The nature of investment

Webster’s New Universal Unabridged Dictionary says an investment is, “the property in which one invests.” That’s tautological and therefore unhelpful.

That same book defines “invest” as “6. to put (money) into business, real estate, stocks, bonds, etc. for the purpose of obtaining an income or profit.”

I wrote a rather advanced book on the fundamentals of real estate investing which you may want to read. Click on the cover to get more information about it or to order it.

How is that different from buying a lottery ticket? Most people would say buying lottery tickets is not investing. It is gambling.

Webster’s defines “gamble” as “1. to play games of chance for money or other stake 2. to take a risk in order to gain some advantage.”

Seems to me there really is no difference between investing and gambling except that one has a good image and the other has a bad image. I have called Wall Street stock brokers “bookies in three-piece suits.”

Also, gambling commonly tells the gambler his result faster than investing tells the investor his. In that sense, investing is merely gambling in slow motion.

Webster’s does not say it, but most people would, that gambling is riskier than investing.

Risk

What is risk? Risk is the possibility of multiple outcomes of varying attractiveness or unattractiveness.

In gambling, the games are structured deliberately so “the house” always wins and the gamblers, as a group, always lose. The odds are known. Generally, the only rational reason to gamble, and it’s not very rational, is for the thrill of it. Gamblers call it “the action.” I have no use for casino gambling. But if you do it sparingly like riding a roller coaster, it’s a fairly harmless thrill. However, I have studied gambling for the insights it gives me into real estate investing.

In business, real estate, stocks, bonds, and commodities, “the house” is the brokers and others who charge transaction fees—much bigger fees than “the house” charges in gambling or the securities markets (stocks, bonds and commodities). (Low-cost index funds like the Vanguard 500 Index have low fees—around .2%—but most real estate and securities accounts carry much higher fees.) In those investments, the odds are NOT known.

A visitor newly arrived from Mars might wonder why the one with low fees and known odds (gambling) is considered riskier than the ones with high fees and unknown odds (investing). Good question.

Is it possible for a particular gambler to win? Absolutely. “The house” has to let a few win or no one would play. Is it possible for an investor to lose? Absolutely. It happens all the time.

The long run

Those who believe investing is better than gambling point to past prices of stocks and real estate as proof that it generally goes up. Advocates of the stock market are fond of talking about the long run. For some reason, their favorite long run seems to be 1926 to the present. Why not September, 1929, to the present? Or 1892 to the present? Not ever stock or real estate has gone up in the long run. Some go down and stay down. Some stay down for so long that by the time they finally go up, the cost of waiting exceeds the profits. Investing is not so simple that simply hanging around for “the long run” guarantees you adequate profits.

Shopping list

The whole idea of investing is that you want to buy something that you cannot currently afford. Accordingly, you should work backward. List the things you want to buy that you cannot now afford and the dates that you want to buy them.

I’ll bet that you want to buy them sooner than the “long run,” which in the case of 1926 to the present is 82 years. In the super book A Random Walk Down Wall Street by Burton G. Malkiel, there is a graph showing the average and ranges of returns in common stocks for various durations between 1950 and 2002.

If you could wait 25 years to buy the stuff your investment program is aimed at getting, your average annual return during that 52-year period would have been 10.5% before adjustment for inflation—less after adjustment for inflation. The best 25-year period had an annual return of 17.24%; the worst, 7.94% both before inflation. Of course, this assumes that there will not be another depression like 1929 during the next 25 years.

If you want to buy that stuff in just ten years, common stocks would have returned just over 10% on average; as much as 19.35% in the best ten-year period and as little as 1.24% in the worst—all before inflation. Again, the worst ten-year period in the Twentieth Century—rather than 1950 to 2002—probably 1929 to 1939, most likely would not have helped you with your shopping list.

Bottom line, the long run that the stock market people need to have a decent worst case return is in the 25 years or longer range. If you want to spend that money sooner than that, you are involved in a crap shoot.

