If you’ve missed some of the prior articles, basic “beginner” guidelines on successful investingare in my book “Stairway to Wealth” available at LuLu.com.
Tipping Point, Etc.
One of my girlfriends recently retired from a suburban Water & Power company after 40 years employment. She started as an entry level clerk, but the utility expanded over the years and she got vacuumed upwards and retired from a mid-level executive position. Her monthly pension is $10,000. That got me to thinking . . . how much would someone have to save to retire on the same amount?
An online annuity calculator (http://cgi.money.cnn.com/tools/annuities/) says that a 65 year old California woman could get $10,098 monthly for the rest of her life in exchange for a $2,000,000 lump sum payment. Ok. So if a person started work at age 25, what would she have to do to have two million dollars in her panty drawer when it came time to retire? Clearly, she could save $50,000 every year for forty years, but that seems a bit of a stretch even for a W&P executive, let alone for someone just starting out. What if she does what most folks might, make regular deposits in some kind of “interest-bearing” account?
What we want to do is to make a long series (in this case, 40 years) of affordable monthly payments leading to the big bag of money we’ll use to buy our retirement annuity.
The First Miracle of investing is when interest is earned on interest already accumulated in the account. Compound interest can raise an initial investment to astonishing levels over time. Exactly how high depends on yield and time. Hiding money in the cookie jar does not qualify.
We are told low yielding investments are often safer, while a long compounding period compensates for the low yield. That’s why it’s important to start retirement savings early: a lengthy investment period is required if secure investments are to grow to meaningful levels.
A common estimate of what kind of yield an aggressive investment account might earn is the long term average for the stock market. The market as a whole is different from individual stocks. Even if you’re a skilled securities analyst Individual stocks can be risky, but over time the market as a whole is much less so. If you “buy the market” you don’t need to be a security analyst because the Law of Large Numbers favors you: as the number of samples increases, the average of those samples approaches the mean of the target population. In other words, if you acquire a sufficiently large number of stocks the impact of both the turkeys and the eagles will diminish and your overall return will approximate the middle of the pack. That’s probably desirable: there’s safety in the middle. If you could be promised that your retirement savings would never grow less than the market but, in exchange, you had to accept they would never generate returns above the market, would you agree to that bargain? Before you answer, let’s see what sort of return we might be looking at.
Over the last 40+ years the Standard & Poor’s 500 has compounded at an average 9.7% annually. (http://en.wikipedia.org/wiki/S%26P_500#Total_annual_returns). Individual years have varied widely but over time the total return, which includes reinvested dividends, has been about 10%. So if you put your money into a good S&P Index fund and kept it in there for forty years, a monthly deposit of $350 should grow to a final sum of $2,000,000.
But just because it meets goals doesn’t make it a good investment. Slipping $50,000 a year beneath your unmentionables meets the goal, but it’s not a good investment because there’s no tipping point.
The Second Miracle is the tipping point. The tipping point is reached when you can meet your investment goal on time without making any more contributions. The best investments have an early tipping point. Interest-bearing accounts tend towards late tipping points.
Consider the S & P Index fund: at 10% total return the first $350 will grow to $16,700 by retirement day. But there wasn’t time for the last $350 that you deposited at the beginning of Month 480 to have grown in any material way. At some point on that forty year timeline you will have reached the moment when it no longer makes a difference to your subsequent lifestyle if you continue the payments.
For our discussion, let’s stipulate that the tipping point comes when your final retirement figure is not significantly reduced due to lack of further contributions. The accumulated funds are left invested so their interest continues to compound, but you don’t have to make more of those pesky $350 monthly contributions. A little work with a short pencil and a long eraser shows that you could stop the payments at the end of 36.7 years – you would have invested $154,000 by that time and your account balance would be $1,453,000 – and the pot would grow to $2,004,500 at the end of the 40th year. So that’s the tipping point: the 37th year of a 40 year program.
Have a sip of tea and reflect on what has just happened: You invested $154,000 over 37 years and it’s grown to $2,000,000. Compound interest is neat, huh?
