If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at LuLu.com.

Continued from Part 32:  Buffett vs. Soros. These are opposing types of investments. The Buffett approach is biased towards safety of principal and the compounding of dividends. His desire is to control a meaningful portion of the supply chain: buy for a reasonable price (you seldom get moated companies “cheaply”) and keep it as population and demand grows. Let the dividends compound while you’re waiting.

Soros takes another approach. There is no stream of income with Put options, all the gain (if there is any) is made at the end, so Soros is not really an investor. A better term might be “speculator”.  He’s speculating that the S&P and Russell 2000 will dramatically decline while his Puts are in place. If that happens, he can achieve extraordinary gains. There is a place for both. 

The Value of a System

Scott Adams, the creator of Dilbert, wrote the book How to Fail at Almost Everything and Still Win Big. Emily had the book on the nightstand near her bed. She’d read it twice, didn’t read it anymore, but still liked to have it near. One great value she found in the book is the principle of having a system.

A system is not a goal. A goal is the hope for some benefit to be suddenly bestowed, generally without too much effort on the beneficiary’s part. The wish, “Mommy, I want a pony for Christmas!” is a goal. So is, “I want to have a gazillion dollars”.

“A system is a series of actions oriented towards a specific purpose”, Adams writes, “that a reasonable person expects to work more times than not”. The operative phrases are “series of actions”, “reasonable person” and “more times than not”, because nothing is guaranteed. Buying lottery tickets and hoping for a gazillion dollars is not a system, no matter how long you’ve been performing the same series of actions. A system must work more times than not.  For example, a possible system for getting into a Tier One university starts with feeder schools, perhaps beginning with the old-money, nonsectarian Episcopal School Early Childhood program in New York, which accepts children up to five years old. “Yes, your mother and I know you’re only four, Muffin, but it’s time you left home.” 

Are Stocks Part of the Apartment “System”?

Emily’s interest was income properties. It was almost her only interest. There was nothing about owning apartments that she did not like, except perhaps for the tenants. But real estate is not the only investment game in town and she recognized that many of the same principles that successful real estate investors employ are also found in stock investments. That is a boon, because it’s easier to tease fundamental investment principles out of stocks. They are bought and sold more often, resulting in more data points. This means conclusions can be more robust. In Emily’s mind, every apartment or shopping center owner should have at least a celibate’s interest in stocks.

No Mentor? There are Books

It’s not unusual for successful people to have been mentored, sometimes by a succession of different people, over the course of many years. In other words, to have followed some series of sequential actions that they (or their mentors) had reason to believe worked more often than not. If such a system was followed, the beneficiary probably climbed further up the professional ladder and / or wound up with a heavier purse than the guy who wandered about bumping into random pieces of furniture.

Emily named her first doll after the infamous “Hetty Green”. By itself, that’s evidence that even as a little girl she had always been interested in wealth building. Emily looked upon wealth as a social good: it was proof the wealthy person provided more goods and services to her community than she consumed.

Reading Scott Adams’ book made her see the value of a system, but she knew no one she could ask to mentor her. Every investor she knew was into apartments, and none of them realized the cross-pollination offered by stocks and bonds. Her solution was to find an investor she wished to emulate and to read as much about him as she could. Very few people are like the hedge fund maven Stan Drukenmiller, who will invest in almost anything, almost anywhere, if the numbers are right. Most successful investors limit themselves to investing in things and under conditions that have been successful for them in the past. At a basic level, they have had only one success in their entire lifetime . . . and they kept repeating it. Emily did not find that objectionable: it constituted one “system” of success, and was a fine beginning.

Through selective reading Emily sought to discover the system that stimulated a particular investor to actually lay money on the table, whatever it might be. In this way, through careful study, she hoped to receive much of what live mentors could offer. It was sort of like Pareto’s 80-20 rule. Vilfredo Pareto wrote that 80% of the benefit comes from 20% of the effort. She figured that studying investment biographies like Warren Buffett’s annual “Letter to Shareholders” had to count for at least the 20% effort part. She wouldn’t get the full benefit of a live mentor but she might hope for as much as 80%, and that’s a start.

The only stock investors that Emily could think of were Warren Buffett and George Soros. In her reading she soon realized that Buffett and Soros favored different parts of the market cycle. Buffett likes the front half: he is famous for investing in assets that he expected to go up over time. Soros prefers the back half: he is renowned for “breaking” the Bank of England. Soros speculated when assets were expected to crash, and crash they did.

When she considered the matter deeply, the Soros approach did not appeal: she was disturbed by anything high risk. There may indeed be a place for Options and other speculative investments, but it was not a place Emily wanted to be.

