Bond rating

16 Real Estate and High-Risk Investments

YOU MUST BE KIDDING, RIGHT?

Friends Nicholas Belisle and Joseph Sanders both have aggressive investment philosophies. Nicholas invests primarily in residential real estate, and Joseph invests in commodities futures contracts. As longtime investors, they consider themselves experts, but occasionally, each has experienced financial losses. What are the odds that the typical investor will make money investing in commodities futures contracts?

A. 50%

B. 30%

C. 20%

D. 10%

The answer is D. Ninety percent of individual investors in futures contracts lose money. Funds used for these investments should be only those that one can afford to lose!

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

 Demonstrate how you can make money investing in real estate.

 Recognize how to take advantage of beneficial tax treatments in real estate investing.

 Calculate the right price to pay for real estate and how to finance your purchase.

 Assess the disadvantages of investing in real estate.

 Summarize the risks and challenges of investing in the alternative investments of collectibles, precious metals, and gems.

 Explain why options and futures are risky investments.

WHAT DO YOU RECOMMEND?

Britanny Day, a 37-year-old marketing manager for a large corporation in Long Beach, California, earns $110,000 per year. She saves an additional about $800 each month beyond her contributions to her employer's 401(k) retirement plan. Her total 401(k) holdings are worth $260,000.

Ever since her grandfather gave her some stocks as a child, Britanny has loved investing—and she has enjoyed a good track record with her efforts. Britanny is an active trader, often trading every three or four weeks, primarily in the oil, technology, and pharmaceutical prescription drug industries. Every year, she has some losses as well as gains. Her private portfolio is currently worth $160,000. Britanny has never bought or sold options or futures contracts, but her stockbroker suggested that she consider them. Britanny also has a friend who owns several residential rental properties that she bought when prices were low who has asked her to consider investing as her partner in her next real estate venture.

What do you recommend to Britanny on the subject of real estate and alternative investments regarding:

1. Investing in real estate?

2. Putting some of her money in an alternative investment, like a collectible or gold?

3. Investing in options and futures contracts?

YOUR NEXT FIVE YEARS

In the next five years, you can start achieving financial success by doing the following related to real estate and high-risk investments:

1. Before deciding to invest in real estate, carefully consider the disadvantages of such investments.

2. Invest only in real estate properties that have a positive cash flow.

3. Finance real estate investments with conventional mortgages, not mortgages with adjustable interest terms.

4. Use the price-to-rent ratio and discounted cash-flow methods to help determine the right price to pay for a real estate investment.

5. Do not put any of your long-term investment money into real estate or high-risk investments are they are not suitable.

A home tends to accomplish more than just putting a roof over your head. It is also an investment, because historically housing values have increased about 3 percent annually over the long term. A  real estate (or housing) bubble  for residential markets occurred in the United States in the middle of the last decade. The bubble saw rapid increases in home valuations (10 or 20 percent, or more, a year) until they were unsustainable.

real estate (or housing) bubble Rapid and unsustainable increases in home prices followed by sharp declines in values.

Then the real estate market crashed as home values plummeted 40 or 50 percent or even more in some communities. The “for sale” signs on millions of foreclosed homes also pulled down the values of nearby homes. Today over 10 percent of all mortgage holders owe more on their homes than they are worth (they are “under water”), making it extremely difficult for them to sell. Unemployment and underemployment also makes it difficult for many others to buy homes. Fortunately, the real estate market has started to recover, thus there are some reasonable investment choices available.

Investors with an aggressive investment philosophy who seek high returns and are willing to accept greater risks might consider owning alternative assets such as collectibles, precious metals, gems, options, and futures contracts. All these are referred to as  high-risk  (or  alternative )  investments  because they have the potential for significant fluctuations in return, sometimes over short time periods.

high-risk (or alternative) investments Present potential for significant fluctuations in return, sometimes over short time periods.

