Real Estate Financing and Investing/Getting Started as an Investor
Before you invest any funds, you should evaluate your present financial condition. Consider your income, expenses, taxes, future prospects for higher earnings, and all other details that affect your monetary situation. Decide how much you want to invest. Realistically, it can be done only with money left over after paying expenses, having proper insurance, and making pension contributions.
Then very carefully formulate your investment goal or goals. Will you invest in order to earn a profit? As a hedge against economic fluctuations such as inflation. To build up a retirement income? Your next step should be to examine the investment choices presented in this column and then decide which kinds of investments are best for you.
You should attempt to formulate an investment strategy based on your goals and financial characteristics. Investment planning should be aimed at arriving at a good mix of risk and reward. You should take into account the types of investments available including their return potential and riskiness. Also, You should be aware of the general risks of investing including those related to stock market price variability, inflation, and money market conditions.
Set your long term goals first, thinking in terms of the middle and distant future. Then establish short term financial objectives that are consistent with the long term aims. After six months or a year, if you haven`t been able to meet your short term goals, you may have to reevaluate the long term objectives. If, however, you have done much better than you expected to do, you may want to formulate more ambitious goals. Keep in mind that investing is an integral part of your overall financial planning.
Sources of Money for Investing
If possible, try to invest 15% of after tax income. Also, make sure before starting to invest in securities such as stock, your total assets should be two times your liabilities. Below are the possible sources of money available for investing.
- Discretionary income. After tax income is disposable income, money available to you for spending or saving. You must commit much of your disposable income to fixed or semi fixed expenditures such as housing cost, food, and transportation. Discretionary income is what is left after these expenses.
- Home equity. You may have a substantial amount of money sitting in your home. You can cash out some of it via either a home equity loan or equity line.
- Life insurance. If you have a cash value (e.g., whole life or variable life) life insurance, you can borrow up to a certain amount.
- Profit sharing and pension. If you own some form of annuity, again you may borrow up to a certain amount at a low interest.
- Gift from your parent or rich uncle.
- OPM (other people`s money).
Factors to be Considered in Investment Decisions
Consideration should be given to safety, return and risk, stability of income, and marketability and liquidity.
Security of principal. It is the degree of risk involved in a particular investment. You will not want to lose part or all of the initial investment.
Return and risk. The primary purpose of investing is to earn a return on your money in the form of: interest, dividends, rental income, and capital appreciation. However, increasing total returns would entail greater investment risks. Thus, yield and degree of risk are directly related. Greater risk also means sacrificing security of principal. Remember: You have to choose the priority that fits your financial circumstances and objectives.
Stability of income. When a steady income is a most important consideration, bond interest or stock dividends should be emphasized. This might be the situation if you need to supplement your earned income on a regular basis with income from your outside investment.
Marketability and liquidity. It is the ability to find a ready market to dispose of the investment at the right price.
Tax Factors. Investors in high tax brackets will have different investment objectives than those in lower brackets. If you are in a high tax bracket, you may prefer municipal bonds (interest is not taxable), real estate (with its depreciation and interest write off), or investments that provide tax credits or tax shelters, such as those in oil and gas.
In addition, there are many other factors to be considered, including:
- Current and future income needs
- Hedging against inflation
- Ability to withstand financial losses
- Ease of management
- Amount of investment
- Taxes and estate status
- Long term versus short term potential
- Denominations of investments required (For example, some real estate investment trusts (REITs) require a $5,000 minimum investment)
- Need for collateral for loans
- Protection from credit claims
Questions To Be Asked
In developing your investment strategy, it will be advisable to ask the following questions:
- What proportions of funds do you want safe and liquid?
- Are you willing to invest for higher return but greater risk?
- How long of a maturity period are you willing to take on your investment?
- What should be the mix of your investments for diversification (e.g., stocks, gold, real estate)?
- Do you need to invest in tax free securities?
