With the stock market hitting new all-time highs, it is natural that many investors are getting a little nervous. There is considerable wisdom in ignoring the short-term thinking in markets, and regardless of where the Dow is now, it will probably be higher in 10 years time. Still, all of that is little comfort to an investor if the market has a correction later this year.
With that in mind, investors should be looking at alternatives. Alternative investments can be attractive if they present uncorrelated returns with the broader US equity market, and they can help level out a portfolio’s performance over time. Most investors think private equity funds and hedge funds when alternatives are mentioned, but the reality is that there are many better (and more interesting) choices out there.
Litigation finance and catastrophe bonds are both great alternative options to explore for instance. Both have gotten a lot of interest of late though, but one investment category that’s flown under the radar despite a long track record is tax lien investing – an esoteric form of debt investment that should do well as the Fed begins raising rates (which will sap demand from competing investors in the space).
To be clear, tax lien investing can offer knowledgeable investors excellent rates of return in some cases, but they can also carry substantial risk, and novice buyers need to understand the rules and potential pitfalls that come with this market.
Here’s how tax lien investing works. When a landowner fails to pay the taxes on his or her property, the city or county in which the property is located has the authority to place a lien on the property. A lien is a legal claim against the property for the unpaid amount that is owed; property that has a lien attached to it cannot be sold or refinanced until the taxes are paid and the lien is removed. Similar to how actual properties can be bought and sold at auctions, these property tax liens can be as well. Twenty-eight states, Washington, D.C., Puerto Rico and the U.S. Virgin Islands allow those liens to be sold to private investors, and about $6 billion in liens come up for sale each year.
When a lien is issued, a tax lien certificate is created by the municipality that reflects the amount that is owed on the property plus any interest or penalties that are due. These certificates are then auctioned off and subsequently issued to the highest bidding investor. The procedures vary considerably from state to state though, so additional research into the actual investment process is usually needed. Tax liens can be purchased for as little as a few hundred dollars for very small properties, but the majority of them cost much more. The auctions may be held in a physical setting or online, and investors may either bid down on the interest rate on the lien or bid up a premium that they will pay for it. The investor who is willing to accept the lowest rate of interest or pay the highest premium will be awarded the lien.
Investors who purchase property tax liens are typically required to immediately pay the amount of the lien in full back to the issuing municipality. The investor must then notify the property owner that they are now the lien holder. The property owner must repay the investor the entire amount of the lien plus interest, which can range anywhere from 5 to 36% (the rate will vary from one state to another). The National Tax Lien Association figures that after all expenses are accounted for, individual investors typically earn 4% to 7% a year, and 99% of sold liens are redeemed by the property owners.
The repayment schedule on tax lien debt usually lasts anywhere from six months to three years, so the rates of return are quite attractive compared to alternative short-term debt investments like bonds and senior bank loans.
Obviously tax lien investing is not for everyone, but the broader point is that the asset class is a potentially attractive one that is likely to have minimal correlation to broader equity markets. For investors who are nervous about sky-high prices at present, a little diversification may help sooth some nerves, and help them ride out any future market volatility.
Mike McDonald is a PhD in finance and a university professor in the subject at Fairfield University in Connecticut. He also runs a consulting company doing work on quantitative investing, big data, and machine learning for a variety of financial firms, asset managers, institutional investors, and government regulators. Prior to getting his PhD, Mike worked for a major Wall Street bank and one of the top hedge funds. Comments, questions, and concerns are always welcome – email Mike at M.McDonald@MorningInvestmentsCT.com or visit his firm’s website at www.MorningInvestmentsCT.com