How to Get Where You Want to Go: Have a Plan
Scott Adams, the Dilbert cartoonist, wrote that goals are specific objectives that you either achieve or don’t sometime in the future. That’s different from a system. A system is something that you regularly do that increases the probability of reaching your goal. Losing twenty pounds is a goal. Eating right (cut the sugar) is a system. Being fit is a goal. Exercising (ex: upper body push, upper body pull, something for the legs, maybe a little cardio) is a system. More times than not, following the system leads to achieving the goal.
There are systems for everything. Is the goal having a well trained dog? The system includes the five basic commands: Come! Sit! Stay! Heel! No! It works. Some dogs are better trained than some children.
There is a system for buying things in common use. It involves following the sales. When there’s a sale on something you use, buy it. If it doesn’t spoil and it’s something you use all the time, buy with both hands.
The same principle that works for buying things also works for investing. Wait for the sale. Buy as much as you can.
Sometimes, Sales Are Apparent Only After the Purchase
Sometimes sales are retrospective: they are only recognizable after the fact, sometimes well after. “Years ago, when we bought that building,” Lucinda said, “It seemed really expensive. Now, twenty five years later, it’s shown itself to have been a bargain. It’s paid off and we have a much better retirement than any of our friends! With the way things went, the price we paid was a huge bargain!”
That little vignette illustrates the simplicity of a system that has brought wealth to people from almost every walk of life: Buy a building on credit. Let the tenants pay it off. Repeat, and repeat again.
But there are other investments that deserve consideration. This is particularly true now, when lenders require large liquid reserves. The required reserves amount to too much money to leave in a passbook savings, but the liquidity requirement means they can’t be tied up in a building.
General Guidelines: Stock Market
The total stock market index has yielded 8.0% annually since 1970, including dividends and adjusted for inflation (portfoliocharts.com). But it fluctuates. There have been periods when the gain has been lower, and times when it’s been higher. Typically, returns are higher when assets are bought at lower prices. And returns are lower when the asset(s) are bought at higher prices. Once again, the teeter-totter: high prices are followed by low returns; low prices by high returns. One approach to recognizing price level is to use the market P/E ratio (price divided by earnings) as an indicator. See the example chart, below.
|Example Market P/E Ratio||Annualized Return next 10 Years|
|8.5 – 11.9||~12%|
|12 – 15||9.4%|
|15.1 – 19||8.5%|
Remember, historical data is from the past and may not be duplicated in the future but that doesn’t mean it’s totally without value. The lesson here is not on the annualized return for individual stocks, but the return on stock indexes containing hundreds (or sometimes thousands) of stocks. The S&P 500 Index for example consists of the 500 biggest public companies (note: a public company issues stocks, a private company – regardless of its size – does not issue stock to the public). Many investors buy shares in the S&P 500 Index as the stock portion of their portfolio. The guidance to absorb from the above chart is the principle that the lower the P/E ratio of the index, the generally greater the subsequent returns.
General Guidelines: Gold
Goldman Sachs has recently recommended the purchase of gold, which suggests they see meaningful inflation in our future. They say gold is a better (inflation) hedge than oil. They also have referred to gold as “the currency of last resort”. Goldman has been around since 1869 and is nobody’s fool, so when they make a recommendation it’s usually wise to consider it.
In this case, there are at least three obvious hurdles. First, others have reported that gold is not an inflation hedge due to very long lag times (“A Golden Dilemma”, Financial Analyst’s Journal, Vol. 69 No. 4). So it’s not a sure thing: We have two opposing views on the matter before the conversation even starts.
Second, there’s the fact that in the last big gold bull market prices rose to almost $2,000 per ounce. That was in 2011. Over the next 5 years the price of gold dropped to almost $1,000. That approaches a 50% drop, which means gold now has to double just to get back to its 2011 level. The price of an ounce of gold has recently been $1,675. It’s been almost a decade from the last cyclical low and the price of gold is still not back to 2011 levels. What kind of investing is that?
Thirdly, say you’ve liquidated all your assets and put every penny into a single kilo bar (about 35 ounces, or $58,500 at recent prices) of the purest, prettiest gold, which you lug around with you for safekeeping. It’s lunchtime and the taco truck is outside. You want a $4 sandwich. Who’s going to give you change, huh?
None of these are insurmountable issues, but they must all be considered before investing.
Income Property Stocks: No Reserves Necessary
Having chatted a bit about stocks and a little about gold, it’s time to move on to income properties. It is necessary to have pretty good reserves only if one buys fee simple buildings.
The default position for a person unable or unwilling to prove the necessary reserves but still wishing their portfolio to include income properties, is a REIT Index. Although backed by buildings, REIT stocks are considered “personal” and not “real” property, so the investor should have sound accounting advice before liquidating fee simple buildings and throwing it all into stocks.
