Trump for Boomers Bank

July 6th, 2008 John Krol Posted in Trump |

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Trump University Presents…

What Makes

Real Estate

the World’s

Best Investment?

“Whether you’re

in the market

for a skyscraper

in Manhattan or

a duplex in the

suburbs, you need

to know what

you’re doing to

succeed as a real

estate investor.”

— Donald J. Trump

By Gary Eldred, Ph.D.

Trump University Real Estate Learning

Faculty Head

Table of Contents

I. Introduction

II. What Makes a Good Investment?

a. Income Flow

b. Accumulation of Equity

c. Protection Against Inflation

d. Preservation of Capital

III. How Does Real Estate Stack Up?

a. Income Flow

b. Accumulation of Equity

c. Protection Against Inf lation

d. Preservation of Capital

IV. Conclusion

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877.508.7867 The World’s Best Investment?

I. Introduction

As the “baby boom” generation ages, concern about adequately funding

retirement has reached a fever pitch. Social Security looks less and less likely to

provide any semblance of former benefits in the near future, driving individual

investors to take charge of their own financial future. Investors are looking for

the simple answer, the “magic bullet,” to funding a long and happy retirement.

What type of investment will give the best performance over the long haul?

Many financial “experts” argue that over the long term, the stock market has

outperformed all other investments. This claim is based on the assertion that from

1926 to 2005, the S&P 500 returned an average annual 10.46% gain. Putting aside

for a moment the veracity of that assertion, we’d argue instead that real estate

has been and, in fact, remains the world’s best investment.

The ownership of small income properties (such as single family homes, duplexes,

and small apartment buildings) is a path to wealth building that you can count on.

A real estate investor uses small properties to grow wealth in six key ways:

1. Collecting a dependable and growing income (rents)

2. Value increases (appreciation)

3. Mortgage payoff (amortization)

4. Value creation (property improvement)

5. Instant gain (bargain purchase price)

6. Government benefits (tax credits, tax deductions, rent vouchers,

advantageous loans, etc.)

In the pages that follow, we’ll take a brief look at the components of a “good”

investment. What factors must you consider as you strategically try to grow your

wealth and build your retirement nest egg? How can you evaluate an individual

investment opportunity? We’ll then use these criteria to compare a typical

investment in small income properties and investments in stocks. You will see

how real estate can offer you a clear path to prosperity.

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877.508.7867 The World’s Best Investment?

II. What Makes a Good Investment?

No specific class of investment is always better than another. A shrewd investor

looks carefully at several aspects of each investment opportunity and considers

relative price, yield, and risk. While market trends and indices can provide some

helpful information, you certainly shouldn’t base your investment decisions on

such broad markers. Your goal as an investor is to protect and grow your wealth

by making individual investment decisions that help you achieve your own

unique goals.

Let’s examine the factors that help determine what kind of a return you’ll earn

on a particular investment and how likely that investment is to help you achieve

your personal investment goals:

• Income flow

• Accumulation of equity

• Protection against inflation

• Preservation of capital

a. Income Flow

One component of the total return earned by an investment is the value of any

cash flows that asset is expected to produce over time. For instance, in the case of

stock ownership, income is obtained through the distribution of dividend payments.

In the case of a small income property, income is obtained through rent paid

by tenants.

When evaluating the overall value of an asset, an investor will consider both the

expected price appreciation and the present value of expected future cash flows.

That is, estimating the current worth of an asset based specifically on the amount

of cash the investor expects to receive in the future by virtue of owning that asset.

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877.508.7867 The World’s Best Investment?

b. Accumulation of Equity

The overarching goal of investment activity is to build your wealth by accumulating

equity over time. Several factors impact how well and how quickly a given

investment helps move you toward this goal:

• Appreciation: One fundamental way to earn money on an investment is

to purchase an asset then sell it at a later date for more than you paid for it.

Appreciation refers simply to the increase in the price of an asset over time.

