Royalty Income Trusts and the Temptation of High Yields
Given a choice between like amounts of income and capital appreciation, investors will generally opt for the income producing asset on the assumption that it represents less of a crapshoot than an asset whose returns are generated via capital appreciation. As they say, a bird in the hand is worth two in the bush. Consequently, it is not surprising that investors are attracted to instruments that bear high yields.
One notable example: Royalty Income Trusts (RITs). Several sport yields in excess of 20%. While an RIT usually represents an interest in the production or sale of some underlying natural resource such as timber, gas, or oil, it is often difficult to determine how much of the underlying natural resource actually exists with any degree of precision. And therein lies the rub.
Take an oil well, for example. If an RIT-investor is to receive 20% of whatever income might be generated by the oil flowing from a particular well, an assessment of just how much oil might remain in that well becomes critical to the evaluation of the investment. Geological studies might support a range of possibilities, but a definitive answer is impossible. Three things are certain, however: 1) the residual value of a producing well tends to decline as oil is pumped from it, 2) a producing well eventually becomes a non-producing well, and 3) a royalty interest in a non-producing well is worthless.
Therefore, some portion of the income generated by the typical RIT actually represents a return of capital – not a return on capital. How much actual income might a given RIT ultimately generate? No one can tell for sure until the cash flows stop – thus the out-sized yields.
