] GC: Yeah, this has definitely been an interesting lens into what maybe the wealthy do to increase their wealth. A lot of people think it’s really about stocks and bonds and maybe some real estate but there seems to be this whole other world out there that people invested and use as a means for building wealth. So thank you so much Kirk for helping us there. What is your final word on alternative investments?
[1:01:54] KC: I guess I would say that, as I have mentioned before, one of the most important things is knowing what you’re investing in. So doing due diligence on any investment. It doesn’t matter if it’s alternative or traditional, due diligence is important. If you don’t know how to do due diligence properly, find someone who does or read.
There’s one thing that I think a lot of people miss. They think that they have money so they need to invest it right now. Cash is a position. There’s nothing wrong with keeping cash. If you don’t have anything to invest in, keep it in cash. It’s like the casino. If you show up with $1,000 in your wallet, it doesn’t mean you have to gamble with it. It’s the same thing with investing. Take your time, do your proper due diligence. We do a lot of risk management, which can be combined with due diligence and a factor is finding ways to reduce risk in a portfolio.
So if you own a stock, you can use options to mitigate your risk, which is what they’re truly intended for although a lot of people don’t use it that way. But in other ways, you can manage risk buying insurance on a property or finding ways to reduce the risk of your investment. That is also an important factor and I think if anybody is getting into a new area, they need to figure all those things out and if nothing else even for the first time, use someone who knows what they’re doing because there are a lot of complicated areas that people need to understand like tax liens. Don’t start big, start small. Just figure it out and then once you understand it well, then you could put more money into it.
I will make one final interesting point because you all have your own blogs and I think this is one of the more interesting things that we have come up recently. Another interesting alternative investment is, you can invest in URL’s for affiliate sites in your IRA or a 401(k). So if you ever think of starting up…
[1:04:01] MM: Well all like, “Hmmm, there’s more points in our IRA’s.”
[1:04:05] KC: Yes. If you start an affiliate site, you could use retirement accounts to shelter that income. You can be very creative and like I said, it goes back to investing in what you know.
[1:04:18] GC: Very, very interesting. I think you kind of popped some brain cells in all of us there. Definitely in mine, at least a little bit.
[1:04:27] KC: Saved that to the end.
[1:04:31] GC: Thank you again Kirk. I really appreciate you bringing your knowledge both to us and to our viewers and listeners. For those out there that may not be familiar with you and the work that you do, can you please tell them a little bit about what you do and about Innovativewealth.com?
[1:04:48] KC: Sure. Once again, my name is Kirk Chisholm. I’m a principal and wealth manager at Innovative Adviser Group. The website is Innovativewealth.com. As wealth managers, we manage money for people. We provide financial planning services and other ancillary wealth management services for people that need them. We are very unique as you can tell working with alternatives and self-directed IRA’s but one of the most important things that we find in what we do is risk management which I think is an overlooked skill set with many in the wealth management profession.
[1:05:31] GC: Excellent. Thank you again Kirk and thank you everybody out there for listening and watching and until next week, be good with your money. Good night.
[END OF MASTERMIND]
[ANNOUNCER] Thanks for joining us on the Money Mastermind Show, get more information at Moneymastermindshow.com. Don’t forget to subscribe to the show on iTunes and YouTube and follow us on Google Plus.
Important issues discussed in this episode:
- What are some alternative investments that are easy to understand?
- Practical ways to include alternative investments in your portfolio.
- What is a self-directed IRA, and what can you keep in it?
- Risks to be aware of before you invest in non-traditional assets.
Panelists In This Episode:
- Special Guest: Kirk Chisholm | Innovative Advisory Group
- Glen Craig | Free From Broke
- Kyle Prevost | Young and Thrifty
- Miranda Marquit | Planting Money Seeds
- Peter Anderson | Bible Money Matters
- Tom Drake | Canadian Finance Blog
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