Appreciation is one component of total return on an investment. For instance,

a piece of artwork purchased for $1,000 in 2000 and sold for $1,500 in 2002

has appreciated $500 (50%) over two years.

• Leverage: The ability to leverage refers to an investor’s ability to control an

asset of greater value than the cash invested, generally by using borrowed

money. Shrewdly using leverage is a powerful way to magnify returns.

• Creating value: An investor may be able to increase the value of his investment

by altering the asset in a strategic manner. Such improvements might increase

the price others are willing to pay for an asset, or increase the income that

asset produces.

• Tax advantages: Certain types of investments and investment techniques allow

an investor to take advantage of opportunities to avoid undue taxes. The less

tax you pay, the higher your return will be on a given investment.

c. Protection Against Inflation

One of the single biggest threats to long-term investments is inflation (the general

increase in the overall level of prices over an extended period of time). Historically,

inflation can be counted on to reduce the value of your money by about 3.2% per

year. When considering the value of different investment options, you must account

for the impact inflation—often experienced at variable and unpredictable rates—

will have on expected future returns.

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d. Preservation of Capital

Volatility refers to the tendency for an asset price to fluctuate sharply within a

given time period. Assets that experience rapid rises and falls in price over short

time periods may be difficult investment choices for individuals with a low risk

tolerance or for those who are looking at a shorter investment time horizon. The

relative volatility of an investment impacts the risk that the price of the asset will

actually fall below your purchase price. For instance, had you invested in a Nasdaq

index fund around the time of the market’s peak in March 2000, you could have

lost a significant proportion of your original investment as prices declined

dramatically and (effectively) permanently.

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877.508.7867 The World’s Best Investment?

III. How Does Real Estate Stack Up?

Let’s take a look at how an investor can evaluate different types of investment

opportunities according to the components of a “good” investment that we

just described.

a. Income Flow

The worth of an investment is measured in part by the amount of annual income

it can be expected to generate—now and in the future. Many investors have the

explicit goal of creating a healthy annual income during their retirement years.

Let’s first look at the income flows generated by stock ownership. What do we

know about the dividend yields of stocks (the annual income that stocks can be

expected to provide)? In June of 2006, average annual dividend yield for the S&P

500 was at 1.8%. The average dividend yield of the Dow Jones Industrial Average

was 2.3%. The owner of a small income property, by contrast, can expect to earn

an annual net operating income of between 6 and 12 percent. With careful

property selection and management, rents can provide a generous and steady

annual cash flow.

With such low dividend yields, how are stocks going to provide you with an

inflation-adjusted annual income for a long retirement? To draw a significant

retirement income, you would need to invest a tremendous amount of capital.

One million dollars invested in stocks might pay you $20,000 per year; that same

amount invested in a small apartment building could pay you $60,000 or more

each year.

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877.508.7867 The World’s Best Investment?

b. Accumulation of Equity

Appreciation

When we look at the past to inform our future decisions, we often give more

weight to the events of the more recent past. Our collective memory, therefore,

tends to emphasize a period of incredible price appreciation in the stock market.

The years between 1981 and 2001 saw tremendous price growth (the Dow-Jones

Industrial Average grew by nearly 14% annually) in the stock market. During such

periods, shrewd investors are able to take advantage of rapid price appreciation

while focusing on preserving their capital (consider the “dot com” boom). Over

the very long haul, however, we see that there are periods in which stock prices

appreciate much more slowly, or even fall. From 1906 to 1981 the DJIA experienced

only about 2.75% compound annual growth.

So how does real estate price appreciation compare to the observed appreciation

in the stock market? Because of the private and unique aspects of the ownership

of small income properties, it’s far more difficult to generalize about price

appreciation. However, one piece of data that we can examine for comparison over

time is the median price of a single-family home in the United States. While not a

perfect measure, it can give us an idea of overall trends in the broad U.S. market.

