Thursday, November 1, 2007

When it pays to buy, BUY!

The key to successful investing is to purchase something, be it a stock, a certificate of deposit or real estate for example and then sell it for more than the original cost. While this sounds simple enough in theory: the key is in the execution. A mistake inexperienced investors make is to incorrectly account for all of the costs either before the investment is purchased or when calculating their profit after the sale. If you buy something for ten dollars and sell it for fifteen dollars then you have a gross profit of five dollars.
Inflation is the investor’s enemy. Inflation erodes the real value of your investment while returning more actual dollars. An extreme example can be found in the US economy of the 1970’s. Back then inflation was as much as eighteen percent per year. So if you bought something for ten dollars and sold it for fifteen dollars in three years you would have lost money in terms of buying power even though you made a gross profit of five dollars. By the end of the third year the money used to buy the asset would have earned almost six dollars in interest and yet the profit was only five dollars.Inflation is the borrower’s friend. If money is borrowed at a rate less than inflation and invested in an appreciating asset the investor makes money on the difference between the loan rate and the inflation rate.Generally, the safer the investment, such as a certificate of deposit, the lower the return. Something to watch out for is if the inflation rate rises to more than the rate of the certificate of deposit as this results in a loss in purchase power. Long-term certificates of deposit are the most susceptible to this scenario. If the rate on the certificate of deposit is greater than inflation then BUY.Stocks are considered more risky or volatile than the traditional certificate of deposit. Barring a bank failure, you will always get more money back when a certificate of deposit matures. Stocks do not always sell for more money than the original cost. However, over time stocks have proven to consistently provide a higher return or profit than traditional certificates of deposit. Besides inflation, stocks incur additional costs that certificates of deposit do not. Most investors use a broker of form or another either traditional or Internet based. These brokers charge commissions when the investment is bought and sold. The size of the commissions is based upon the amount of the investment and quantity stock purchased. These commissions can seriously erode or even eliminate an investment’s profit.The best way to avoid commission is to buy and sell in chunks and hold for periods long enough to diminish the commission’s impact. Stocks that pay regular dividends can also help enhance an investments profit. The best time to sell a stock is when the stock has appreciated enough to cover the commission costs and the resulting profit is more than the going rate of a certificate of deposit. A wise stockbroker once said, “You never go broke selling at a profit”. Unfortunately some investors are unsure of when to sell an investment and watch the stock go up and back down, sometimes way down, before they then sell in frustration. Investors and their advisors need to choose what stocks to buy. Just remember to sell when you have made a profit. If a quality stock is paying a dividend that is greater than the going rate for a certificate of deposit, BUY.Real estate can be a very rewarding investment. There are basically two types of real estate, raw land and improved land. In simpler terms think of land as an empty lot in a subdivision and improved land as a lot with a house. The problem with all real estate as an investment, regardless of type is property taxes. There are not many if any other forms of investment that charge an investor an annual fee with so much impact on the bottom line. Another problem with real estate is few investors can make the initial purchase without a mortgage. These two costs are collectively called “carry costs”, as in the investment will not pay for itself so the investor must carry the costs until the investment is sold. Much like stocks, real estate also has brokers and commissions. In real estate, commissions are usually paid by the seller and only rarely charged to buyers. A “hidden cost” sometimes forgotten by investors is the real estate commission. It is true that an investor can sell their own land without a broker but few possess the skill set, time or experience necessary to find a credible buyer.Investors that purchase vacant land therefore have a two-fold hedge against making a profit; property taxes and mortgage payments. In areas of high appreciation investors have been able to make stunning profits in short periods where the carry costs were minimal compared to the profit made. These days, the amount of rapidly appreciating real estate is almost non-existent. When an opportunity to buy vacant land comes along, be sure to account for the carry costs and sales commission when forecasting a potential profit. An important note to make here is if the asset is being purchased for either a present or future use then maybe the profit potential is less important. An example of this is if you buy the vacant lot next to your house for increase privacy or simply a place for the kids to play then carry costs are less important than the present and future enjoyment of the “investment”.Investors that purchase improved land are usually looking for income on a regular basis from the investment. Examples are rental houses, shopping centers, office buildings and other commercial property. Besides the carry costs noted above, improved real estate usually needs insurance and maintenance for the building portion of the investment. Traditionally insurance and maintenance costs were a small part of the overall budget. With heavy losses from the insurance industry, property insurance in many locations is very expensive. Sometimes the tenants cannot afford to absorb the increased insurance meaning the owner faces the choice of either paying the additional expense of the insurance or finding a new tenant that will.On one hand commercial real estate is much more involved than buying stock or a certificate of deposit. On the other hand, if the cost of purchasing the property plus the reoccurring costs (taxes, insurance, maintenance and management) still result in steady positive cash-flow then the extra effort is worth the trouble.The gross income minus the reoccurring costs is known as net operating income or NOI. The NOI divided by the total cost of the property and building is known as the capitalization rate and often referred to as the “cap rate”. The cap rate is the dividend of real estate investment. Generally, the cap rate should be at least the rate of a certificate of deposit plus the rate of inflation. So if a certificate of deposit is paying 5% and inflation is 3% then the cap rate should be at least 8%.Finding investment property that meets the criteria outlined above is very difficult. Now that we are in the beginning stages of the baby boom retirement tsunami, there is a lot of money chasing income producing real estate. Since 2004 the cap rates have steadily declined due to “return hungry” investors willing to pay more for a property than the previous owner. Since investors pay more and the NOI stays about the same, the new investors are willing to earn less of a return on their investment dollars.The foreseeable future, will most likely reward multi-family investments more than traditional strip malls and suburban office buildings. This is due to the anticipated increase in demand for apartments as millions of homes head in to foreclosure. Rents should be stable and grow modestly as demand remains steady or even rises. Office rental rates may stagnate or even decline due to oversupply or reduced demand depending upon the location. The slowdown of the housing industry has greatly reduced the number of solvent builders and subcontractors, thus the demand for office space. As vacant homes fill over time the demand for services will improve the demand for office space.Be careful when choosing your real estate investment. Ask questions, consider all of the costs including your time and determine your ability to deal with uncertainty. Real estate investing can be very rewarding, just ask Donald Trump. While today’s economy appears shaky and there are many reasons not to buy investment property the rule of thumb is “When it Pays to buy, BUY!”

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