Many investment advisors today recommend that people put 10 percent of their money into alternative investments as a way to diversity their money, recommending for example that someone in their twenties have a portfolio of 65% stocks, 15% bonds, 10% alternatives, and 10% cash. They are wrong. Real estate and alternative investments are not suitable investments for long-term investing program, such as for your retirement, because they are too risky for you too diversify appropriately Think about it? How many real estate investments can you make? How many precious metals can you own? How many options and future contacts can you buy?

16.1 HOW TO MAKE MONEY INVESTING IN REAL ESTATE

Real estate investing is not the same as buying a home in which to live, which was the subject of  Chapter 9 . Investing in real estate might provide you with extra income now and give a boost to your future retirement plans. But you have to do a lot of things right.

LEARNING OBJECTIVE 1

Demonstrate how you can make money investing in real estate.

Real estate investing is complicated given today's market conditions, thus you must become smart about taxes, financing, insurance, and community economics. Real estate investments are complex, and they are much riskier than investing in mutual funds and stocks. People often do not possess the mental toughness that it takes because investing in real estate is a job. Most people are not cut out to be a do-it-yourself landlord. Dealing with tenants requires a business attitude, not a willingness to view tenants as friends.

Real estate  is property consisting of land, all structures permanently attached to that land, and accompanying rights and privileges, such as crops and mineral rights. For example, you can invest directly as an individual or jointly with other investors to buy properties designed for residential living, such as houses, duplexes, apartments, mobile homes, and condominiums. You also could invest in commercial properties designed for business uses, such as office buildings, medical centers, gas stations, and motels. You might buy raw land or residential lots, although they are extremely risky and often lose money for the investor. For someone considering an investment in real estate, there are two key questions that you must answer.

real estate Property consisting of land, all structures permanently attached to that land, and accompanying rights and privileges, such as crops and mineral rights.

16.1a Question 1: Can You Make Current Income While You Own?

The most important consideration for real estate investors in today's real estate market is not whether the price will rise enough in a few years to make a profit. The boom days of the rapidly rising prices of the housing bubble are probably gone in most markets. The focus for real estate investors now is whether the rental income will be sufficient to make ends meet while waiting for the property to increase in value.

If you invest in a property and you are paying out more than the rental income coming in, the negative cash flow exposes you to two risks: (1) whether you can afford to continue paying out that money month after month and year after year, and (2) whether you can make up for these cash flow losses when the property sells, which you hope will be for more than you paid for it. Get either of these wrong, and you lose your invested money and maybe more.

Know the Price-to-Rent Ratio To measure the current income in a real estate market, investors can begin by using the  price-to-rent ratio , which is the ratio of median residential real estate prices to the median annual rents that can be earned from the real estate. The lower the ratio, the smaller the gap between annualized rental and purchase costs and the more attractive the decision to buy a home versus renting a similar one. If the price-to-rent ratio is too high, the prices for homes are likely to be too high.

price-to-rent ratio The ratio of median residential real estate prices to the median annual rents that can be earned from the real estate.

Nationally the price-to-rent ratio was 15 at the peak of the housing bubble. Now it is 11, which is back to 2004 levels. For recent information on price-rent ratios see Trulia ( trends.truliablog.com/category/rent-vs-buy-index/ ) and Altos Research ( blog.altosresearch.com/single-family-home-rental/ ). The ratio might range from perhaps 4 in Detroit to 35 in Honolulu, or more, depending on local market conditions— meaning how low or high housing prices are.

For investors, the lower the price-to-rent ratio is in a given community and a particular property, the easier it should be to earn back your investment. For example, in San Jose, California, a condominium renting for $2600 a month might sell for the high price of $890,000 for a price-to-rent ratio of 28.5(12 × $2600 = $31,200; $890,000/$31,200).

DO IT IN CLASS

Alternatively, a home in Pittsburgh, Pennsylvania, might cost $165,000 and rent for $1200 a month, thus providing a price-to-rent ratio of 11.5($165,000/$14,400 [$1200 × 12]). Investing in rental property with a high ratio will provide a profit only with a future increase in its resale value, which may be difficult to achieve in the near term.

