Whenever an individual places surplus funds in the bank or stock market, purchases real estate for speculation, or other alternative investments, he or she has made an investment decision. There are a wide variety of investment vehicles available. Each type of investment has unique characteristics that may be desirable to one investor yet undesirable to another. In addition, investors may evaluate each investment differently.
Why People Invest
In this complex and rapidly changing world, it is essential to develop and implement a plan for obtaining financial independence. Achieving financial success usually takes time, careful planning, and the assistance of other professionals. Most people invest for some of the following reasons:
1. To generate additional income
2. To acquire wealth for their retirement
3. To accumulate for their children's education
4. To create an estate for their heirs
5. To acquire prestige in the community
6. To obtain security
Common Investment Vehicles
An investor has an almost unlimited number of investment vehicles to choose from. The most common are:
1. Saving accounts and certificates of deposit
2. Stocks and mutual funds
3. Real estate
4. Partnership interests
5. Bonds
6. Mortgages/trust deeds
7. Collectibles/art
Many times, people think that saving is different from investing. In reality, a savings account is just another type of investment vehicle.
Investment Characteristics
An investment may seem more or less desirable depending on the objectives of a specific investor. The objectives of one investor can be completely different from those of another. To understand investor objectives, we must first understand the basic characteristics of investments. As we review each of these, we will make comparisons between savings, stocks & bonds, and investment real estate.
Basic Investment Characteristics
Liquidity: Liquidity refers to the ability to convert an asset quickly into cash, without a significant loss of principal. Investments vary substantially in how quickly they can be converted to cash at their full value. Money in your possession is purely liquid because it is already cash.
Savings: Money in savings accounts can be withdrawn quickly and is therefore highly liquid.
Stocks & Bonds: Stocks and bonds can be sold quickly, any day the financial markets are open. Brokerage fees vary, but are usually nominal. For these reasons stocks and bonds are highly liquid.
Real Estate:In contrast, real estate is much less liquid. A sale or refinance can take weeks or months. Fix-up expenses, commissions, and closing costs reduce the cash actually received. Also, to facilitate a quick sale, a property owner may be required to discount the price substantially.
Marketability: Marketability refers to the ability to convert an asset to cash quickly regardless of price.
Savings:Money in a savings account can be withdrawn quickly. It does not require marketing.
Stocks & Bonds: Stocks and bonds can be sold quickly, any day the financial markets are open. However, on a given day, the sale price of an asset may be less than the purchase price.
Real Estate: The marketability of real estate is directly tied to the principles of supply and demand. Marketability can change dramatically as the market fluctuates between a seller's market, a flat market, and a buyer's market. In a strong seller's market, a seller can be reasonably certain of selling property quickly at a reasonable price. In a buyer's market, it can take months or years to sell a property, and even then, it is likely that the seller will receive less than anticipated.
Leverage:The use of borrowed funds to finance a portion of the purchase price of an investment. The ratio of borrowed funds to total purchase price is known as the loan-to-valueratio. The higher the loan-to-value ratio, the greater the amount of leverage. The financial impact of the use of borrowed funds depends on many factors. They include the amount borrowed, the interest rate on borrowed funds, the repayment terms, and the actual return on the investment. Leverage can have a positive, neutral, or negative effect on an investment.
Savings: An investor is not likely to borrow money to invest in a savings account (unless of course, money could be borrowed at an interest rate lower than the interest rate being paid on the savings account).
Stocks & Bonds: Stocks may be purchased on margin. For every dollar invested, up to one additional dollar can be borrowed to acquire stock. This is called margin borrowing.
Real Estate: Real estate transactions can be more highly leveraged than most other types of investments.
Management:The cost associated with monitoring an investment. To maintain a productive and solvent investment, planning is needed and decisions must be made. There are two levels of investment management: asset management and property management. Asset management involves monitoring the financial performance of the investment and making changes as needed. Property management is exclusive to real estate investments.
Savings: The investor usually manages individual savings accounts and certificates of deposit, as they require very little attention.
Stocks & Bonds: Stocks and bonds can be managed either by the investor or by professional managers. With the advent of e-trading, individual investors are able to trade investments at a much lower cost than through brokerage firms; but remember, quality management can have a significant effect on an investment's performance.
