If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book Stairway to Wealth available at LuLu.com.
A young couple drops by once in a while to discuss investment opportunities. This time they brought their son, not quite a year old, but already, if you use a little imagination, saying Mama and Dadda, although not yet useful things like Capitalization Rate. As his mother was occupied with the baby, most of the discussion was between the husband and me.
Originally, the husband’s first desire was to buy real estate immediately, but he’s now thinking that may still be too early. Remember, we’re inclined towards waiting until interest rates go up (and values down) before buying. Best, probably, is to wait until the government announces that rates have peaked (and values are way down), and then to jump in with both feet. You and I have talked about this before, so you know my thinking on the matter. The other side of this issue is that recently the Fed has indicated it may be longer than expected before interest rates shoot up, so perhaps buying now may not be such a bad idea. But the longer we stay at unnaturally low interest rates, the greater, I fear, the subsequent inflation.
At the moment, however, they have not bought any property. While waiting for the real estate market to adjust, the husband’s taken some of their savings and, two months ago, bought a taxi cab to rent out, meaning he owns the cab and someone else pays him a daily fee to drive it. While this is a purchase I’d never seriously considered, I do recall that years ago we had a client who owned 17 cabs, so the concept is not new. The automobile really should be considered as a declining asset that must be replaced regularly. The value is in the taxi license.
The young husband, after telling me about the taxi cab purchase, opened his laptop and showed a spreadsheet. His projected net was $1,000 / monthly on a $40,000 purchase. ‘s only been a short while, but so far the cab is meeting projections. If it continues, he said he’ll be buying another cab in three months, and a third by the end of the year. He expects, over the next couple of years, to acquire a total of five taxis which, he said, will generate enough income to be useful. That works out to $60,000 annually on a $200,000 investment. Useful indeed.
But owning a rental taxi is a business, not an investment. We moved on to real estate and dividend producing stocks.
The discussion evolved into how much to invest in properties and how much to invest into stocks. His original thought was to invest the same amount of money into each asset class. Assuming $600,000 of investable funds that would indicate $300,000 in real estate, possibly the down payment for a nice five or six unit building, and the remaining $300,000 into a low-cost dividend fund.
The building might bring an initial 4 % (plus or minus) annual cash return, and Vanguard Dividend Growth Fund (VDIGX) is paying 2% on the day this is written. (Note: Reference to VDIGX does not constitute a recommendation to buy.)
Why is there such a difference in returns? Why is one investment giving a cash flow of 4 cents on each dollar invested and the other investment only pays 2 cents? Investments are supposed to return money in three ways: the return of your capital, the return on your capital, and a risk premium that reflects the chance that the investment may go belly up. U.S. Treasury bonds, a riskless investment, pay less interest than other bonds because there is no risk premium. So classical economics says the answer is that the lower the yield, the safer the investment.
Since real estate, in this example, pays a 4% yield and the stock fund 2%, the market is clearly saying that real estate is a riskier investment than a diversified stock fund. It follows that if the husband splits their money equally he will be putting $300,000 into each asset class. Another way of looking at this is to note that he’ll be putting as much money into a high risk endeavor as into the safer investment. That may not seem very prudent.
Ok, maybe we should rethink this.
What if he doesn’t balance the dollars going into each investment? What if he balances the income coming out of them? Say he invests asymmetrically, putting most of their money into the low yielding but theoretically safer investment (VDIGX) with the balance in the direct ownership of riskier apartment assets. The aim would be to wind up with the same dollar return from each of the investment areas. Thus we would use market data (as reflected by their yields) to generate an acceptable risk “ return profile. Sounds like a plan, huh?
Disregarding the exact dollar amounts he’d have to invest in each asset class “ we’re developing a principle, here “ it is certain that he’d have to invest more money in the lower yielding, theoretically safer, asset and less money in the higher yielding asset. Only in that way would the respective cash flows equalize.
Now, what are some things that might go wrong with this program? Well, what would happen if interest rates pop and suddenly they’re facing double-digit rates on the triplex mortgage? Clearly, the building should be bought with a long term, fixed rate loan. That’ll resolve the rate-pop issue and also allow them to harvest most (not all, because expenses will also go up) of whatever rent increases they arrange.