Current Income Results from Positive Cash Flow For an income-producing real estate investment, you pay operating expenses out of rental income. The amount of rental income you have left after paying all operating expenses is called  cash flow . The amount of cash flow is obtained by subtracting all cash outlays from the cash income. If the property has a mortgage (a common occurrence), payments toward the mortgage principal and interest also must be made out of rental income. Operating expenses such as mortgage payments, real estate property taxes, repairs, and vacancies may eat up half or more of the rental income.

cash flow Amount of rental income you have left after paying all operating expenses.

Calculate the Rental Yield Investors also calculate the  rental yield  on properties, as shown in Equation (16.2). This is a computation of how much income the investor might pocket from rent each year before mortgage payments as a percentage of the purchase price. Most properties yield about 4 percent of income annually, although the rental yield may be as little as 1 or 2 percent and as high as 8 or 9 percent.

rental yield A computation of how much income the investor might pocket from rent each year (before mortgage payments) as a percentage of the purchase price; divide the annual rent by 2 and then divide by the purchase price.

DID YOU KNOW  

Invest in Foreclosed Property Using a Short Sale

Foreclosure is the legal and professional procedure in which a mortgagee, or other lienholder, usually a lender, repossesses a home and sells it because the borrower has fallen behind in making payments on the loan. Prior to foreclosure, the homeowner has three options: (1) depart the property and try, for moral reasons, to repay the lender the deficiency, (2) declare bankruptcy, or (3) try to arrange a short sale. Oftentimes the remaining balance owed on the home is more than the property is worth. Unless the lender is willing to modify the terms of the loan, the lender then pursues the homeowner for the deficiency.

In a short sale the lender accepts less than the full mortgage amount and often forgives whatever debt is left unpaid. The deficiency amount is the difference between the amount owed and what the bank collects at the short sale. When a bank agrees to a short sale, the homeowner hires an agent to find a buyer. New rules require lenders to provide preapproved terms for short sales; thus, an investor's bid is more likely to be accepted. Lenders agree to absorb the loss, although they might demand the homeowner make some kind of payment or share the loss. A debt that is forgiven may be subject to income taxes. A short sale may be a buying opportunity for investors, although negotiating with banks is sometimes a cumbersome and lengthy process.

Less expensive properties often offer higher yields. The formula assumes half of rental income goes for expenses other than debt repayment.

	San Jose	Pittsburgh
Purchase price	$890,000	$165,000
Annual rent	31,200	14,400
Annual rent/2	15,600	7,200
Yield (annual rent/2/purchase price)	1.75%	4.36%

A slowly growing economy can lead to unfinished units and losses for real estate investors.

16.1b Question 2: Can You Profit When You Sell the Property?

The capital gain earned in a real estate investment comes from price appreciation. It is the amount above ownership costs for which an investment is sold. In real estate, ownership costs include the original purchase price as well as expenditures for any capital improvements made to a property prior to sale.  Capital improvements  are costs incurred in making changes in real property—beyond maintenance and repairs—that add to its value. Installing a pool and adding a room represent capital improvements.

capital improvements Costs incurred in making value-enhancing changes (beyond maintenance and repair) in real property.

Repairs  are expenses (usually tax deductible against an investor's annual cash-flow income) necessary to maintain the value of the property. Repainting, mending roof leaks, and fixing plumbing are examples of repairs, but in the eyes of the IRS they are not capital improvements.

repairs Usually tax-deductible expenses necessary to maintain property value.

DID YOU KNOW  

Money Websites in Real Estate

Informative websites for investing in real estate, including price-to-rent ratios in your community are:

Altos Research ( blog.altosresearch.com/single-family-home-rental/ )

LasVegas4Us.com  discounted cash flow calculator  www.lasvegas4us.com/JwwDCF/discounted_cash_flow_calculator.htm

Realtor.com ( www.realtor.com/ )

Trulia ( trends.truliablog.com/category/rent-vs-buy-index/ )

Yahoo real estate ( homes.yahoo.com/ )

Zillo ( www.zillow.com/ )

In markets in which real estate is difficult to sell (too many properties on the market and too few buyers), perhaps because of continuing job losses in a sluggish regional economy, residential housing prices might decline 2 or 3 percent annually for a long time. That means continuing deflation in home prices in some markets year after year.