Real Estate: Property management includes the day-to-day operation of the property and the physical maintenance of the building(s). Properties can be managed either by the owner or by professional property managers. An owner gives either money or time in order to properly manage an investment property. The yield on an investment in real estate is directly affected by the quality of its management.
Taxation: Taxes have a significant impact on an investment's rate of return. Some investment vehicles may be tax-exempt. Some may be tax-deferred. Other investments may receive no preferential tax treatment, and are taxed at ordinary income-tax rates.
Savings: Interest earned on savings and money-market accounts does not receive preferential treatment. The interest earned is taxed each year at ordinary income-tax rates.
Stocks & Bonds: Some investment vehicles, such as municipal bonds, may be tax-exempt. Some may be tax-deferred: for example, the earnings from Individual Retirement Accounts are not taxed until withdrawn. Profits from the sale of stocks may qualify for preferential long-term capital gains treatment.
Real Estate: There are major income-tax advantages for investment property owners. They include:
1. Interest on loans is deductible from rental income when the loan is used to purchase or improve rental property.
2. Operating expenses such as property taxes, insurance, maintenance, repairs, management, etc. are deductible from rental income.
3. Cost recovery (formerly called depreciation) is a non-cash tax-deductible expense, sometimes called a paper loss. It reduces taxable income but does not reduce cash flow.
4. The $25,000 exemption under the passive loss rules allows certain investment property owners added tax benefits.
5. If the property is held for more than one year, longterm capital gains treatment is allowed when the property is sold.
6. Investors who own rental properties can qualify for Internal Revenue Code Section 1031 taxdeferred exchanges.
7. Investors, when selling an investment property, can qualify for Internal Revenue Code Section 453 installment sale provisions.
8. Investors can also purchase, hold and sell investment real estate within a self directed Traditional IRA and defer taxes on capital gains or avoid them completely if a Roth IRA is used.
Rate of Return (Yield): The rate of return is the percentage return on each dollar invested per period of the investment. Generally, the rate of return is greater for higher-risk investments. Investors often use the rate of return to compare various investments, looking for the greatest yield possible with the degree of risk they can tolerate.
Savings: Investments such as certificates of deposit have a rate of return that is fixed for a specific period, while interest paid on passbook savings can fluctuate. These rates tend to be relatively low.
Stocks/Bonds: The rate of return or yield on certain bonds is fixed for the life of the investment. The return on money invested in a stock varies according to the perceived value of its earnings and overall consumer confidence in the marketplace.
Real Estate: Real estate investments usually produce variable returns. The income produced is dependent upon market conditions. Because of this, the amount and timing of the receipt of returns is an important issue for real estate investors. The full return of the amount invested usually does not occur until the property is sold.
Risk:Risk is the uncertainty associated with the expected performance of an investment. If the outcome is certain, there is no risk.
Savings: Very low risk on federally insured deposits up to $100,000.
Stocks & Bonds: Many investors have built wealth by investing in the stock market; however, most people understand that the potential exists for the market to plunge. Over the past century the stock market has plunged more than 40% on seven different occasions. Some of these plunges have happened in as little as one year, while others have taken as many as six years to reach bottom. However, as holding periods increase, the risk associated with a stock or bond market drop is reduced.
Real Estate: When held for a reasonable time period, real estate is usually considered a low- to medium-risk investment. As with stocks, the longer the investment property is held, the lower the risk.
Comparing Investments
We have looked at the investment characteristics of a saving account, investment in stocks and bonds, and investment in real estate. Let's take a moment to determine the wealth accumulation potential of these types of investments.
Savings: If we invest $40,000 in a certificate of deposit (CD) at 5%, compounded yearly, our investment will grow to $42,000 by the end of year one. $40,000 x .05 = $2,000 interest. $40,000 + $2,000 = $42,000. If interest is compounded monthly, the original investment will grow to $42,046. If it is compounded daily, it will grow to $42,051.
In 15 years, an original investment of $40,000 with interest compounded daily will grow to $84,675. Would you consider this to be a good investment? What if the average rate on inflation during this 15-year period was 6%? Adjusting for inflation, the original investment of $40,000 would not be able to purchase as many goods in 15 years as it would today.
Mutual Fund:Now let's invest $40,000 in a mutual fund growing at 10% annually. Our investment will grow to $44,000 by the end of year one. $40,000 x .10 = $4,000 interest. $40,000 + $4,000 = $44,000.