Contrast the tipping point in our Index Fund example (about 37 years) with the purchase of income property. You make a down payment and pay some auxiliary fees and you’re done: the tipping point was immediate. It was reached when the deed transfers, even before it recorded. From that moment on you don’t have to contribute to the pot any more. As a matter of fact, you receive cash flows almost immediately because total rents are (or should be) greater than the sum of expenses plus mortgage.
There are a couple of significant differences between what amounts to passbook savings and buying an income property. One is if you buy an apartment building you can borrow most of the price. This can be really helpful.
The Third Miracle is leverage. If you could acquire a $100,000 asset with $10,000 of your own money, and later sell that asset for $110,000 you’ve made $10,000 on your $10,000 investment. You’ve made 100% on your money. Leverage is a miracle when its results are favorable. If you ultimately sold that asset for only $90,000 you would have lost 100% of your money and that is not a miracle.
Leverage makes it possible to control large assets with only a small amount of your own money. The purpose of the down payment is to shield the lender against first loss. If you bought a $100,000 asset with $30,000 down, the property would have to lose thirty percent of value before the lender is exposed to any loss of principle. Customary down payments vary with the economic cycle. When things are economically unsettled, higher downs are required. Down payments tend to shrink during periods of enthusiasm.
The Fourth Miracle is self-extinguishing debt. All good investments generate enough money to pay the debt acquired for their purchase. Gold and diamonds don’t do that.
There are lots of ways to pay off investment debt. It’s conceivable that no payments would be required until some future point when suddenly the principal plus all the accumulated interest is due in one lump sum. If you borrowed $100,000 at 6% interest for 10 years, there would be no payments at all until the due date when $182,000 (principal and interest) would be owed. That’s one way: make a lump sum payoff at some agreed upon time in the future.
Another way is to make inadequate payments, as when loan payments are based on a 30 year amortization schedule but the loan has to be repaid in 10 years. You make principal and interest payments of $600 as though the loan were going to pay itself off in 360 months, but the loan is due at the end of 10 years. At that time you pay off the remaining principal balance of $84,000 and whatever interest is due. Such a loan is referred to as a “30 due in 10”.
And, of course, there’s the fully amortized “30 due in 30”. Your $600 payments just continue on and on and on until at the end of 360 months the loan is paid off.
In all of these examples your net worth is developed with another person’s money (the lender), and the debt is paid with yet other people’s money (the tenants). This is a system made in Heaven.
Equity increases as the loan is paid off (equity build-up). The rate of increase varies with the loan-to-value ratio. As an example, if we financed the purchase of a $100,000 building with a (hypothetical) 30 year mortgage at 67% LTV (i.e., we put 1/3rd down and borrowed the rest) our equity build-up will average a touch under 7% (original amount borrowed divided by 30 years divided by down payment). If we put only 20% down on a $100,000 purchase our equity build-up would average 13% ($80,000 divided by 30 divided by $20,000).
Self-extinguishing debt makes it possible to plan equity growth. A long time ago I read that you can guess how rich a person will be in 30 years by how much investment debt he owes today.
The Fifth Miracle is automatic inflation adjustments.
Since 1971 when dollars became no longer convertible into gold, U.S. inflation has averaged 4.24%. In other words, a ten unit apartment building that cost $260,000 forty-two years ago would cost $1,500,000 today. That’s good if you’re the borrower.
Nobody mentions it because it’s the underside of inflation, but if you were the lender the money that would have bought a $1,500,000 apartment building for in 1971 will only buy a $260,000 building today. The difference might be made up in interest, but that doesn’t mean it’s a good thing to be a lender in an inflationary environment.
Just because your building is sitting there looking cute is not why its value adjusts with inflation. It’s because new buildings in the area cost more to build than they used to. As they cost more to build, it sort of vacuums the value of your building up too. You know, like my girl friend in the Water & Power Company. And for the last 42 years the vacuum of inflation has averaged 4.24% annually.
Between inflation and equity build-up (est. 11% combined) equity in an apartment building can grow faster than in a (market) interest-bearing account.
These miraculous benefits can be simultaneous if you select your investments carefully. A proper investment has as many of those beneficia as possible.
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 [email protected].