The REIT (Real Estate Investment Trust) index has returned 8.7% net of inflation (but including dividends) since 1970. Such a return, if compounded, would have turned $100,000 into $6,500,000 (rounded) over the past 50 years. REIT stocks are liquid. They are as easy to sell as any other stock. REITs are the property owner’s everyday alternative to fee ownership.
Generally, a country’s highest priced buildings are in gateway cities (gateway city: a city whose airport or seaport is one of a country’s primary arrival or departure points). In America, our chief gateway cities are places like New York, Los Angeles, Chicago, Dallas, Washington DC, San Francisco, Seattle, Miami, Orlando, and Las Vegas. There might be others. Detroit may have been a gateway city once upon a time, but lost that honorific long ago.
The reason gateway cities are important is that they have a higher Gross Domestic Product than quiet little villages on the other side of the mountain. More money in circulation means higher property values, whether buying or selling.
In terms of fee ownership, not all buildings are equal. Imagine two buildings built by the same contractor, from the same material, off the same plans, at the same moment in time. The only difference is that one building is in downtown Manhattan and the other is in the Forest Park neighborhood of Detroit. They are each put on the market at the same time. Even though identical, they will sell at different prices due to location.
It’s important to understand how that works.
Buying Expensive Properties
Hypothetical Purchase: Presume the Manhattan building gets multiple offers at a 3% cap rate, while its Forest Park twin can realistically sell at a 15% cap rate. Further presume the NOI (net operating income) of each building is $100,000.
On a cap rate basis, the Manhattan building is worth $3,333,000 (NOI divided by cap rate: $100,000 divided by .03)
The capitalized value of the Detroit building is $667,000.
Cheap is good, right?
Gain on Sale: Thirty years pass. Cap rates have remained the same: Manhattan, 3% and Detroit, 15%. Although the cap rate has stayed steady, the net income of each building has increased 3% annually, to $243,000.
The value of the Manhattan building (at a 3% cap) has grown to a bit over $8,000,000. Its Detroit sibling (15% cap) is worth only $1,600,000.
Given the above, that’s roughly a $6,500,000 difference accruing to the owner of the expensive, low-cap building.
Cash Flow: “Yeah, yeah,” someone might say, “but gain on sale is only one source of profit. There’s also all that lovely, lovely cash flow!”
Consider this. $6,500,000 divided by 30 years comes very close to $217,000 a year. That Detroit building would have to generate an additional $217,000 in annual income (total: $317,000) to amortize the $6,500,000 difference in Gain on Sale.
So, what can we get from this? Two points: (1) buy a building that generates a reasonable cash flow, wherever it is or whatever it is. If Lucinda had never bought that building, even at full market price, she and her husband would not have the retirement they currently enjoy. (2) But, everything else being equal, if a better located building is available, take it. (3) During the amortization period, more money can be made by the gain on sale than by cash flow.
REIT vs Fee Simple: Another View
We’ve seen that REITs, most of which have most of their assets in gateway cities, have returned around 8.7% annually (net of inflation) over the past 50 years. At that rate $100,000 would turn into $6,500,000 at the end of those five decades. It is reasonable to consider how that compares with simply buying a property with a sensible mortgage and paying it off over 25 years, selling it, and reinvesting in another property for the subsequent 25 years. In each case we’re looking at a 50 year timeframe.
For simplicity’s sake, (a) we’ll pretend there were no purchase or sale expenses and no tax consequences. (b) We’ll adjust for neither depreciation nor capital gains taxes. (c) This example assumes a 75% loan-to-value mortgage. (d) And we’ll completely exclude any cash flow received over the 50 year (combined) holding period.
Assume Lucinda put $100,000 down on a $400,000 property, which she mortgaged for $300,000. The building was paid off at the end of 25 years, during which time it appreciated 3% annually. At sale she would have about $825,000 to put down on a $3,300,000 building. In 25 years that building would be paid off. It would have appreciated to approximately $7,000,000. At a very basic level, Lucinda invested $100,000 and 50 years later had $7,000,000 for a return on investment of 8.9% (rounded). That is terribly close to the 8.7% return earned by REITs over the same period.
The Plan: Getting to Where You Want to Go
Total Stock Market Index: 8.0%
Fee Simple Buildings: 8.9%
The period of study (50 years) suggests, however, that (01) it is important to stay invested through the inevitable ups and downs, and (02) small gains compounded over a long period lead to huge numbers. $100,000 compounded at 8% for five decades comes to $4,690,000. If compounded at 8.8% (midway between REITs and fee simple buildings) that $100,000 will grow to $6,783,000, a pretty significant two million dollar difference, but even so, (03) some people just don’t want the hassle of properties. Warren Buffett, for example, favors stocks. The forthcoming quote is from page 20 of the 2014 Annual letter to Berkshire shareholders: “My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.”
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 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]