Self Directed IRA Investing – Beware of the Liquidity Premium
Everybody needs some liquidity in their portfolio. After all, all of us are going to have to go to the grocery store at some point before the end of the month, and we’ll have to pay cash. Cash flow is a very good thing. But Self Directed IRA owners should know that IRA money is long-term money.
This isn’t money for your next grocery store trip, or next month’s mortgage payment, or ‘walking around’ money. For the vast majority of Self Directed IRA owners, their retirement money is money they intend to invest over time, and to let it compound over time, to gain the maximum benefit of the tax advantages of IRA/401(k) investing.
Self Directed IRAs and Alternative Asset Classes
And that’s precisely why more investors should consider using more alternative asset classes within their retirement accounts: Assets like direct ownership of real estate, non-traded REITs, private equity and venture capital, and on the debt side, private lending and tax liens and tax certificate investing each have risks, of course (depending on the collateral you lend on!), but in general, the expected long-term returns of each class are usually going to beat the long-term returns on publicly traded, popular securities that are easy to buy and sell at the drop of a hat.
Liquidy is a fine thing, and a necessary thing when it comes to income that you need to live on. When you’re deep-sea diving, you cannot live for long on oxygen stored in tanks on the boat!
But there’s a price to be paid for liquidity. Indeed, liquidity can be very expensive indeed.
Why should this be so? Well, simply because the people looking to attract your Self Directed IRA capital to fund very liquid projects can get away with it. The people who want to tie up your capital for months or years at a time know they have to offer investors a sweeter deal, to compensate for the lack of liquidity.
Think of it: Imagine two classes of shares in the same real estate development project. Both are expected to have a value of $100 per share in three years, at which time the company expects to liquidate. The Class A share comes with a guarantee that the investment company will return your money to you within 24 hours, upon request. Class B share, on the other hand, comes with no such guarantee. They only want B-share investors who are willing to commit to leaving their money in place for the entire three year period.
Everything about each share class is the same, and the amount each share generates at the end of the three year lock-in period are identical. But the A shares come with liquidity and the B shares have no built-in liquidity feature. Do you think these two shares are going to sell at the same price? No. The B-shares will sell for a much lower price!
The difference between the two share prices is called the liquidity premium, and simply shows how expensive liquidity is.
Another way to look at it is to compare the annualized interest rates on a money market – convertible to cash at the end of the day no matter what (almost, anyway!), and a 1-year certificate of deposit. Going to Bankrate.com today, the average interest rate on a 1 year CD is 1.11 percent. The average rate on a $10,000 money market account is 0.56 percent.
For risk-free money, the liquidity premium costs a Self Directed IRA investor half his or her returns in a single year.
For assets you don’t need to liquidate for a number of years, you will get a much better rate of return on your investment if you buy them at a much better price.
The Self Directed IRA Advantage
That’s where Self Directed IRA strategies have an advantage over conventional IRAs. By expanding their options beyond the off-the-shelf funds, bonds and annuities offered by most investment companies, they have the opportunity to buy assets at much better discounts to future NAVs, and sidestep the substantial cost of liquidity.
With offices in Asheville and Charlotte, North Carolina, American IRA specializes in working with investors who reduce hidden expenses, improve expected returns increase diversification by including alternative asset classes in their retirement strategies.
For more information or a no-obligation consultation, contact us at 828-257-4949, or visit our website at www.americanira.com.