If we compare home price appreciation over time to stock market appreciation,

we see that in some periods (1960 to 1982, 2000 to present), single-family home

prices have appreciated faster than stocks; while in others (1982 to 1999), stocks

have appreciated faster than home prices. Overall, and over the very long term,

the growth in price is fairly similar.

However, appreciation alone does not tell the whole story. Although overall long

term growth in price is comparable, investors in income properties can accumulate

equity much more quickly and predictably than investors in stocks. To understand

why, let’s look at the effects of leverage.

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Leverage

Leverage is a powerful reason for investing in small income properties. If an

investor uses 100% cash to acquire a house worth $100,000, and the house

increases in value by $5,000 in one year, the investor makes a return of 5%

(assuming no other costs). However, if the investor obtains 90% financing, only

$10,000 cash is required at the closing table, and a bank or other lender loans

the remaining $90,000 to acquire the property.

Assuming the same $5,000 increase in value, the investor’s cash contribution of

$10,000 yields an increase in equity of $5,000 in one year—a 50% return. Readily

available f inancing at favorable terms helps the real estate investor buy, and earn,

significantly more than he or she otherwise would.

These favorable lending terms make it possible for small investors to grow acorns

into oak trees over time. Imagine this fairly conservative scenario: Joe Smith

purchases a small apartment building in his hometown. He puts 20% down and

finances the remaining 80% of the purchase price with a 30-year mortgage.

Joe’s rental revenue is just enough to cover his mortgage payments and operating

expenses. He isn’t bringing home any additional income from owning the property.

Isn’t Joe merely breaking even?

Far from it. Joe has purchased a predictable accumulation of equity. Even in the

unlikely scenario that the property doesn’t appreciate, and rents do not go up in

the future, equity is built up with each mortgage payment—with no additional

money coming out of Joe’s pocket. As Joe’s equity grows, he can consider

borrowing against it and using those funds as a down payment on another incomeproducing

property. In this way, Joe—and other savvy real estate investors—can

“pyramid” equity into more wealth.

Leveraging cannot be applied so effectively when investing in other types of assets,

such as buying stocks on margin. At around 1.8% to 2.3%, the dividend yield from

stocks is generally not sufficient to cover interest payments on the debt (typically

around 6-10%). This means an investor will have to pay money out of pocket to

cover finance charges. Further, if a stock price falls enough, even temporarily, the

lender may demand that you provide additional capital. If you fail to provide the

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additional capital, you will be considered in default and the broker may sell your

shares. A mortgage lender, by contrast, cannot require that you provide additional

capital if the market goes into a temporary downturn.

Creating value

It’s not possible for the typical small investor in stocks or bonds to exert any

substantial control over the performance of the purchased asset. The savvy owner

of a small income property, on the other hand, can take advantage of opportunities

to create value by making strategic improvements or employing a shrewd market

strategy.

Tax advantages

A real estate investor is able to take advantage of a number of tax avoidance

techniques and strategies. If a small investor sells stock to purchase more, he or she

will lose part of the investment through taxation. A real estate investor, on the

other hand, is frequently able to reinvest the proceeds of a sale to take advantage

of the 1031 (or “like kind”) exchange and avoid capital gains taxes.

c. Protection Against Inflation

No investor should underestimate the investment-eroding power of everclimbing

prices. Even moderate rates of inflation can significantly diminish the

buying power of your future income.

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877.508.7867 The World’s Best Investment?

Because stock market investments offer such low dividend yields, an investor must

count on price appreciation that consistently outpaces inflation rates. But has that

been historically true? If we look at the performance of the stock market during

America’s greatest inflationary period (1965 to 1982), it’s clear that stock prices

failed to keep pace with inflation.

Unlike stocks, real estate can offer dependable increases in both price and income—

even during inflationary periods. While no national index can capture these trends

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877.508.7867 The World’s Best Investment?