Real Estate Investing

Real Estate investing is also a very popular vehicle for investing. Real estate investing provides several ways to make money:

• Appreciation - this is the difference between the price you paid for the property and the price you get when you sell.


• Depreciation - The non technical definition of depreciation is the amortized value of the non land value of your property. Property requires maintenence, so you are able to depreciate (one thing to be careful of here is that your income deteremines how much depreciation you can claim on your taxes) the structure over the amortization schedule. The value you get from depreciation is deducted from your taxes (so you can get the value*tax rate) so you can realize this before you sell, but when you sell the depreciation taken is added on to the basis.


• Rent - The expense of maintaining investement properties can be offset by rental income. If the rental income exceeds your monthly expenses, then this is referred to a cash value property and you will have income from this property.


• Equity - this is the amortized portion of your debt service. The equity you build is your money, once the loan is paid off or a cash out refinancing occurs

Real Estate is a somewhat more hands on investement as you actually own the property and have to be more involved than in equities where you need to just write a check.

Where to Invest your 401(k)

The last blog entry described the advantages of participating in a 401(k) or equivalent retirement plan. In this entry, I will focus on some investment options. Generally, a company provided retirement plan will support investing in a variety of mutual funds. The investment options will likely include money market, bonds, and equity funds.

Overview of investment types

• A money market fund is a very safe investment, similar to a savings account, and the return reflects the safety. Generally, this is really only useful in a retirement fund when retirement is imminent. The share price of a money market fund is typically one dollar although this may fluctuate. The interest, typically paid monthly, is where money is made on this investment.
  


• A bond fund invests in different types of bonds. A bond is a loan typically to a large company or government. The quality of a bond is measured in terms of the credit worthiness of the borrower. The junk bonds of 80's fame were high yield (paying a higher interest rate) and were thus more risky (the chance the principle would not be returned). A bond fund pays interest based on the interest rate of the bond. The price of a bond fund fluctuates based on the interest rates. The price fluctuates based on the return of a bond purchased currently. For example, if comparing two $100 bonds (assuming everything else about the bonds is identical) one at 8% and another at 10%. The price of the 8% bond is discounted so that the yield would be the same (2%).
  



• Equity funds invest in stocks. There are many different types of stocks large cap (which invest in large companies), small cap (which invest in small companies [relative to the large cap companies], and international funds. There are also vertical funds which invest in specific areas such as energy or technology. Stock pricing is difficult to predict because of the many variables. Earnings are growth are typically predictors of a good stock.
  

I strongly agree with the mutual fund investment philosophy of John Bogle (the founder of Vanguard). John Bogle has several books on investing but he has several premises:

• An active mutual fund, one which attempts to pick stocks which will outperform the market, is at a disadvantage to funds which represent the entire market. The rationale is that the trading and research costs will increase the expenses in the fund. An index fund can be run by a computer and does not need to spend as much on research and trading expenses. In addition to the increased expenses which put the active fund at a disadvantage, the active fund must be able to select stocks which outperform the market (the index fund). There have been several studies which show that the top performing funds for one year tend to be the worst performing funds in subsequent years. This is the reversion to the mean theory, which states that the if a fund has been earning 5% more than the average it is likely that a fund will have some losing periods to help revert to the average return. There is a great book A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing by Burton G. Malkiel which provides some great insight on stock picking and mutual fund investing.


• The other point from Bogle and many others books is on how diversification is more important than the exact fund you pick. As long as the expenses are reasonable, then the fund for the asset class doesn't matter as much. Diversification is how to allocate your investment money between different types of assets. The goal for diversification is to attempt to reduce the volatility of your portfolio with decreasing your return. Volatility of a portfolio requires going back to statistics to determine how much a typical period will deviate from the average. A smaller volatility provides additional confidence that in any given year the return on your portfolio will be close to the average. Volatility can be reduced by investing in more stable investments like bonds, but the tradeoff is that less volatile investments have a smaller return.
  

My approach has been to choose my allocation in different classes, currently I am allocated as follows:
Stocks 80% (44% in the Vanguard 500 Index Fund, 20% Mid/Small [Vanguard Tax Managed Small Cap, Vanguard Explorer Fund], 16% international (Fidelty International fund, Vanguard International Index)
Bonds 20% (Vanguard Intermediate Index Fund).

401(k) Overview

A 401(k) or similar investment vehicle (403(b), 457) provide a way to contribute pretax income into an investment option selected by the administrator of the retirement plan. Pretax investing allows money to invested without reducing your take home pay as much as investing after tax. The effect on tax home pay depends on where you live and the number of dependents you are currently claiming. There is a good calculator from Wachoviahttp://partners.financenter.com/wachovia/calculate/us-eng/paycheck01.fcs where you can see the effect on your paycheck as well as the differences between investing after tax and pretax.

While investing pre-tax income is great, many employers provide some level of matching employee contributions.
This also varies on the employer, but many people are leaving money on the table and not taking advantage of an enhanced return.
Lets consider a hypothetical 50% match on 5% of your salary.
Pay period salary $1,000
Employee contribution 10% = 1000*.1 = $100
Employer match 50% of 5% of your salary = 1000*.05*.5=$25
Total contribution = $125
Return on investment = 25/100 = 25%

The return on this investment is much better than the historical stock market (around 10%). My recommendation is that if you have an employer match, I would strongly recommend participating in the employee plan at least to the maximum extent you will be matched by your employer. The employer match is hard to beat, but when deciding how much to contribute beyond what will be matched by your employer consider the following:

• What investment options are offered by your employers plan administrator. For money without an employer match one of the biggest factors in the rate of return is the expense of the investment. Most employers typically offer mutual funds, so the expense of the mutual fund will strongly influence the rate of return. If the funds offered are low performers or there expense ratios are higher than the expense ratios for other funds in the same investment class (small cap, large cap ...), then it maybe worthwhile to contact your plans administrator and ask to enhance your choice of investements as well as considering investing additional funds through an IRA (the fund alarm website is a good resource to check the performance of mutual funds relative to other funds in the same class). Many companies provide access to the investement grade funds, which have large minimum investments ($1,000,000 or more) as well as lower expenses.


• What matching options are available. Some companies do not match investment funds or match funds in company stock. Matching in company stock is tricky as your retirement and continued employment are with the same company. If the company were to go bankrupt, not only would you lose your job but some of your retirement assets as well. This is what happened to a lot of Enron employees. I would not invest my retirement assets in company stocks (an ESPP is a different matter however)


• How long until you are vested. Vesting is when the matching funds are effectively transferred to the employee. For example, if an employer has a 5 year vesting schedule then the matching funds are only available if the employee stays on the job for 5 years. If you don't think you will stay with an employer long enough to be vested the investment options are important

Introduction

I considered starting this blog for a long time and finally decided to begin a blog on the investment knowledge and decisions that I make. I am not a professional investor but I do not have a pension and am responsible for ensuring my own financial future, so I thought other people would be interested. I invest in both Real Estate and equities and thus this blog will focus on what I have learned about these investment vehicles (with perhaps a little tax information thrown in where it makes sense).

This blog will NOT be about getting rich quick, so don't expect any hot stock tips.