What are some other things that might disappoint? What if a tenant trashes the unit and runs away in the middle of the night? That’s a risk of property ownership that they must accept in exchange for the cash flows, equity build-up, appreciation, and tax advantages. But they’ve got plenty of liquid funds to restore and perhaps even upgrade the trashed unit. Should the other two tenants catch the same infection and run away at the same time, the VDIGX portfolio is there to continue paying the mortgage while the units are renovated and re-rented at higher rates. The young couple is not going to lose the triplex due to inadequate reserves. Liquidity is good.
What if the euro crashes, eviscerating banks on both sides of the Atlantic? That might mean that the banks won’t have the fractional reserves to lend. It may mean that businesses won’t be able to borrow working capital. The VDIGX might “ probably will “ go down, but the effect on the triplex’s cash flow should be minimal.
So the euro shatters, so what? Their triplex has a 30 year fixed rate mortgage that will shelter them from interest rate increases. As far as the stock fund goes, conventional wisdom says that stocks generating a respectable dividend don’t go down as much in market corrections as do non-dividend stocks. The stocks in VDIGX are supported by dividends, so that’s a good thing.
Of course, if the economy takes a massive hit, one so huge it’ll strike everyone down, only people enrolled in one or more of the various welfare programs will pass through that sort of economic period unaffected, but it seemed to the husband that if he balances the incomes from his investments, he and his wife might, in normal times, very well be among the least damaged investors. And, after all, that’s the purpose of investing for safety, isn’t it?
We’ve looked at a few things that could damage their property / stock portfolio, but what if things do well? Things could, you know. The euro could get its act together, banks could enlarge their loan portfolios, larger businesses could borrow to expand and new businesses start. In this event it seems like that little triplex could appreciate nicely as new buyers enter the market and banks become eager to finance the purchases. The husband’s dividend fund could grow as earnings improve. Both the triplex and the stock fund generate cash flows that go directly into his pocket. More than that, both asset classes appreciate in value. The young couple would be in the sweet spot.
So that’s the way to go, isn’t it?
Actually, diversifying by cash flows may well be the road to disaster, and the reason is found in the capitalization rate formula: Yield goes down as price goes up; as price goes up, yield goes down.
Let’s not use VDIGX, because our illustration applies not to just stock funds but to all streams of income. Hypothetically say an investment, Erratic Payment, Inc. (EPI), pays a 6% yield. Over the past ten years it’s paid a median of 4%, but right now it’s yielding six percent. What happened? As yields go up, price goes down. The market had to stop valuing EPI as much as it used to or yields would still be at 4%.
Back when EPI was paying a 4% dividend, the market looked at the company and collectively determined that things have changed “ maybe it’s the company, maybe it’s the economy, but owning stock in EPI (remember, EPI is an imaginary company we are using just to illustrate our point) is riskier than it used to be “ so people started to sell their shares. As early adapters sold, the share price declined. The dropping share price incentivized other shareholders to sell . . . who wants to hold a declining investment? And the price continued to fall. Eventually EPI’s price per share went down until that same dividend, unchanged, represented a 6% yield and other folks started to say, What, 6%? For a 6% yield I’ll take a chance and buy some shares! When enough people do this equilibrium will be reached and the share price will stabilize. The guys who bought at 4% and just held on will lose principal, that’s true, but EPI may be a splendid buy at a 6% yield. That’s well above the 10 year median yield. EPI has only to return to a 4% yield and the investor has benefited in two ways: he’s made significant capital gains and earned 6% while he’s waited.
But in the case of VDIGX, yields aren’t very likely to fall. A 2% yield is already historically low. That means that the market looked at EPI in the past and thought it was a good investment. As folks bought, EPI stock went up. Others noticed, Balthasar, did you see what’s happened to EPI? ‘s gone up every day this month! And Balthasar bought, and others after him. As they did so, the price continued to go up while the yield (which goes in the direction opposite to price) went down. So now we’ve got that young husband who wanted to put 2/3rds or so of his family’s savings into a stock that has a low yield and a vulnerable high price. As the market moves along, rewarding some and punishing others, odds are VDIGX will return to its 10 year median and the husband will just watch his principal evaporate while he keeps trying to figure out a good way to explain the matter to the baby’s mother.
So, is balancing asset classes by their income a good idea? Probably not. By the way, anybody notice how Kim Jon Un looks like Chumlee?
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email at [email protected].