 CONCEPT CHECK 16.1

1. What are the two key questions to consider before investing in real estate?

2. Distinguish between the price-to-rent ratio and the rental yield as measures of current income.

16.2 TAKE ADVANTAGE OF BENEFICIAL TAX TREATMENTS

The U.S. Congress, through provisions in the Internal Revenue Code, encourages real estate investments by giving investors five special tax treatments.

LEARNING OBJECTIVE 2

Recognize how to take advantage of beneficial tax treatments in real estate investing.

16.2a 1. Depreciation Is a Tax Deduction

Investors in real estate become successful by understanding the “numbers” of real estate investing. For example, assume that Jisue Han, a lawyer from Columbus, Ohio, invested $200,000 in a residential building ($170,000) and land ($30,000). She rents the property to a tenant for $24,000 per year. You might initially think that Jisue has to pay income taxes on the entire $24,000 in rental income. Wrong. IRS regulations allow taxpayers to deduct depreciation from rental income.  Depreciation  represents the decline in value of an asset over time due to normal wear and tear and obsolescence. A proportionate amount of a capital asset representing depreciation may be deducted against income each year over the asset's estimated life. Land cannot be depreciated.

depreciation Decline in value of an asset over time due to normal wear and tear and obsolescence.

Jisue can deduct an equal part of the building's cost over the estimated life of the property. IRS guidelines provide that residential properties may be depreciated over 27.5 years, while nonresidential properties are allowed 39 years. Jisue calculates (from  Table 16-1 ) the amount she can annually deduct from income to be $6182 ($170,000 ÷ 27.5).  Table 16-1  shows the effects of depreciation on her income taxes, assuming Jisue pays income taxes at a combined federal and state rate of 36 percent. In this example, the depreciation deduction lowers taxable income on the property from $24,000 to $17,818($24,000 − $6182) and increases the return on the investment to 9.29 percent.

DID YOU KNOW  

What to Do before Investing in Real Estate

1. Set up a limited liability corporation to own your real estate investments because it protects your personal assets in case someone is injured on your rental property and sues you.

2. Consider investing in properties only in locales where there are thriving businesses located near good schools, supermarkets, and public transportation.

3. Hire an accountant experienced in real estate investing.

4. Line up financing options before searching for properties.

5. Hire an inspector to inspect the physical condition of the property.

6. Hire a licensed contractor for plumbing, electrical, and expensive repair jobs rather than doing them yourself.

7. Consider hiring a management company to tend to your property; the cost is 5 to 10 percent of rental income.

8. Set aside $5000 as a contingency fund for unanticipated problems with real estate investment property.

16.2b 2. Interest Is a Tax Deduction

Real estate investors incur many business expenses in attempting to earn a profit: interest on a mortgage, real estate property taxes, insurance, utilities, management bills, homeowner's association fees, capital improvements, repairs, and accounting and legal costs. The largest of these costs often is the interest expense, as properties are often purchased with a mortgage loan.  Table 16-2  illustrates the effect of interest expenses on income taxes. To purchase her $200,000 investment property, assume Jisue borrowed $175,000 for 15 years at 5 percent with a monthly payment of $1383 (from  Table 9-4 on page 273). After deducting annual depreciation of $6182 and interest expenses of $7900 her taxable income is reduced to $9918. Because her income tax liability is only $3570, Jisue's after tax return of $12,530 yields 50.12 percent on her leveraged investment.