In 15 years, an original investment of $40,000 that increases 10% each year will grow to $176,090. As you can see, there is a significant difference in the yield of a mutual fund earning 10% and a CD earning 5%. The increase in yield in this case explains why investors will take on the increased risk associated with stocks, bonds, and mutual funds. Which investment makes more sensea CD growing at a rate that may be less than inflation, or a long-term investment in a mutual fund? The answer to this question depends on an investor's objectives.
Real Estate: For this example, we will invest $40,000 (20% down) in a $200,000 real-estate investment. The property will be financed using a fully amortized 15-year loan. After payment of the taxes, insurance, maintenance, property management, and mortgage payments, let's assume that the income and expenses of the property break even. This allows us to focus on the increase in equity that results from paying off the mortgage along with the increase in equity resulting from 5% annual appreciation.
The value of an investment property appreciating at 5% a year for 15 years will grow from $200,000 to $415,786. Let's take a look at the future equity potential of this investment.
Future value of property in 15 years $415,785
7% overall cost of sale $29,105
Loan balance paid in full
= Net proceeds from sale before tax $386,680
Review: In the above examples we determined that if we invested $40,000 for 15 years, we would be able to accumulate wealth (before tax) in the following amounts:
1) Certificate of Deposit $84,675
2) Mutual Fund $176,090
3) Real Estate $386,680
Which is the better investment for your client? Answer: It depends on your objectives. Each investor has a different:
1. Need for liquidity
2. Risk tolerance
3. Yield requirements
4. Desire for cash flow vs. equity growth
The Comparison chart in your program graphically displays the comparison between a Property, a Mutual Fund, and a Certificate of Deposit. Check out this chart for the Sample Property "Comparison
What Is Investment Real Estate?
Investment real estate is any type of real estate with the exception of the investor's personal residence(s). NOTE: Even though an investor's personal residence(s) is/are not considered Investment Real Estate by definision, it/they are still very mush an investment and should be considered as part of an individuals personal system of financial growth.
Examples:
1. Single-family homes, condominiums, and multi-residential properties.
2. Commercial properties such as office buildings, retail stores, and hotels.
3. Industrial properties such as manufacturing plants, warehouses, and research facilities.
4. Vacant land held for appreciation.
It's how you use a property that determines whether or not it is investment real estate.
Four Major Advantages of Investment Real Estate
First Advantage: Income from Cash Flow
After payment of all operating expenses and mortgage payments, the resulting income is called before-tax cash flow. This topic will be covered in greater detail as we study the cash flow model in our next chapter. For now, just remember: Positive cash flow is good! Negative cash flow, while not desirable, is not necessarily all bad! Keep in mind these guidelines:
1. Choose the property that will produce the highest rents.
2. Choose the property with the most reliable tenants.
3. Choose the property that will return your investment the fastest.
Second Advantage: Equity from Loan Pay-Down
When we obtain financing to purchase investment property, we are using the principal of leverage. In the following example, we will focus on the equity obtained by paying down the mortgage in a leveraged real-estate investment (as opposed to the equity obtained from appreciation of the property's value).
The Net Equity chart in your program graphically shows you how the Price, Net Equity, and Loan Balance change with time. If you set Appreciation to 0% on the Assumptions tab, you can see that the price of the property will stay constant with time. This allows you to isolate the increase in equity obtained by paying down your loan.
Third Advantage: Equity from Appreciation
In the real world, property values fluctuate. An increase in value is referred to as appreciation, while a decrease in value is referred to as depreciation. Investors generally purchase real estate on speculation that property values will increase over time. When a leveraged investment appreciates, equity in the property increases in two ways. In addition to the increase in equity obtained by paying down the mortgage, equity also increases as a property appreciates in value.
If you will set the Appreciation to 5% or so in your program , the Net Equity chart will show your Appreciation Equity with time added to your equity obtained by paying down your loan. If you wish to view only the equity obtained from appreciation, remove the loan information from the financing tab.
Fourth Advantage: Tax Savings
One of the tax benefits derived from an investment in real estate is the ability of an investor to pay taxes on an amount that is less than the income received. We will cover this more comprehensively as we study the cash flow model in our next chapter.
Go to your program and look at the Annual Values Chart where you can watch the components of your investment change with time.