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Real Estate: When you invest in real estate, you are buying physical land or property. Some real estate costs you money every month you hold it - think of a vacant parcel of land that you hope to sell to a developer someday but have to come up with cash out-of-pocket for taxes and maintenance. Some real estate is cash generating think of an apartment building, rental houses, or strip mall where the tenants are sending you checks each month, you pay the expenses, and keep the difference as the profit. Stocks: When you buy shares of stock, you are buying a piece of a company. Whether that company makes ice cream cones, sells furniture, manufacturers motorcycles, creates video games, or provides tax services, you are entitled to a cut of the profit, if any, for every share you own. If a company has 1,000,000 shares outstanding and you own 10,000 shares, you own 1% of the company. Wall Street makes it seem far more complicated than it is. The companys Board of Directors, who are elected by stockholders just like you to watch over the management, decides how much of the profit each year gets reinvested in expansion and how much gets paid out as cash dividends. If you are interested in this concept, read Investing Lesson 1. It will explain how a company sells stock in itself and how those shares end up being traded on Wall Street. You may even want to check out Investing Lesson 2 Why Stocks Become Over or Under Valued to understand what moves stock prices.
The Pros and Cons of Real Estate vs. Stocks Now, lets look at the pros and cons of each type of investments to better understand them. Pros of Investing in Real Estate
Real estate is often a more comfortable investment for the lower and middle classes because they grew up exposed to it (just as the upper classes often learned about stocks, bonds, and other securities during their childhood and teenage years). Its likely most people heard their parents talking about the importance of owning a home. The result is that they are more open to buying land than many other investments. When you invest in real estate, you invest in something tangible. You can look at it, feel it, drive by with your friends, point out the window, and say, I own that. For some people, thats important psychologically. Its more difficult to be defrauded in real estate compared to stocks if you do your homework because you can physically show up, inspect your property, run a background check on the tenants, make sure that the building is actually there before you buy it, do repairs yourself ... with stocks, you have to trust the management and the auditors.
Using leverage (debt) in real estate can be structured far more safely than using debt to buy stocks by trading on margin. Real estate investments have traditionally been a terrific inflation hedge to protect against a loss in purchasing power of the dollar.
Compared to stocks, real estate takes a lot of hands-on work. You have to deal with the midnight phone calls about exploding sewage in a bathroom, gas leaks, the possibility of getting sued for a bad plank on the porch, and a whole host of things that you probably never even considered. Even if you hire a property manager to take care of your real estate investments, its still going to require occasional meetings and oversight. Real estate can cost you money every month if the property is unoccupied. You still have to pay taxes, maintenance, utilities, insurance, and more, meaning that if you find yourself with a higher-than-usual vacancy rate due to factors beyond your control, you could actually have to come up with money each month! As you learned in The Great Real Estate Myth, the actual value of real estate hardly ever increases in inflation-adjusted terms (there are exceptions, of course). This is made up for by the power of leverage. That is, imagine you buy a $300,000 property by putting in $60,000 of your own money, and borrowing the other $240,000. If inflation goes up 3% because the government printed more money and now each dollar is worth less, then the house would go up to $309,000 in value. Your actual value of the house hasnt changed, just the number of dollars it takes to buy it. Because you only invested $60,000, however, that represents a return of $9,000 on $60,000. Thats a 15% return. Backing out the 3% inflation, thats 12% in real gains before factoring in the costs of owning the property. That is what makes real estate so attractive.