Table 16-1 Depreciation Reduces Income Taxes Which Increases Investor's Return

Table 16-2 Additional Effect of Interest Paid on Income Taxes on Return

Gross rental income	$24,000
Less annual depreciation deduction	−6,182
Subtotal	$17,818
Less interest expense for the year (5 percent, $175,000 mortgage)	−7,900
Taxable income	$ 9,918
cash flow after paying interest ($24,000 − $7900)	16,100
Less income tax liability (0.36 × $9918)	−3,570
After-tax return ($16,100 − $3570)	$ 12,530
After-tax yield [$12,530 ÷ ($200,000 − $175,000)]	50.12%

DO IT IN CLASS

Tax laws permit investors to deduct interest expenses. The interest deduction gives Jisue a cash flow after paying mortgage interest of $16,100 ($24,000 − $7900). In essence, the $7900 in interest is paid with $2844 ($7900 × 36 percent combined federal and state income tax rate) of the money that was not sent to the federal and state governments and $5056 ($7900 − $2844) of Jisue's money.

The  loan-to-value ratio  measures the amount of leverage in a real estate investment project. It is calculated by dividing the amount of debt by the value of the total original investment. On this property Jisue's loan-to-value ratio was 87.5 percent ($175,000/$200,000) because she made a down payment of $25,000.

loan-to-value ratio Measures the amount of leverage in a real estate investment project by dividing the total amount of debt by the market price of the investment.

16.2c 3. Capital Gains Are Taxed at Very Low Rates

Capital gains on real estate are realized through price appreciation. For most taxpayers, long-term capital gains are taxed at a rate of 15 percent.

16.2d 4. Exchange of Properties Can Be Tax Free

Another special tax treatment results when a real estate investor trades equity in one property for equity in a similar property. If none of the people involved in the trade receives any other form of property or money, the transaction is considered a  tax-free exchange  (or a  1031 exchange ).

tax-free exchange (or 1031 exchange) Arises when a real estate investor trades equity in one property for equity in a similar property and no other forms of property or money change hands.

If one person receives some money or other property, only that person has to report the extra proceeds as a taxable gain. For example, assume you bought a residential rental property five years ago for $220,000 and today it is worth much more. You trade it with your friend by giving $10,000 in cash for your friend's $280,000 single-family rental home. Your friend needs to report only the $10,000 as income this year. In contrast, you do not need to report your long-term gain, $50,000 ($280,000 − $10,000 − $220,000), until you actually sell the new property.

16.2e 5. Taxes Can Be Lower on Vacation Home Rental Income

If you rent out your vacation property for 14 or fewer days during the year, you can pocket the income tax free because the IRS does not want to hear about this gain. The home is considered a personal residence, so you can deduct mortgage interest and property taxes just as you would for your principal residence. That same tax break is available for those who rent their primary home for 14 days or less, for example, to people attending a major sporting event in your city.

If you rent your property for 15 days or more, you are a landlord and you have turned the endeavor into a business. You may deduct expenses attributable to the rental business, such as mortgage interest, real estate property taxes, depreciation, utilities, repairs, insurance, advertising, homeowner's association fees, and property management fees, as well as auto and other travel expenses.

If you actively participate in the management of the property (defined as approving new tenants, deciding on rental terms, or approving repairs and capital improvements), you can deduct rental expenses up to the level of rental income you report prorated for the number of days it was rented out. When your adjusted gross income (AGI) is less than $100,000, a maximum of $25,000 of rental-related losses may be deducted each year to offset income from any source, including your salary. The $25,000 limit is gradually phased out as your AGI moves between $100,000 and $150,000. This ability to shelter income from taxes represents a terrific benefit for people who invest in real estate on a small scale.

 CONCEPT CHECK 16.2

1. Summarize how depreciation is used to reduce the income from a real estate investment.

2. Briefly explain how the interest paid on the mortgage of a real estate investment reduces one's income taxes.

3. Summarize the special income tax regulations on renting out vacation homes.

16.3 PRICING AND FINANCING REAL ESTATE INVESTMENTS

LEARNING OBJECTIVE 3

Calculate the right price to pay for real estate and how to finance your purchase.

Sure ways to go wrong in a real estate investment are to pay too much for the property and finance it incorrectly.