Types of Investments
Investments can be classified into two forms: fixed income and variable income. Simply stated, fixed income investments promise you a stated amount of income periodically. These include corporate bonds and preferred stocks, U.S. government securities (Treasury bills), municipal bonds, and other savings instruments (savings account, certificate of deposit). On the other hand, variable dollar investments are those where neither the principal nor the income is contractually set in advance in terms of dollars.
That is, both the value and income of variable income investments can change in dollar amount, either up or down, with changes in internal or external economic conditions. These include common stocks, mutual funds, real estate, and variable annuities. A Treasury bill is a short-term U.S. government obligation that is sold at a discount from its face value. A Treasury bill is highly liquid and nearly risk-free, and it is often held as a substitute for cash.
Investments can be viewed as financial or real assets. Financial assets comprise all intangible investments things you cannot touch or wear or walk on. They represent your equity ownership of a company, or they provide evidence that someone owes you a debt, or they show your right to buy or sell your ownership interest at a later date. Financial assets include:
1. Equity claims direct
- Common stock
- Options and warrants
2. Equity claims indirect
- Mutual funds
3. Creditor claims
- Savings accounts and certificates of deposit (CDs)
- Treasury bills
- Money market funds
- Commercial paper
- Corporate and government bonds
4. Preferred stock
5. Commodities and financial futures
Real assets are those investments you can put your hands on. Real assets include:
- Real estate
- Precious metals
- Collectibles and gems
An investment may be short term or long term. Short term investments are held for one year or less, while long term investments mature after more than one year. An example of a short term investment is a one year CDs; a typical long term investment is a ten year bond. Some long term investments have no maturity date. Examples of along term investment are equity securities such as common stock and preferred stock. But you can purchase a long term investment and treat it as a short term investment by selling it within a year. Note: In selecting the types of investments you would want, be cautious in taking salespeople (e.g., brokers, mutual fund representatives) advice because their prime motivation is to earn a commission. Consult instead financial planners, CPAs, or investment advisors.
Common Stocks, Preferred Stocks, and Bonds
Common stock is a security that represents an ownership interest in a corporation. This ownership interest is evidenced by a transferable stock certificate. Each share is a fractional ownership interest in a corporation. You acquire an equity interest in the corporation by buying its stock. As a stockholder, you can vote for the board of directors of the corporation. The equity investment has no maturity date. Preferred stockholders have preference over common stockholders with respect to dividend and liquidation rights, but payment of preferred dividends, unlike bond interest is not mandatory. In exchange for these preferences, the preferred stockholders give up the right to vote.
A bond is a certificate evidencing a loan by you to a business or to government. You will receive interest and principle repayment for your investment. Bonds may be categorized as follows:
(a) Mortgage bonds. Mortgage bonds are backed by collateralized property which may be.
(b) Debentures. They are backed by the issuing corporation`s good faith and credit. The issuing company must be financially sound. High credit ratings are essential. Government bonds are examples.
(c) Subordinated debentures, honored after debentures in the case of liquidation or reorganization (though still before stocks). Junior debentures are sometimes issued by finance companies.
(d) Income bonds. The bonds pay interest only if there is profit.
Risk, Return, and Investment Policy
How much financial risk should you be willing to take on an investment? Risk is the chance you take of losing money on an investment; it is the uncertainty regarding the investment`s final payoff, in other words. The more an investment can vary in value during the maturity period, the greater the risk you take when you buy and hold on to it.
All investments involve some degree of risk. In general, you will have to find a balance between risk and return; the higher the risk, the greater must be the return. Aggressive investment policies attempt to maximize return and take above average risk. Defensive investment policies are designed to reduce risk but also provide less return. If you invest aggressively, you tend to buy and sell more frequently. In a defensive strategy, there is a "buy and hold" philosophy. Aggressive investment may include buying securities on margin (credit) so as to increase profit potential. Defensive investment does not rely on credit (or leverage). Diversification is a defensive policy.
