I read an interesting post two weeks ago that discussed buying gasoline for 25 cents per gallon. Just reading the title made me think it was an article about getting gas in one of the OPEC nations where gas is provided at a subsidized price to citizens. But it turns out the post was talking about getting gasoline for a quarter per gallon here in the United States. I am not including a link since it was a thinly guised ad but the basic concept behind the ad was thought provoking to say the least.
The premise was that, in 1964, quarters (as well as other coins) contained silver. According to coincalculator.com, a 1964 Washington quarter contains 0.18 troy ounces of silver. Valued according to the silver content at $35.54 per ounce, a quarter would have a melt value of $6.43! This is a lot more than the $3.45 per gallon of gas that I paid yesterday. In fact, I could get almost 2 gallons of gasoline with that one 1964 quarter. When I do a search for gas prices in 1964, I find that the cost of a gallon of gas was 30 cents so I probably could get a full 2 gallons for the equivalent of 30 cents.
Another interesting comparison is the cost of a new house compared to the price of spot silver. Again if you can believe what you find on the internet, the price of a new house was $20,500, and the price of spot silver was $1.29 per ounce. These numbers make sense to me knowing that my parents paid $30,000 for their house in 1973. These prices mean that it would have taken 15,891 ounces of silver to buy a new house. Today, the median house is priced about $157,000 and silver at $35. Do the math and you find that it takes about 4,485 ounces of silver to buy a house today.
Now, you can argue all you want whether or not silver is a good investment or whether silver should be considered money. But that is not the point of this post. The point is that this information should really get one to thinking about the impact that inflation and money supply has on what we all pay for basic necessities of life.
What impact will this have on your retirement savings? You may argue that stocks beat inflation so there is no worry. Will you be 100% in stocks during retirement? Well, the S&P 500 closed 1964 at $84.75 according to this site. At $1.29 per ounce of silver, that is a stock market to silver ratio of 65.7. The current stock market to silver ratio is about 35.8 meaning that it takes less silver to buy the S&P 500. Interestingly, the difference is about 45%, and I have read that about 44% of the S&P 500 returns can be provided by dividends. Since the index numbers are without re-invested dividends, it seems that stocks have simply kept pace with the price of silver but offered no better returns on capital gains. Maybe the only reason stocks can outperform inflation is because of the dividends? Just another fact to ponder.
So, does this information mean anything to you? Were you a little surprised that a gallon of gas today would cost less than a quarter if that quarter were from 1964? Do you even consider silver a viable investment? I would love to hear your thoughts.
As I mentioned in my last post on how to make money following the real estate bubble, there are 4 primary ways of making money in real estate. Knowing and considering each one before purchasing a piece of property is an important part of the analysis of any real estate investing opportunity.
1. Cash Flow
The first way to make money in real estate is through positive cash flow. This requires either getting an incredible deal on the purchase price so that the rental proceeds exceed the cost of debt service, maintenance, and expected vacancies or that the amount of leverage used to purchase the property is low enough so the debt service is easily manageable.
I like to look at a property’s potential by looking at the capitalization rate if I had all cash to purchase a property. Here in central Indiana, it is fairly easy to find a single family home that can be rented out for $900-$1000 per month for $90,000-$100,000. This is actually the market that I have targeted. If I figure about 5% for vacancy and 5% for annual maintenance, that means I would be able to expect an annual net income of $12,000 minus $1200 or $11,800 on a $100,000 giving a cap rate of 11.8%. Think of that as the yield on a stock or bond. Not bad when compared to a savings account.
If you can find a property that has a decent cap rate, you are almost guaranteed to make money provided you don’t overleverage.
The second way to make a profit in real estate is through appreciation. Many investors in the real estate bubble counted on this as their main source of profits. It works pretty well until the music stops and there are no chairs left. Of course, the one ending up holding the bag is out of luck. That is why it is so important to analyze cash flow on a property and not overpay.
There are two types of appreciation. The first is that which is mentioned above which is the natural appreciation of a piece of real estate that occurs because demand is high and supply is low or the appreciation that comes as a result of natural inflation over time.
The other type of appreciation is forced appreciation. This is where an investor purchases real estate and deliberately increases the value of the property to either sell at a profit or to improve the cash flow. Think about buying a foreclosure that is in need of lots of repair and making those repairs for the purpose of flipping. That is forced appreciation. Another example might be buying a piece of raw land and building a storage facility or apartment building on it that will be rented out.
3. Leverage Pay Off
Not everyone can invest in real estate without using some borrowed money. The mortgage principal that is paid down each month is another way to profit from real estate especially if the mortgage payments are being paid by a third party. This is one of my main goals for investing in real estate. I don’t make a ton of cash flow each and every month and what I do make usually ends up being spent on vacancies or repairs. However, my goal is to come close to breaking even on a cash basis so that in 30 years, I will own a piece of property free and clear which will provide an on-going source of monthly income during retirement.
4. Depreciation and Tax Benefits
Depreciation as it relates to accounting and taxes is a method of decreasing the value of an asset over its usable life. The amount of depreciation can be used to offset income when figuring taxes. The purpose is to be able to set aside tax free money that can be used to ultimately replace that particular asset. However, when the asset is sold, that depreciation must be recaptured and tax eventually paid.
In real estate, it is possible to roll the proceeds from a sale of property into another property and defer taxes much like investing in a tax deferred retirement account. There are also tax benefits that individuals can use when selling a primary residence at a profit. It is important to consult an accountant or real estate tax attorney for all the details regarding the tax benefits of property ownership but these benefits can add up to substantial sums of money. Once these have been determined, be sure to get the best tax software available to ensure the accuracy of your returns.
In summary, there are several different ways that an investor can profit from owning real estate. Cash flow, appreciation, debt reduction, and tax benefits can all be used as potential sources of profit. It pays to know about each method and to maximize them all if possible.
Real estate has always been a decent investment provided some basic fundamentals of investing are remembered and followed. The problem that some investors and home purchasers had during the real estate bubble was failing to follow these basic rules.
1. Buy low and sell high
It can be almost impossible to make a profit in any investment if you overpay. It is easy to look back at the bubble and recognize it now, but would there have been some clues prior to the peak? One of the ways to have recognized that real estate prices were getting frothy would have been to look at the capitalization rate. In its simplest form, cap rate can be thought of as the cash yield on the investment. For example, if I purchase a property for $100,000 and make a net cash return of $10,000, the cap rate is 10%. You can think of it like the dividend yield on a stock. Going into the bubble, cap rates declined well below their historical average meaning investors were paying more and more money for less and less yield.
2. Don’t Overleverage
Leverage can be a double-edged sword. It’s great when prices are rising, but can wipe you out when prices are falling. Think about the 2 extremes of leverage when purchasing real estate, and it’s easy to see what can happen. If an investor pays all cash for a property to use it for cash flow and pays attention to the purchase price using cap rate, he cares little if the market value of the property drops 5-10%. That drop in value will not affect the cash flow so his investment is still making money. On the other hand, an investor who borrows 100% of the purchase price (or worse 120%) and doesn’t have any cash flow is losing some serious money and can’t afford to sell the property for any less than the original purchase price plus commissions and expenses.
3. Know How You Make Money
What is the exit strategy? You should have a plan going into the purchase regarding the profits to be made in your real estate investment. There are 4 main ways to profit in real estate which I will include in my next post. You want to know how to profit on that particular piece of property before you actually purchase it. It’s called having a plan. Plus since there are 4 different ways to profit from real estate, you might even have a back-up plan as well.
Real estate investing can be profitable if you pay attention to the purchase price, don’t overpay or use too much borrowed money, and know how you plan on making money.