16.3a Pay the Right Price

The  discounted cash-flow method  is an effective way to estimate the present value or appropriate price of a real estate investment. It emphasizes after-tax cash flow and the return on the invested dollars discounted over time to reflect a discounted yield. Software programs are available online to calculate the discounted cash flows. (For example, see  www.lasvegas4us.com/JwwDCF/discounted_cash_flow_calculator.htm .) You also can use Appendix A-2, as illustrated in  Table 16-3 .

discounted cash-flow method Effective way to estimate the value or asking price of a real estate investment based on after-tax cashflow and the return on the invested dollars discounted over time to reflect a discounted yield.

To see how this method works, assume that you require an after-tax rate of return of 10 percent on a condominium advertised for sale at $210,000. You estimate that rents can be increased about 2 percent each year for five years. After all expenses are paid, you expect to have after-tax cash flows of $4000, $4100, $4200, $4300, and $4400 for the five years. Assuming some price appreciation, you anticipate selling the property for $230,000 after all expenses are incurred. That's a conservative increase in the value of the property of less than 10 percent over 5 years. How much should you pay now to buy the property?

Table 16-3  explains how to answer this question. Multiply the estimated after-tax cash flows and the expected proceeds of $230,000 to be realized on the sale of the property by the present value of a dollar at 10 percent (your required rate of return). Add the present values together to obtain the total present value of the property—in this case, $198,343. The asking price of $210,000 is too high for you to earn an aftertax return of 10 percent.

Table 16-3 Discounted Cash Flow to Estimate Price

DO IT IN CLASS

Your choices are to negotiate the price down, accept a return of less than 10 percent, increase rents, hope that the sale price of the property will be higher than $230,000 five years from now, or consider another investment. The discounted cash-flow method provides an effective way to estimate real estate values because it takes into account the selling price of the property, the effect of income taxes, and the time value of money.

ADVICE FROM A PROFESSIONAL

Timesharing Is a Financial Disaster as an Investment

Timesharing is the joint ownership or lease of vacation property through which the principals occupy the property individually for set periods of time. Timesharing is not an investment, although it is promoted as a way to simultaneously invest and obtain vacation housing. For $5000 to $30,000, buyers can purchase one or more weeks' use of luxury vacation housing furnished right down to the salt-and-pepper shakers. Timeshare owners pay an annual maintenance fee that averages $822 for each week of ownership. Maintenance fees increase every year, and occasionally there are special assessment fees.

With deeded timesharing, the buyer obtains a legal title or deed to limited time periods of use of real estate. Purchasers become secured creditors who are guaranteed continued use of the property throughout any bankruptcy proceedings. They really own their week (or two) of the property.

Nondeeded timesharing is a legal right-to-use purchase of a limited, preplanned timesharing period of use of a property. It is a long-term lease, license, or club membership permitting use of a hotel suite, condominium, or other accommodation, and the right to use usually expires in 20 to 25 years. If the true owner of the property—the developer—goes bankrupt, creditors can lock out the timeshare purchasers (technically they are tenants) from the premises. And it happens.

It is extremely hard to sell a timeshare, and sales commissions of legitimate resellers are 30 percent of the price. The Resort Property Owners Association says that the average timeshare unit languishes on the market for 4.4 years before being sold. At any point in time, 60 percent of all timeshares are up for sale. Timeshare sellers rarely sell for 30 percent of their original investment. As one observer said, “If someone tries to sell you a timeshare, run!”

In good economic times or bad, you can find rental lodgings in the same area at a lower price than owning. The good thing about owning a timeshare is that it forces you to take a yearly vacation, and the vacation will be at the same time and place regardless of where you live in the future. If you want variety in vacation time or place, some timeshare plans allow owners to swap their property for others in distant locations through membership in a worldwide vacation exchange such as My Resort Newwork (www.myresortnetwork.com /timeshare-exchange/) or  www.RCI.com .

Philip C. Bryant

Ivy Tech Community College, Bloomington, Indiana

DID YOU KNOW  

Sean's Success Story

Sean got greedy and then got smart. He greedily invested too heavily in aggressive stock mutual funds and then, because of the gyrations in the stock market, got scared and pulled out by the end of the year with his portfolio down about 10 percent. He got smarter when he decided to no longer jump in and out of the market trying to make quick profits. Thus he has decided to invest his 401(k) funds in ETF mutual funds that pretty much track the broader indexes. In addition, Sean and his brother calculated the numbers on a real estate investment with a projected 7 percent annual return, so they made a down payment on a duplex that is close to an A-rated high school. The old renters have signed new leases, and the investment produces a positive cash flow.