More than 100 years of research have proven that despite all of the crashes, buying stocks, reinvesting the dividends, and holding them for long periods of time has been the greatest wealth creator in the history of the world. Nothing, in terms of other asset classes, beats business ownership (remember when you buy a stock, you are just buying a piece of a business). Unlike a small business you start and manage on your own, your ownership of partial businesses through shares of stock doesnt require any work on your part (other than researching each company to determine if it is right for you). There are professional managers at headquarters that run the company. You get to benefit from the companys results but dont have to show up to work every day. High quality stocks not only increase their profits year after year, but they increase their cash dividends, as well. This means that every year that goes by, you will receive bigger checks in the mail as the companys earnings grow. As Fortune magazine pointed out, "If you'd bought a single share [of Johnson & Johnson] when the company went public in 1944 at its IPO price of $37.50 and had reinvested the dividends, you'd now have a bit over $900,000, a stunning annual return of 17.1%." On top of that, you'd be collecting somewhere around $34,200 per year in cash dividends! Thats money that would just keep rolling into your life without doing anything! Its much easier to diversify when you invest in stocks than when you invest in real estate. With some mutual funds, you can invest as little as $100 per month. With companies such as sharebuilder, a division of ING, you can buy dozens of stocks for a flat monthly fee of as little as a few dollars. Real estate requires substantially more money. Stocks are far more liquid than real estate investments. During regular market hours, you can sell your entire position, many times, in a matter of seconds. You may have to list real estate for days, weeks, months, or in extreme cases, years before finding a buyer. Borrowing against your stocks is much easier than real estate. If your broker has approved you for margin borrowing (usually, it just requires you fill out a form), its as easy as writing a check against your account. If the money isnt in there, a debt is created against your stocks and you pay interest on it, which is typically fairly low.
Despite the fact that stocks have been proven conclusively to generate more wealth over the long run, most investors are too emotional, undisciplined, and fickle to benefit. They end up losing money because of psychological factors. Case in point: During the most recent collapse, the Credit Crisis of 2007-2009, well-known financial advisors were telling people to sell their stocks after the market had tanked 50%, at the very moment they should have been buying. The price of stocks can experience extreme fluctuations in the short-term. Your $40 stock may go to $10 or to $80. If you know why you own shares of a particular company, this shouldnt bother you in the slightest. You can use the opportunity to buy more shares if you think they are too cheap or sell shares if you think they are too expensive. As Benjamin Graham said, to get emotional about stock prices that you believe are wrong is to get upset by other peoples mistakes in judgment. On paper, stocks may not look like theyve gone anywhere for ten years or more during sideways markets. This, however, is often an illusion because charts dont factor in the single most important long-term driver of value for investors: reinvested dividends. If you use the cash a company sends you for owning its stock to buy more shares, over time, you should own far more shares, which entitles you to even more cash dividends over time. For more information, read the work of Ivy League professor Jeremy Siegel.
To avoid this, the bank staff is going to take proactive measures to get the lo an back on accrual status as quickly as possible so that it wont damage the financial statements. The main way this can be done is to foreclose on the property and auction it to a buyer. Now, sitting from your perspective as the bank owner, who are you more likely to go after first? John, who has almost no equity in his home, or Mary? If you were to foreclose on John, you are going to have to get nearly the full $200,000 asking price to wipe out the loan on your books. If you foreclose on Mary, however, you can liquidate the property at a steep discount very, very quickly and wipe out the full $15,000 loan. Yes, Mary has been a very good customer. Yes, she has done everything right. Perhaps its not fair that she is the first one you would go after but to understand why this is done, you must realize the incentive structure set in place for the employees by Wall Street which is, in turn, a result of investors wanting more profits. Who are the investors? You and me. In our 401k plans, IRA accounts, or just through outright ownership of stocks. Its the pension fund that pays the checks to your parents or grandparents. Its the insurance company that needs to generate funds to pay claims. With investors demanding profits, Wall Street doesnt want to see a bank own a lot of real estate. The employees at your bank will not risk their job by attempting to list Johns house for six months so that he can get a little of bit of equity out of it. They are only interested in protecting the funds they advanced John and he promised to repay. Thats why they turn to auctions. They cant afford to dump Johns house because the proceeds might not be sufficient to repay the loan. Marys house, on the other hand, can be listed for $125,000 at an auction. They get their $15,000 and keep a pristine balance sheet while she loses $75,000 in equity that could have