Aggressive investing involves concentration by investing in a few securities at one time in anticipation of a high return. Often, the more money you invest in one source, the higher the rate of return. For example, a bank will usually pay you a higher interest rate on a $100,000 investment compared to a $10,000 investment.
Most investors favor safe investments over risky ones. If you are one of them who wants a safe investment with predictable but low return, invest in U.S. government securities, bank account, or money market mutual fund. If you are retired, you may favor safe investments providing fixed yearly returns. Appreciation in the price of a security is not as important as stable, guaranteed income. Risky investments are undesirable due to uncertainty. Thus, a retiree may be satisfied with a long term government bond.
Marketability and Liquidity
Marketability should be distinguished from liquidity. Marketability means you can find a ready market if you want to sell the investment. Liquidity means the investment is not only marketable but also has a highly stable price.
Liquidity may be important if you have limited investments or are saving for a specific personal or business item (e.g., down payment on a house). However, liquid investments typically earn less of a return than illiquid ones. You desire to minimize delays and transaction costs to convert the investment into immediate cash. Liquid investment include savings accounts, money market funds, and certificates of deposit. If you may need funds in an emergency, liquid fund should exist!
The following table depicts marketability and liquidity factors for an investment.
INVESTMENT MARKETABILITY AND LIQUIDITY
|Savings accounts||Not applicable||Good|
|Short term U.S. government securities||Good||Good|
|Long term U.S. government securities||Good||Average|
How do Interest Rates Affect Your Investment?
Bonds are sensitive to changes in interest rates. When interest rates go up, bond prices go down. If you paid $1,000 (par) for a bond that paid 6%, or $60 interest per year, and then interest rates went up so that newly issued bonds were paying 8%, or $80 interest, no one would want to buy your bond for $1,000. Why would anyone take 6% if that person could get 8%? The price of your bond would have to decline so someone could buy it at a discount (below $1,000), so he or she could make a profit on the lower price paid and get back $1,000 at maturity.
As interest rates increase, stock prices also tend to decrease for the following reasons:
- Dividends are less attractive. Thus, there tends to be a sale of stocks.
- It makes it more costly to buy stock on margin (credit) discouraging investment in stocks.
- It results in higher cost to business of financing, decreasing profits and inhibiting expansion.
Real estate is pretty sensitive to interest rate changes.
How Would Inflation Affect Your Investment?
Inflation is an increase in price for goods and services over a short time period. A rapid increase in inflation will cause interest rates to rise, and bond and stock prices to fall.
Recommendation: Avoid fixed income securities. Consider buying real assets such as real estate since they are generally considered inflation hedgers. Investments doing well or poorly in inflation are given below.
Investment Performance In Inflation
Good Performance in Inflation:
- Real estate
- Precious metals (gold and silver)
- Mutual funds specializing in mining stocks
Bad Performance in Inflation:
- Short term securities (T bills and CDs)
- Mortgage backed securities
What Are Some Investment Guidelines to Follow?
- If you want to speculate do it in stock where the gains can be significant, not in corporate bonds.
- You are better off buying a high quality bond issue.
- Purchase stocks when they are undervalued and hold for the long term.
- Do not invest in a tax shelter unless it appears to be a good investment.
- Do not invest too heavily in precious metals because of volatility.
- Buy into a mutual fund that shows a consistent long term performance (e.g., five or ten year period) and did well in both good and bad markets. A mutual fund may show great performance only in one year because of luck, unusual circumstances, or the risky stocks bought shot up.
Warning: Avoid selling short, buying options, and investing in commodities because these are short term, risky investment strategies and if you are wrong on timing and market direction, you may suffer significant losses.
- Buy real estate in good location and hold for 5-7 years.
Is It Worth Borrowing Money to Invest?
You may want borrow money to make investments. This is known as leverage. You can drastically increase the yield on an investment otherwise made entirely from your own funds. This increase occurs when the return on investment exceeds the cost of borrowing. You can achieve maximum return:
- By buying stocks on margin
- Through options or futures contracts
- By putting down as little money as possible (or sometimes no money down) in real estate.