Promoters of every type of cockeyed scheme and speculation claim to offer investment opportunities. Peddlers of financial products, purveyors of financial services, pandering politicians, and even car dealers tell us to buy what they are selling because they offer us a good investment. Commodities, jewelry, condo timeshares, baseball cards, and old Mason jars all are marketed as worthy investments. Even luxury goods (i.e., wealth-destroying extravagances) such as $5,000 wristwatches and $80,000 cars are now advertised as investments.
If you borrow against your home equity to invest, choose assets that yield both a growing stream of income and a near certain increase in value. Mortgage Secrets favors property. In terms of cash flows, no other asset beats income-generating real estate. In terms of inflation protection, no other asset beats income properties. Yet when inflation falls, interest rates fall. Property cash flows go up because you can refi into lower mortgage payments. Values go up because buying power increases. With rental properties, you win when inflation runs rampant; you also win as it declines.
In addition, rental properties provide tax advantages such as taxfree, cash-out refinances (to further pyramid your wealth); noncash tax deductions for depreciation; tax-free trade-up exchanges; and deferred taxes on capital gains through the use of installment sale contracts.4
To pursue this investment strategy, use a cash-out refi (or a home equity line of credit) to raise $25,000 or $50,000 (perhaps more). Apply that money as a down payment to acquire a rental property.
Your interest costs (at today's rates) should total less than 7.5 percent, but the rental income plus appreciation of your property should yield (after expenses) 10 percent to 20 percent on the amount of your invested capital. With this spread between borrowing costs and yield, your leveraged rate of return proves wise. If you choose your rental property according to sound investment principles (as explained in my books on real estate investing), you could achieve these high returns with little risk. Mortgage Secrets would never advise you to gamble your home equity with risky ventures.
If you live in a high-priced housing market, invest in areas of the country (or world) that yield higher cash flows per dollar of investment. In recent years, for example, many Californians have bought property in Nevada, North Carolina, Arizona, Texas, Mexico, and Costa Rica.
What About Stocks?
During the 1990s, some financial writers and advisors urged homeowners to cash out their home equity and invest it in the stock market. In his 1997 book, The Strategy: A Homeowner's Guide to Wealth Creation (Key Porter Books), Garth Turner painted a wealthy, risk-free future for homeowners who would borrow against their home equity to buy stocks:
Imagine, wealth virtually without risk. It's now possible thanks to the amazing convergence of low interest rates, solidly rising financial markets in the long run and an economic rebound in North America that will last well into the new millennium Today you can dip into your
4 For more details, see my book, Investing in Real Estate, 5th ed., (John Wiley & Sons, 2006).
real estate equity and put that money into financial assets with confidence as long as you invest for the long term.
Turner goes on to tell his readers, "The new rule of real estate: [a home] is now just shelter, not an investment What you ultimately want and need is wealth, not a house Your future lies with financial assets, not real estate."
Indeed, hundreds of thousands of United Kingdom homeowners bought into this idea through a financial product known as endowment mortgages. To learn about the wealth-destroying disaster that ensued, google "U.K. endowment mortgages."
In his influential book, Stocks for the Long Run, 3rd ed. (McGraw-Hill, 2002), Wharton School professor Jeremy Siegel enthuses over stocks as the salvation for all investors who will keep the faith.5 "Buy and hold through the market's ups and downs," Siegel advises. You will become wealthy. It's virtually guaranteed. Like Garth Turner, Siegel suggests (though not so emphatically) that homeowners leverage up their home financing and put their cash proceeds into the stock market.
From a casual perspective, this technique to build wealth seems reasonable. Borrow mortgage money at a tax-deductible rate of 6 to 8 percent. Use that cash to buy stocks. Stock fund promoters claim that over the long run stocks yield returns of 10 to 12 percent a year—albeit with bumps and jolts along the way. Hang on for the ride and you eventually end up with far more money. What a wonderful opportunity to borrow home equity money cheap and invest high.
Sounds pretty good, and it could work. If stocks for the long run do yield a near certain 10 to 12 percent annual return, this strategy pays off big as long as your retirement—or other need for the funds—does not occur during one of those long periods of down markets, for example, 19661982.
5 For a detailed discussion of Siegel's faulty analysis and conclusions, see Gary W. Eldred, Value Investing in Real Estate (John Wiley & Sons, 2002).
Unfortunately, that 10 to 12 percent stock return figure does not warrant confidence. Stock market volatility creates more destabilizing uncertainty than the enthusiasts admit. If your retirement years coincide with a bear market, you could end up flipping burgers at McDonald's or greeting customers for Wal-Mart. Facts oppose the claims of the stock enthusiasts. Financial assets display major long-term risk. That's why Mortgage Secrets favors long-term investing in real estate rather than stocks: Safely leveraged real estate returns exceed the stock market's (overstated) yield of 10 to 12 percent. Yet real estate (housing) experiences fewer, milder, and shorter downdrafts while providing near certain upside potential over periods of five to ten years. (For historical data on stocks, bonds, and housing, see pegasusdialogues.com and garyeldred.com.)
For proof that property investments experience fewer and less severe price slides than stocks, try this experiment. Call several mortgage lenders. Ask them if you can borrow 90 percent of a property's purchase price for a period of 15 to 30 years at a fixed rate of interest. Of course you can. Now, ask those same lenders—or even your stock-touting brokerage firm—if they will make you a similar deal on a portfolio of stocks. "What? Are you crazy," they'd respond. Or just as likely, they'd tell you to pay cash for your stocks with money borrowed with a low interest rate home equity loan.
This simple, commonsense approach to risk assessment speaks volumes. If stocks were less risky than real estate, why won't banks accept stocks as collateral for loans with the same terms and costs that are widely available for property? (Remember, too, unlike stocks, property loans do not require a margin call.)
Rental properties outperform stocks as an investment because they yield a dependable and growing flow of income. Over time, rents for well-kept houses and apartments trend up. In contrast, at current market valuation, most stocks pay dividends of only 1 to 3 percent a year. More than 125
companies in the S&P 500 pay no dividends at all. By any reasonable standard, income yields do not support current stock prices. For the most part, stocks remain speculative because you hope to later sell them for a higher price to someone else—and of course, your buyer feels the same. But when confidence in the "greater fool" theory wanes, the bear strikes. Stock prices free fall.
All true investments must yield enough expected income to justify their current price. If you pay for future price gains without a commensurate level of income, you're speculating, not investing. Most speculators do not build a long-term, solid foundation of wealth. (See the classic exposition of this point in John Burr Williams, The Theory of Investment Value, Harvard University Press, 1938.)
Of course, I am speaking in terms of averages and tendencies. Undoubtedly, some stocks offer great promise for income and growth. Some properties are overpriced money traps. No matter which assets and asset classes you choose for your investments, due diligence must prevail. Anyone who merely assumes that any given property (or stock) will prove itself profitable should rethink those assumptions.
Good Idea: You Choose
Garth Turner writes in The Strategy:
The greatest threat facing North Americans is not having enough capital to finance decades in retirement. And one of the greatest assets you have for fighting that threat is your home. It can help save you, but only if you follow The Strategy.
Undoubtedly, a shortfall of savings and investments does endanger millions of people. And you can profitably use 6 to 8 percent mortgage money to build wealth when you invest in assets that dependably earn more than your cost of capital. But if you do adopt this strategy, evaluate your investment alternatives in terms of their reasonable potential for income, appreciation, and risk. Your home equity sets the foundation for your wealth. Don't spend it for vacations and new cars. Don't throw it into ill-fated investment schemes.
SECRET # 102
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