About buying a home as an investment, thought this would be of interest to some people....
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A Close-to-Home Investment Where Less May Be More
By Albert B. Crenshaw
Sunday, February 3, 2002; Page H04
Figuring out what's a good investment would seem to be an easy calculation.
Something that returns 12 percent a year does a lot better than something that returns around 4 percent, right?
Well, maybe, maybe not.
Franklin D. Raines, chairman of Fannie Mae, the giant housing-finance corporation, told a story last month that shows how a 4 percent asset can outperform a 12 percent asset.
Imagine, Raines said, that it is January 1990, and three workers, John, Bill and Mary, have just gotten $10,000 bonuses.
John puts his $10,000 into stock of the Standard & Poor's 500-stock index. Bill puts his into a Nasdaq index fund. Mary uses hers as the down payment on an $80,000 bungalow to live in.
By last month, the S&P has more than tripled, so John has reaped a $22,294 pretax profit. The Nasdaq has done even better, nearly quadrupling, to give Bill a $29,882 profit, pretax. Not bad in either case.
But Mary's bungalow, if it racked up the average 4 percent annual appreciation of U.S. housing during that period, rose in value to $126,000, giving her a $47,287 gain. What's more, Mary escapes federal capital gains taxes under a special provision available to homeowners.
Raines, of course, was touting housing, which Fannie Mae helps finance.
But what his numbers illustrate, more than the joys of homeownership, is the way leverage works in investment finance.
You hear the term all the time. A "leveraged buyout." A company struggling with too much "leverage."
It sounds mysterious, but all leverage really means is borrowing, or the result of borrowing, which is debt.
Using leverage means putting down a small amount of cash and borrowing the rest to buy a large asset, which you hope will appreciate in value. If it does, your gain relative to the cash you invested is much larger than the percentage appreciation of the whole asset.
In Mary's case, the 4 percent annual appreciation was 4 percent of the full $80,000 value of the house, not just the $10,000 she put up.
In simpler numbers, imagine you buy a $100,000 house for $10,000 down and a $90,000 mortgage. If the house's value rises to $110,000, it has appreciated 10 percent. But if you sell it and pay off the $90,000 mortgage, ignoring any transaction costs and debt service, you'll get to keep $20,000.
The return on your asset, the house, was only 10 percent, but your "cash on cash" return, as it's sometimes called, was 100 percent.
John and Bill were getting a much higher return on their assets, but absent leverage, the cash gain generated by their $10,000 investment was actually less than Mary's. (Raines ignored debt service on the grounds that almost everyone has housing costs, so John and Bill would have been paying similar amounts in rent.)
So does this mean you should borrow to invest?
Wall Street is well aware of leverage, and brokerages commonly offer customers the ability to borrow to buy stock. Debt in this context is called "margin," and investors using it have margin accounts.
Margin accounts have strict rules, and if the market goes down, the brokerage can demand more cash or sell the investor's stocks. In markets like those of the past two years, that is a very real risk.
For most people, leverage is appropriate for a few investments, such as a home. It's also reasonable for investment real estate, as long as you understand what will happen if the place falls vacant -- no rent coming in, mortgage payments and other costs still due -- and could deal with that.
When it comes to stocks and other volatile investments, leave leverage to the pros. They can afford better bankruptcy lawyers.
© 2002 The Washington Post Company |