Real estate

Real estate also requires a long run the way most people do it; that is, just buying a property and hoping the whole market goes up in value. Transaction costs in real estate are extremely high—in the area of 10% of the cost of the property—and often 100% or more of your investment (generally called a down payment or equity in real estate).

So if you tried to, r were forced to, sell quickly in most cases you would lose money after transaction costs. So if you are a speculator, that is, you are hoping the whole market in your area goes up, you probably need to hang around for the long run to have any chance of the profit exceeding the transaction costs. If you have negative cash flow, which is typical, hanging around for a long time is expensive and hard to do.

I do not advocate such speculating. See my books and my other articles at this Web site for more information on the approaches I recommend.

For example, the often-bandied-about 12% annual return of the stock market is based on goofy assumptions like never incurring transaction costs or paying taxes and ignores that many of the stocks you would have bought decades ago were for companies that went bankrupt and/or out of business. The Vanguard 500 Index fund actually has earned 12.01% per year on average since its inception in 1976, but they did that by avoiding transaction costs and taxable events. Only the Vasnguard 500 Index did that well. All the others did less well. The founder of Vanguard is John Bogle. He wrote an excellent short book called The Little Book of Common Sense Investing that you should read.

Other stock-market figures that are often cited are undercooked books that are selected by securities-industry types to make the stock market or their stock picking look good. At any given moment, somebody has a good track record, but that means nothing about whether they will in the future. At any given moment, some stopped clocks have the correct time. An army of chimpanzees that picked stocks would have some with good recent track records at any given time. It is a random effect explained by the Law of Large Numbers.

The truth is that sometimes the stock market goes up and sometimes it goes down. What the long-term return will be in the next twenty or thirty years in unknown. If you still believe that the stock market has been great, pick a portfolio of stocks and a start date like 1960 then see what happened to that portfolio since then. Assume whatever level of trading and commissions is realistic, not zero. Make sure you do not overlook stock splits, dividends, income taxes, and such.

Gary Eldred talks a lot about the stock market in his real estate investment book Value Investing in Real Estate. You can see my review of it here.

What if you ‘know what you’re doing?’

Many laymen figure that real estate is normally risky, but not “if you know what you’re doing.” Is that true?

Generally, no. There is only a little bit of truth to it.

Real estate like any investment is subject to many risks. Some, like interest rates rising, are totally unpredictable. Can you manage or control interest-rate risk? You can and should use only 30-year, fixed-rate, self-amortizing mortgages. But that still leaves you vulnerable to the adverse effects on your property value of interest rates rising. There are some sophisticated tricks like selling bonds short and such that would enable you to hedge against interest rate rises adversely affecting your property values. But there are a number of weaknesses to that strategy. Generaly, since you can neither control nor forecast interest rates, they represent a huge risk that “knowing what you’re doing” is irrelevant to.

You can use only 30-year, fixed-rate mortgages in your real estate investing. That is what I recommend. Does that insulate you from interest-rate risk?

Partly. It insulates you from an increase in your payments as long as you own the property and keep the mortgage current. But it does not protect you from the adverse effect on your property value if interest rates go up. That’s because the new buyer of your property would have to get a new mortgage at then market interest rates. The higher those are, the less they can pay for your property. Is there any “knowing what you are doing” than can reduce or eliminate that risk? Nope.

How about managing? If you “know what you are doing” with regard to how to manage rental property, does that eliminate risks relating to poor management?

The more competence you have in management, the fewer mistakes you will make, but there are still unavoidable risks. I was a professional property manager, managed my own buildings for 23 years, attended numerous seminars on property management, got a Harvard MBA, read many books on property management, was a featured speaker at a number of national, state, and local apartment association conventions and meetings. And I have written a book that is now in its fifth edition on how to manage rental property. Most people would say I knew what I was doing. But I still had drug dealers, a prostitute, and other bad tenants. Not everything is revealed by careful tenant screening. Plus, you get the previous owner’s tenants when you buy a multi-family building.

