James Sterngold for MarketWatch writes: Rick Kahler can’t explain the mysteries of string theory, speak Mandarin or quote long passages from the Odyssey, but after buying and selling hundreds of properties for 30 years, he has a virtual Ph.D. in real estate.
That’s why the South Dakota native felt quite comfortable some years ago when he made what the rest of us might think of as an obscure investment, plunking down $7,500 to acquire a tax-lien certificate on a piece of property in his hometown of Rapid City. The certificate gave Kahler the right to the delinquent taxes on the property, plus interest, if the city collected them. He’d get the whole place if the owner defaulted. County records included a photo of a sturdy looking house and showed there were no other liens or mortgages.
Months later, the deed arrived in the mail, and the property was his. So he decided to drive over and check the place out. That’s when he noticed something was amiss. There was no roof or windows, not even a front door to knock on. In fact, there was no a house at all. Kahler had bought himself a vacant lot. The dwelling had burned down years before.
Kahler, now a financial adviser who manages $195 million in client funds, recounts the story with a chuckle, but this particular flop wasn’t just for any investment. He had planned to use this, actually, to help him retire. Indeed, while many Americans rely on their savings or 401(k) plans to see them through their golden years, high-end folks are falling in love with another option—something called the self-directed individual retirement account.
The idea is simple enough: Invest in anything you want, but put the investment into a special IRA, so it isn’t taxed until retirement. Suddenly, if you have enough wealth to get into alternative investing, the possibilities become almost limitless for setting up your future. If dressage horses are your thing, go ahead and invest in them. Sunflower farms? Sure. A heli-skiing business? No problem. And it doesn’t even have to be thrilling stuff. A lot of people are staking their retirements, at least in part, on everything from self-storage facilities to rental properties.
How many people are doing this isn’t exactly known because it’s not formally tracked. The Securities and Exchange Commission last year estimated that about 2% of all IRAs are self-directed, which works out to more than $100 billion. Clearly, it’s seen some crazy growth. In 2005, Millennium Trust Co., an Oak Brook, Ill., firm that is one of largest custodians of self-directed IRAs, handled about $733 million in assets; today, it administers $6.1 billion. Similarly, another big player, Pensco Trust, in San Francisco, is handling $10.3 billion in assets after acquiring another trust company to take advantage of industry expansion. Five years ago, it was $1.5 billion.
But while numbers like that are certainly impressive, some experts are expressing serious reservations about the skyrocketing growth of self-directed IRAs (we’ll call them SD-IRAs from now on—maybe it will catch on). That is because many parts of this business aren’t regulated. Indeed, critics say it’s called “self” for a reason. The accounts are administered by specialized custodians and trust banks rather than mainstream banks and brokerages. The administrators make sure you’ve got all your paperwork in order and provide annual valuations, but that’s about it: They don’t identify, recommend or vet investments. That job is solely up to the person whose name is on the account—in your case, that would be, uh, you.
One option, of course, is to hire someone with the expertise to do the due diligence when investing in alternative assets. Most of the people who successfully invest in SD-IRAs, however, seem to prefer to go it alone. Perhaps they possess specific expertise thanks to a lifelong career or hobby. Or maybe they’re tight with an entrepreneur or two, or three. Others just like learning new things and doing the homework. What these folks all have in common is that they see the do-it-yourself approach to alternative investing as a positive. It’s a chance to achieve wide diversification, be truly hands-on and exploit opportunities to earn above-average returns. It’s all about self-reliance. Ralph Waldo Emerson would love it.
As flexible as these accounts are, the law that created them back in 1974, the Employee Retirement Income Securities Act, does exclude some types of investments. The rules enforced by the Internal Revenue Service mostly are intended to prohibit self-dealing or stuffing an account with things that might be considered more than just an investment. Art and other collectibles such as antiques and stamps are no-nos. Life insurance, tangible personal property and booze—sorry, no wine cellars—are also verboten. You can buy a yacht with an SD-IRA, but only if it’s used in a legitimate charter business, and only if you keep your topsiders off it. Another important area that’s out of bounds: your family. There’s no helping the kids with a down payment on a house or cousin Joey with his scheme to open a disco carwash. You also can’t borrow from an SD-IRA or use the assets as collateral. Otherwise, feel free to get creative.
The recent growth in self-directed retirement accounts mirrors the broadening popularity of alternative investments of all kinds. Institutional investors have been using alternatives for years, of course, often putting up to a quarter of their assets in private equity, hedge funds, real estate and private partnerships. In a study last year titled “The Mainstreaming of Alternative Investments,” McKinsey & Co. noted that the trend has been catching on in retail accounts, too, leading to an expansion of 14 % a year in managed alternative assets “despite a very public flame out during the crisis” in 2008. Globally, alternative assets under management shot up to $6.5 trillion in 2011, from $2.9 trillion in 2005, the report says.
To a degree, the trend has been fueled by disappointment with Wall Street’s usual offerings. Joseph Mara, 62, a financial adviser in Palm Beach, Fla., is a case in point. He got interested in alternatives after souring on stocks and bonds. He opened his first self-directed account in 2011 for a portion of his seven-figure retirements savings. “I don’t have to tell you how disappointed we all have been with traditional assets in the past decade or so,” Mara says. His first foray involved a Las Vegas-based fantasy camp that lets would-be musicians jam with real rock ‘n’ rollers like Dave Navarro, Jon Bon Jovi and Roger Daltrey. Mara says he pored over the camp’s financial statements carefully and did his own analysis of what it would take to expand the business before agreeing to invest $200,000. He now expects his private-partnership interest in the camp to yield 12 to 15 % annually over its anticipated five-year life span. At his age, he says, he can’t tie up all of his dough in long-term deals. Yet he was so pleased with his first venture that he is now planning a second, a $100,000 investment in a private company that offers corporate training and development.
