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 70Diversification

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.

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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:

 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.

  • Different kinds of property: Retail storefronts or a small corner shopping center might be fully leased even when apartments have meaningful vacancies.
  • Change of Location:  Santa Monica might pass onerous rent control measures, while Manhattan Beach may not.
  • 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.                 

 Emily’s Portfolio

Diversification could be within a single asset class, as noted above, or among multiple classes. An example of portfolio diversification within an asset class might be buying both four unit buildings and larger complexes. The larger complexes are to generate “forever” income. The fourplexes are to be sold (as needed) to pay for future obligations like college tuition or a granddaughter’s wedding. Selling those little buildings, when the time comes, does not complicate the larger 60 unit buildings.

On the other hand, an investor may diversify across asset classes by offsetting a weakness of Asset 1 with the strengths of Asset 2. It’s a type of self-insurance. For example, income properties take longer to buy and sell than personal property like stocks or bonds. The weakness is that buildings are not “liquid”. A rational portfolio would balance some of the illiquidity of apartment buildings with the liquidity of stocks or bonds (or both), depending on the investor’s anticipated requirements.  As an example, an investor might keep 75% of her wealth in income properties and the remaining 25% in a (liquid) stock / bond portfolio.

Emily didn’t have a clear idea of how much liquidity (immediate cash) would be required to make her feel secure, but she imagined it would be a lot less than 25%, and perhaps something around 10% might do it. Thus, if her apartments were worth (hypothetically) $1,000,000, her liquid account should be no less than $100,000. It’s not uncommon for lenders to require the borrower to have a certain level of documented liquid assets before the lender will commit to a loan request.

Apartments were Emily’s major interest and she expected it would always be so: she was comfortable when most of her investible assets were in safe investments. And “safety” was largely judged, in her mind, by how much of the purchase price she could borrow from a sophisticated lender.  Sophisticated lenders have gimlet eyes. They see things that most people don’t. A sophisticated lender has the institutional knowledge necessary to form an opinion on the security of the requested loan. That gave her another cautious pair of eyes examining the safety of the investment.

Uncle Hyak doesn’t count. He may have made a great living rebuilding old VW Bugs, but he still can’t tell a cap rate from a rate cap.

After thinking about it for a bit, Emily settled on a percent liquidity factor for her combined portfolio. She could always increase (or decrease) the ratio as her circumstances evolved.

She’d given much thought to the Soros manner of investing versus the Buffett. Emily realized that she’d have the greatest comfort level investing her liquid assets in the same way Warren Buffett invests for Berkshire Hathaway.

The stock market makes that very easy. Berkshire Hathaway issues two series of stocks: A and B. Not long ago, at the same time the BRK-A series were selling for $294,000 per share, the BRK-Bs were available for $196. This ratio is not unusual: the B series was designed to be 1/1500th the value of the As.  Heavy investors with lots of money to invest usually buy the A series. The B series is a way for normal people like Emily to invest in Berkshire Hathaway, if their advisors so recommended.

Emily took another look at her yellow pad, liking what she saw: the safety of income properties on the heavy end of her portfolio and the liquidity of stocks (or bonds or some mixture of both) on the other end.

She remembered a story her grandfather once told her when she was a little girl. It was about a farmer who had only one milk cow.  One morning before school, his young daughter finished the milking and returned to the house carrying the stainless steel milk bucket clutched to her chest. She tripped on the porch steps. The pail fell. The milk spilled. In tears, she ran to her father who asked only about the milk cow. Assured that the cow was in splendid condition, her father took her hand and led her to breakfast. “Daddy, aren’t I in trouble?” “No, honey, the milk is replaceable. Just don’t kill the cow!

As an adult, Emily understood from her grandfather’s tale that she should never take big chances with her investment principal, but the cash flow was replaceable. Spill the milk, but don’t kill the cow. Emily imagined the cow to be represented by her apartment buildings. On the other side of her portfolio were the investments she made from the cash flows (milk) generated by her apartments (cows).

Even after deciding on BRK-Bs, Emily continued her studies about how Buffett invests. She didn’t have to, but Buffett was getting older and her cautious nature moved her to try to understand how he invested while he’s still leading Berkshire. She liked to think that if she was successful she might conclude her investment career with more assets than if she simply stumbled along buying Scratchers and hoping for a pony.

Early on, Emily noticed something about Buffett’s system: he was firmly on the supply side of the supply and demand equation. She was much interested in why that might be.