There are other management risks that are not totally controllable like hiring a dishonest or incompetent employee, hiring a bad subcontractor, overlooking some obscure new law, and so forth.

Toxic contamination

Does knowing what you are doing protect you from the risk of toxic contamination?

Partly. If illegal toxics are found on your property, you are liable. Doesn’t matter whether you put them there or a prior owner did. Often, the cost of clean-up exceeds the value of the property after it has been cleaned up. That means that the property before clean-up has a negative value. You would have to pay someone to buy it. If it has a mortgage, so much the worse. You would not only have to pay them to buy it, you would also have to pay them the balance of the mortgage.

When you buy, you can and should get a report from an environmental inspector. Is that total protection? No. Read the report. It says the inspector is not liable if he or she screws up, they only inspected what was in plain view, and so forth. Also, the government adds new substances to the list of what is illegal all the time. My friend Leigh Robinson owns mobilehome parks. They have water wells. Each year, the number of chemicals he must test for in the water goes up.

Similarly, the inspector you hire will only check for substances that were illegal when you bought the property. He did not check for those which were declared illegal after you bought it. Are you liable for cleaning them up? Yep. Even if you were not, you would be required to inform any buyers about them and no one would buy the property until it were cleaned up.

Can you buy insurance to protect you from toxic liability? I believe so, but the policies are unusual, do not cover everything, and have deductibles.

Incorporating

Can you protect yourself by incorporating? Ask a lawyer, but generally, no. See my article on “How should you hold title to real estate or your business.” Even if the law was willing to let you escape liability for toxic cleanup or some tort that occurred in conjunction with your corporation owning the property, they would confiscate the property to pay the amount in question. And few lawyers would fail to try to pierce the corporate veil in pursuit of your other assets.

Can you use “asset protection” techniques like putting your property in a trust based in some foreign country that was advantageous? The people who sue you know where the property is. The only “asset protection” I know of that is totally legitimate and practical is bankruptcy planning. That is, putting as many of your assets as possible into assets that are protected from creditors in your state. The two most notable such assets are your home in some states like Florida and Texas and your pension in some states like California (e.g., O.J. Simpson). Even there, you do not get unlimited protection.

Are there other risks in real estate?

Sure. Natural disasters like hurricanes, floods, hail, blizzards, tornadoes, termites, slides, and earthquakes. Adverse changes in federal income tax laws like the Tax Reform Act of 1986. Increases in property taxes. Increases in the cost of building utilities. A recession or depression. Closing of a military base or factory that is important to the property in question. Obsolescence of the building type (e.g., multi-story warehouses). Adverse change in the economics of a natural resource important to the property like local farming or mining.

Insurance

Doesn’t insurance protect you?

It can protect you from some risks like fire, wind, tort liability, and so forth. But most real estate risks are uninsurable.

So are the gurus who say they will teach us how to invest in real estate “safely” lying?

Yes.

Am I anti-real estate investing?

No. I recommend approaching it as an active business rather than a passive investment. For example, if you find a way to buy a property at a bargain price (at least 20% below market value) and resell it in a relatively short period of time, you generally hold down your exposure to the risks listed above to an acceptable level. The problem comes when you just buy and hold. The longer you own, the greater the probability that you will get sued, infested with termites, see a law change that makes your property less valuable, and so forth.

Investing—where you park money in a rental property—is really just a form of gambling. If you are lucky, it can be profitable. If you are unlucky, it can lose your money.

Business, where you actively make bargain purchases or upgrade a property has a far lesser element of gambling because adverse occurrences are less likely to happen during a short period and the profit margins in bargain purchases and upgrading are much greater than buy and hold so you can absorb some bad things without going into the red. You also have far more control so there is less risk and you are less dependent on things that you can neither forecast nor control.