Howard Sontag, a former tax lawyer at Lazard Freres & Co. and now the chief executive of Sontag Advisory in New York, says he steers affluent clients into self-directed accounts to take advantage of the tax benefits when they invest in high-yielding alternatives such as middle-market leveraged-loan funds, which can spin off huge flows of cash—at returns of 10% or more—with minimum investments of $500,000 or so. Occasionally, wealthier clients from Wall Street firms use SD-IRAs to hold private-equity interests, which are often acquired at low valuations and can be illiquid for years.
Then there are the truly unorthodox investors, like Rajeev Kotyan, 43, a partner in the financial firm NUA Advisors, in Lexington, Mass. As a money pro, Kotyan fully understands the appeal of something like a Standard & Poor’s 500 index fund as well as the importance of portfolio diversification. Even so, he’s invested 70 % of his own retirement savings into alternative assets in an SD-IRA. He started out buying real estate, but when a friend, a farmer in California, mentioned how difficult it was to get financing for dairy cows, Kotyan had an inspiration: He’d front cash for the cows using funds from his IRA; the farmer would lease them back with an option to buy after five years. Kotyan studied animal husbandry, the milk market and how to gain title on a cow, but let his buddy handle the heifers. “I did lie awake for the first month wondering, ‘What have I gotten myself into?’” Kotyan says. But he says the arrangement worked well and the—pause for dramatic effect—moo-lah was marvelous: He ended up earning a 20 % return tax-free.
Kotyan also invested in competitive dressage horses. At first, “I didn’t even know what dressage meant,” he says. But a horse handler at a farm in New Jersey told him a story that piqued his interest: Americans were willing to pay hefty premiums for high-quality competitors from Europe. Kotyan says he went to work investigating every aspect of the sport, in which horses and their riders perform a sort of equestrian ballet. “One of my first surprises was finding out that horses have passports with photos,” he says. He teamed up with the horse handler, forming a private partnership that acquired successful dressage horses in Europe—with names like Whitney and Franziskana—and then brought them to the U.S. Elaborate measures had to be taken to prove the identity and health of the horses, including samples of blood and tissue. In essence, the two investors flipped horses, buying them in Europe, importing them and then selling them for what turned out to be big profits in 2008 and 2009. While prices for dressage horses sometimes reach several hundred thousand dollars, Kotyan and his partner limited their downside risk by keeping their acquisitions below $40,000. The venture delivered about a 35 % return for his self-directed account.
The fees paid to the custodians of SD-IRAs are generally much steeper than in traditional accounts. Millennium Trust charges $50 to open an account, a $300 annual fee no matter the size of the account, a $125 holding fee per asset or security and a $250 transaction fee for real-estate investments bought for the accounts, according to T. Scott McCartan, the firm’s chief executive. Not only does income from the assets remain in the account, but the expenses needed to maintain the assets—such as upkeep on rental properties, taxes and management fees—must come from the IRA too. As with any trust arrangement, investors aren’t allowed to commingle their personal funds with the trust’s funds. That’s why advisers urge that investors keep a cash cushion in their accounts, particularly when they invest in real estate.
Proponents of SD-IRAs believe they benefit society because they help lubricate entrepreneurial activity and provide more options for investors. Although corporate lobbyists might think otherwise, some experts say there’s no good reason why tax law should push retirement savings only into things like publicly traded stocks or mutual funds. That said, self-directed accounts can be an attractive vehicle for fraud because they are meant for long-term investments, and there’s a tax penalty for early withdrawal. This can make investors in these accounts more passive as well as provide cover for “a fraud promoter to perpetrate a fraud longer,” according to an investor alert issued by the SEC in 2011. What’s more, because alternative assets often involve no prospectuses and are unregistered, there is little if any oversight by regulators—until it is too late and a con artist has made off with an investor’s retirement money. Other potential problems include price gouging and, of course, illiquidity. When investors need to sell some of these assets, there may not be a ready market for them.
“By itself, the idea of a self-directed IRA is not a problem,” says Joseph Borg, director of the Alabama Securities Commission. “But you can put all sorts of junk in there. We have a lot of issues with them. One of the biggest is that people just assume that the custodian is looking out for them. The fraudsters love it.” Regulators add that con artists sometimes deliberately push people to open SD-IRAs when selling them bogus investments because of the lack of scrutiny of the whole field.
Such problems, however, haven’t deterred investors like Dick Eschleman, a 73-year-old semiretired investor in Sonoma, Calif. A decade ago, he got fed up with Wall Street and dumped all of the mutual funds in his IRA. Instead, he began using the funds to make subprime loans on prefabricated houses. The switch, Eschleman says, enabled him to turn the $200,000 he started with in the account into nearly $1 million. Eschleman says his returns now average 15 % a year—even after accounting for some loans that inevitably go bad. The activity has transformed his retirement and given him something to do that he enjoys and finds fulfilling. “When everything works out, and you check things out yourself, you can do very well,” he says.