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The Investing Secrets Your Stockbroker Won’t Tell You

Feb 21, 2014

Posted by

Ken Holman

Kenneth T. Holman is president of Overland Group, RE/MAX Overland, and the National Association of Real Estate Investment Advisors. For more than 30 years, Mr. Holman has had extensive experience in t Read more

Most investors have two goals in mind: one, safeguarding the principal while two, maximizing the return on investment. Billionaire investor Warren Buffett once said he had two rules when investing, “One, Preserve the principal, and, Two, when in doubt, see Rule Number One.”  For people who invest in the stock market, following Buffett’s sage advice can be difficult.  Do you remember Enron, WorldCom, Lehman Brothers, Delta Airlines, Washington Mutual, Eastman Kodak, Hostess Brands, Saab Automobile, American Airlines, MF Global Holdings, Borders Group, Sbarro Pizza, Solyndra, Friendly’s and the biggest of them all, General Motors?  If you owned stock in any of these companies, it’s likely you lost everything, including your principal, when they went bankrupt. Shareholders are the last to get paid when a company declares bankruptcy.

In The Smartest Retirement Book You’ll Ever Read

, Daniel R. Solin wrote: “During one recent five-year period, according to Standard and Poors, more than one in four stock funds vanished. The funds that disappear are typically the ones with terrible performance statistics.  Fund companies will often get rid of the embarrassing funds by merging them into more successful ones.  With the dead bodies hidden away, the remaining actively managed funds look better than they deserve.”

Compared to the stock market, there are three reasons why investing in income-producing real estate is better than investing in actively traded mutual funds:

  • Preservation of Capital

  • Predictable Returns

  • Leveraged Appreciation

    Preservation of Capital

    When was the last time you went on vacation and came back to find your house was missing?  Never?  Well that’s because it doesn’t happen.  Real estate is a tangible asset that requires careful management, but you don’t wake up one day to find it gone.  Even if your house burns down, it’s insured.  Maybe that’s why Warren Buffett’s firm, Berkshire Hathaway, recently got into the real estate business.

     A good real estate investment preserves your capital.

    Real estate is based on the law of supply and demand.  When supply outpaces demand, prices fall.  When demand exceeds supply, prices rise.  From 2003 to 2007, demand exceeded supply and prices rose.  From 2007 to 2012, supply outpaced demand and prices fell.  Today, demand in most markets exceeds supply and prices are rising.

    Predictable Returns

    If you have a good income-producing real estate investment, it is likely that you didn’t feel the ups and downs of the market.  Regardless of market fluctuations, your tenant still had to have a place to live or to work. Unless your tenant falls on hard times, they pay their rent.

     If they fall on hard times, you find another tenant.  The cash-on-cash returns for real estate are predictable.  Whereas, the returns in the stock market are much more volatile.  They even have a volatility index called the VIX.

    Leveraged Appreciation

    Banks will lend their customers’ money to borrowers who want to buy real estate but not to borrowers who want to buy stocks.  Why is that?  Because real estate is a safer investment.  Typically, even in today’s stricter underwriting world, a real estate investor can put 25 percent down and borrow up to 75 percent of the asset’s appraised value.  Try asking the bank to do that with a reputable stock.  When you put 25 percent down on a real estate investment, and it appreciates in value over time, which it always does over the long-run, you get the benefit of the increase in value of the entire asset, not just the increase in value of your 25 percent investment.

    A quick example of leverage is this:  You buy a $100,000 property for all cash.  The property pays $8,000 per year cash flow, and you get an 8 percent return on your investment.  On the other hand, if you buy a $100,000 property and pay $25,000 down and borrow the other $75,000 at 5 percent interest amortized over 30 years, you get a 12.7 percent return per year.  The math is simple:  $8,000 cash flow minus $4,831 mortgage payment equals $3,169 divided by $25,000 equals 12.7 percent return on investment. That’s positive leverage.

    When you put 25 percent down on a real estate investment, it appreciates in value over time. It always does over the long run. You get the benefit of the increase in value of the entire asset, not just the increase in value of your 25 percent investment.

    In addition, rents typically increase each year due to inflation and other market conditions.  The value of your entire asset continues to increase beyond your immediate cash flow.  The National Association of Realtors conducted a 30-year study where it concluded that single family homes increased in value an average of 6 percent per year.  Couple leverage, borrowing a sum of money to buy a real estate investment, with appreciation and you get leveraged appreciation.

    The next time you plan on putting your money with a stockbroker to invest in companies you know very little about, try putting your money with a qualified real estate investment advisor. The result will be a safer investment with a more predictable return and positive leverage due to your ability to borrow and long-term appreciation in value.

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