That did not mean, however, that she lost her interest in a second portfolio, complimenting her rental units. In her case the portfolios would not be Low Risk and High Risk, but rather Illiquid and Liquid. Her Illiquid portfolio would be her apartment buildings. It takes a long time and it’s expensive to buy them. It takes a long time and it’s expensive to sell them. But while they are owned they present the owner with four important benefits:

Benefits

  • Appreciation: Well located apartments typically adjust automatically with inflation. Inflation raises the prices of the three elements of production: land, labor, and capital. As those costs increase, so do the values of existing buildings.
  • Depreciation: Tax advantages have been legislated to benefit income property owners. These ebb and flow with successive administrations, so there are no long term guarantees, but they are generally greater than the tax benefits afforded salaried taxpayers.
  • Equity Build-Up: A person who buys a building for cash doesn’t get equity build-up because she already owns all the equity there is. But if the purchase was made with an amortized loan, then every mortgage payment would include a portion that paid off a tiny bit of the loan balance. Eventually the purchase money loan would be paid off and the building’s entire Net Operating Income would go right into the owner’s purse. It’s a beautiful thing.
  • Cash Flow: After rents have been collected and all the costs of running the building have been paid, whatever remains is the Net Operating Income. The mortgage payment comes out of NOI and the balance is cash flow. 

Risks

There are also four risks to owning property:

  • Inflation: Inflation is the weakening of the dollar. Assume an investor bought a $100 Certificate of Deposit paying 2% annual interest. At the time of her investment that $100 would buy 25 hamburgers at $4 apiece. But a year later she finds that the same hamburgers now cost $5 each and to buy 25 hamburgers would cost her $125. The dollar has lost 25% of its value in just one year. Inflation (it takes more dollars to buy the same thing) can benefit the owners of leveraged property because inflation adjusted rents increase, but it is a huge risk to long term fixed rate investments like bonds or mortgages whose payments do not increase. Inflation is a feature (or a bug, depending on which side of inflation an investor is on) of a society offering a social welfare safety net enabled by deficit financing.
  • Deflation: Deflation is the opposite of inflation. Your deflated $100 will buy more hamburgers, not less. If jackfruit will cost less tomorrow, why not wait to buy? If the prices of cars are going down, and we can get another year out of the old car, why not wait? Deflation is an important sign of a failing economy. It is very rare in advanced economies with widely diversified industries.
  • Confiscation: The government has decided that it can seize property (real or personal) that it claims has been involved in certain criminal activity. Once seized, it can retain the property for the government’s own use. The previous owner does not have to be found guilty of a crime. The property itself is charged with being involved in a crime. Yes. Really. Since the police keep the forfeited assets, there is incentive for abuse. As an example, the city of Tenaha, Texas regularly seized property of out-of-town drivers, with the local district attorney’s cooperation, and coerced the drivers to sign waivers of their property rights. Emily remembered hearing the phrase “policing for profit” and now knew what it meant. She was appalled.
  • Devastation: Certainly less common than inflation (which affects all property) but more common than deflation or confiscation (both relatively rare), some examples of devastation include spring floods, late summer wildfires, earthquakes, hurricanes, sinkholes, and locust swarms. Some forms of devastation can be insured around. For others insurance is available but cost-prohibitive. And still other forms must be self-insured: if something bad happens, the owner must hope he’s saved enough to cover it.  

Diversification

Emily, after reviewing once again the positives and negatives of property ownership, thought there was no question about it: the benefits heavily outweighed the risks . . . until the property was confiscated or devastated. Fortunately, the stock market had a partial solution: diversification.

A general guideline is that if a person knows how to select stocks, she should use that knowledge to pick specific stocks. If the person does not know, she should buy a fund (see your advisor) that owns broad sections of the entire market. There are no guarantees, but as a starting point only, the website portfoliocharts.com, might help people to get a foothold.

Applying the guideline of diversification (from the stock world) to the income property portfolio, losses in self-insured situations might be minimized if the property portfolio was diversified. This could be done through:

  1. Adding units – One vacancy in a duplex is a 50% reduction in rental income. One vacancy in a 50 unit portfolio is a rounding error.
  2. Different kinds of property -Retail storefronts or a small corner shopping              center might be fully leased even when apartments have meaningful vacancies.
  3. Change of Location -Santa Monica might pass onerous rent control      measures, while Manhattan Beach may not.
  4. REITs -Real Estate Investment Trusts are kind of a stock-real property hybrid. They come in many flavors: residential, health care, industrial, commercial, etc. Shares can be bought and sold as stocks, and they offer both liquidity and wide diversification.

Shakespeare, as the 1500s were ending, addressed diversification when Antonio said, “My ventures are not to one bottom trusted, nor to one place, nor is my whole estate upon the fortune of this present year.” (Merchant of Venice, Act 1 Scene 1)

Diversification is not a flavor of the month. It crosses both time and asset class barriers. It is fundamental to investment.

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.

Klarise Yahya is a Commercial Mortgage Broker, BRE: 00957107  MLO: 249261, specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate, Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email Info@KlariseYahya.com.