Be a Supplier

Emily could not recall anybody who got rich trading things that were in unlimited supply. It is scarcity that drives the asset market, and it is being on the right side of scarcity that creates and maintains wealth. In terms of both goods (Manolo Blahniks, lactating milk cows), and services (professional hair coloring, difficult-to-place-mortgages) “being on the right side” means to be a provider rather than a consumer. The flow of money is always towards the provider (the supply side) and away from the consumer (demand side). Emily was reminded of Steve Jobs’ famous quote, “A lot of times, people don’t know what they want until we show it to them” and now realized that Jobs was stating that often supply creates its own demand.

Supply: Elastic vs Inelastic

There are two different kinds of supply. They are distinguished by how scarcity affects their prices. “Elastic” supply can be increased or decreased as a function of demand. People make a business out of the (elastic) supply and demand model, sometimes a very good business. A classic description of a generic business is the man who buys one piece of cloth for 4 pennies, tears it in half and sells each half for three pennies. If demand is high, he’ll rip the cloth into three pieces. With decent volume, his kids can go to a costly pre-school in New York. But tearing cloth into ever-smaller pieces does not rise to the level of investment. Investments are different. Investments benefit greatly from a non-elastic supply. It took a moment or two for Emily to get her arms around that concept. It helped when she remembered that time she fell asleep before a waiter returned with the appetizer.

 Plymouth: No New Supply

Emily recalled only a little of what a date once told her over dinner. He was fascinated with the prices of old Plymouth Barracudas and often lectured her endlessly on their minutia. Having heard it before, she would tune out early in his lecture, and sometimes even drift off for a moment or two. He just rattled on and on and never seemed to notice. This particular evening he repeated things he told her on the last date, and even the date before. This was the time she dozed off, right at the table, even before the appetizers were served, so what follows is believed correct but not guaranteed. In any event, the details are unimportant. It’s the principle of how inelastic supply impacts value that bears watching.

In 1971, Plymouth built 16,159 Barracudas. Of these, 11 were convertibles with the hemi engine option. And of those 11, only two were ordered with a manual transmission. And only one of those still has all matching part numbers. That makes that particular “number matching” automobile one of the rarest of American muscle cars. As you would expect due to its scarcity, prices have been ratcheting upwards. In June, 2014, the car sold at the Mecum Auto Auction’s Seattle sale for $3,500,000 (including buyer’s premium).

Even at $3.5 million no company has been motivated to replicate the car because it can be copied but not duplicated. No copy would ever be an equally desirable substitute to the original. Among other obstacles, a contemporary model would not be a Plymouth because the Plymouth brand was discontinued in 2001. And it would not be built in 1971 because that year is gone forever.

This remarkably scarce vehicle was valuable due to its rarity and its inelastic supply. Rarity is not enough. There should also be a zero chance of increased supply.

Imagine another common, recent model car that could be painted a color never offered by the factory. Say, Nauseous Verde, a color available on demand at low-end paint shops. The supply of Nauseous Verde cars is elastic: any car could be painted that color. And any teenager with mommy’s credit card can have her car repainted. “Surprise! Last time you’ll ground me for coming home late!”

The principle here is that elasticity is mortal to rarity. The corollary is that even the threat of a small increase in supply can disrupt the existing market.

Diamonds: Always the Possibility . . .

For another illustration of how the variations of scarcity impact value, consider the “absolute scarcity” of Da Vinci’s painting Salvator Mundi, which sold in 2017 for $450,000,000, and contrast it with the “relative” scarcity of the 46 carat Graff Pink diamond, which changed hands in 2010 for $46,000,000. There is a reason the painting sold for ten times the Graff Pink: Salvator Mundi is unique, while collectable diamonds are only rare; they are not unique. It is almost inconceivable that another similar Da Vinci overpainting of Christ will ever be found, and partially because of this the painting sold for the middle nine figures. The confidence of permanent scarcity, Emily realized, is a value multiplier.

While there are no more Salvator Mundis and thus absolute scarcity applies to the painting, large diamonds are discovered reasonably frequently and auctioned more often than they are found. That is so because the world’s inventory of rare diamonds includes not only the unknown numbers in the ground, but also all those currently in private hands. Records show both newly found and pre-owned investment grade collectable diamonds (IGCDs) are available at auction at reasonable intervals. Examples are the 2016 sale of the Oppenheimer Blue, a fancy vivid blue 14.62 carats, for $57,500,000. It was the most expensive diamond ever sold at auction . . . until one year later when the Pink Star, a fancy vivid pink of (59.6 carats) sold for $83,000,000. With that history, it’s reasonable that buyers of IGCDs consider it is almost certain that other equally or even more desirable diamonds will be auctioned in the future. Nobody is sure quite when, of course. But because the known stock of IGCDs is small, each new discovery threatens to disrupt the value of all presently known comparable diamonds. It’s a supply risk and impacts values.

But Salvadore Mundi is unique. And so is that 1971 Plymouth Barracuda.

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 [email protected].