been captured were she able to list the property on the market long enough to receive a respectable offer. What about John? you ask. Thats the cruel part. They are far more likely to restructure the payment terms to help him out of the situation because they could then legitimately keep it on the books as a good loan. They might offer a balloon payment at the end of the mortgage to lower present payments. They might permit two years of interest-only payments. The sky is the limit and it really depends upon how desperately the bank wants to avoid hits to its profit margins. How can you protect yourself from this situation? The biggest defense any investor has against foreclosure is liquidity. Say it over and over again. The bank is not concerned with the amount of money you owe them just that you continue to make payments on time, without delay. Instead, Mary would have been much better off by taking those double and triple payments she had been making and putting them into a tax-free money market account or fund earning four or five percentage points. Yes, her mortgage rate may be higher but that doesnt matter because if she is in a decent tax bracket, its likely that the after tax cost of the mortgage interest will wash with the tax-free interest rate shes earning on this investment fund. Why would I borrow money at a net 5% after the tax deduction and turn around and invest it at 4% to 5% tax-free? you might ask. Liquidity. When hard times hit, it wouldnt matter what her mortgage was, she could have drawn from that account and easily made the payment until she was able to get back on her feet. In fact, at the rate she had been putting aside excess funds, she could have probably made several years worth of payments! The single biggest danger with a strategy that focuses on liquidity is the risk that someone spends the cash while maintaining the debt. An account with a large sum of unrestricted cash is simply too great a temptation for a lot of people. Maybe they get behind on their credit card bills. Perhaps they want a new flat screen television and think theyll just dip into the fund and pay it back in a few months. (It never works that way.) If there is any possibility that you are inclined to spend the money on anything other than to make your house payment in the event of an emergency, its probably a bad idea. It really comes down to self-discipline and temperament. Another big danger is the temptation to go for a few extra percentage points of return by investing in riskier assets. This particular financial strategy depends upon safety of principle. For most people, this means highly liquid tax-advantaged securities such as a money market fund that invests in municipal bonds. In exceptional cases, those with highly specialized knowledge of specific markets (such as stocks or real estate) could invest these funds with reduced risk.
or automatically reinvested. Although, statistically over the long term you are more likely to build your net worth through this type of ownership, it doesnt feel as real as property. 2. Real Estate Doesnt Have a Daily Quoted Market Value Real estate, on the other hand, may offer far lower after-tax, after-inflation returns, but it spares those who havent a clue what theyre doing from seeing a quoted market value every day. They can go on, holding their property and collecting rental income, completely ignorant to the fact that every time interest rates move, the intrinsic value of their holdings is affected, just like stocks and bonds. This mistake was addressed when Benjamin Graham taught investors that the market is there to serve them, not instruct them. He said that getting emotional about movements in price was tantamount to allowing yourself mental and emotional anguish over other peoples mistakes in judgment. Coca-Cola may be trading at $50 a share but that doesnt mean that price is rational or logical, nor does it mean if you paid $60 and have a paper loss of $10 per share that you made a bad investment. Instead, the investor should compare the earnings yield, the expected growth rate, and current tax law, to all of the other opportunities available to them, allocating their resources to the one that offers the best, risk-adjusted returns. Real estate is no exception. Price is what you pay; value is what you get. 3. Confusing That Which Is Near with That Which Is Valuable Psychologists have long told us that we overestimate the importance of what is near and readily at hand as compared to that which is far away. That may, in part, explain why so many people apparently cheat on their spouse, embezzle from a corporate conglomerate, or, as one business leader illustrated, a rich man with $100 million in his investment accounts may feel bitterly angry about losing $250 because he left the cash on the nightstand at a hotel. This principle may explain why some people feel richer by having $100 of rental income that shows up in their mailbox every day versus $250 of look-through earnings generated by their common stocks. It may also explain why many investors prefer cash dividends to share repurchases, even though the latter are more tax efficient and, all else being equal, result in more wealth created on their behalf. This is often augmented by the very human need for control. Unlike Worldcom or Enron, an accounting fraud by people whom youve never met cant make the commercial building you lease to tenants disappear overnight. Other than a fire or other natural disaster, which is often covered by insurance, you arent going to suddenly wake up and find that your real estate holdings have disappeared or that they are being shut down because they ticked off the Securities and Exchange Commission. For many, this provides a level of emotional comfort.