FINANCIAL POWER POINT  

Find Out Home Prices in Seconds

To find prices on a home anywhere in the country, check out Zillo ( www.zillow.com/ ), AOL.com ( realestate.aol.com/blog/home-values/ ), and Trulia ( www.trulia.com/home_prices/ ). Simply type in an address to obtain an estimate of its price. Be advised, however, that there have been complaints about accurate prices so perhaps check more than one site.

16.3b Financing a Real Estate Investment

Borrowing to finance a real estate investment is more expensive than borrowing to buy one's own home, often 0.5 to 1.5 percentage points above the rate for customary homebuyers. There is more risk because the investor does not live at the property. The minimum down payment for investors is often 20 or 25 percent. To make a smaller down payment and perhaps get a lower mortgage rate, some real estate investors buy a home, live in it for a year, and then rent it out as an investment.

A popular way to finance a real estate investment is through  seller financing  (or  owner financing ). This occurs when a seller is willing to self-finance a loan by accepting a promissory note from the buyer who makes monthly mortgage payments. No lending agency is involved. Investing buyers pay higher interest rates for seller financing. The seller may accept little or no down payment in exchange for an even higher interest rate, perhaps 1½ to 2½ percent above conventional mortgage rates. Owner-financed deals can be transacted very quickly for investors.

seller financing (or owner financing) When a seller self-finances a buyer's loan by accepting a promissory note from a buyer, who makes monthly mortgage payments.

Another way to start in real estate investing is to purchase  sweat equity property . With this approach, you seek a property that needs repairs but has good underlying value. You buy this fixer-upper at a favorable price and “sweat” by spending many hours cleaning, painting, and repairing it to rent or sell at a profit.

sweat equity property Property that needs repairs but that has good underlying value; an investor buys the property at a favorable price and fixes it up to rent or sell at a profit.

 CONCEPT CHECK 16.3

1. Summarize how the discounted cash-flow method helps determine the right price to pay for a real estate investment.

2. Comment on the wisdom of buying a timeshare as an investment.

3. List three ways to finance a real estate investment.

16.4 DISADVANTAGES OF REAL ESTATE INVESTING

LEARNING OBJECTIVE 4

Assess the disadvantages of investing in real estate.

Real estate investing can be profitable. But it does have some significant disadvantages.

• Business risk. It is quite possible to lose money in real estate investments, as lots of investors found out in recent years. A local recession, perhaps because a large employer closed, can depress housing prices. Zoning changes can slash housing values. Rents cannot keep up with costs in communities in which industries and jobs are moving elsewhere or in deteriorating neighborhoods.

• Foreclosures. In communities where there are many foreclosures, other sellers have to lower their home prices to compete. This depresses the values of all comparable housing—no matter how wonderful the location or condition—thus making it more difficult for anyone to sell at a reasonable price.

• Illiquidity. Besides being expensive, the market for investment property is much smaller than the securities market. As a result, it is common to experience trouble in selling. It may take months or even a year or more to find a buyer, arrange the financing, and close the sale of a real estate investment.

• Complex Assumptions. Real estate investments require much more investigation than do most other investments. Numerous assumptions about financial details such as projected rents and the cost of repairs in the future also must be made.

• Large initial investment. Direct investment in real estate generally requires many thousands of dollars, often with an initial outlay of $15,000, $30,000, $50,000, or more.

• Lack of diversification. So much capital is required in real estate investing that spreading risk is almost impossible.

• Dealing with tenants. Picking the wrong tenants can quickly turn a real estate property into a big financial loss. Someone has to screen rental applicants for their credit histories, criminal records, work references, and experience with previous landlords. Lexisnexis.mysmartmove.com runs credit and criminal background checks. State laws may make it impossible to evict a deadbeat tenant for several months or a year or more.

• Time-consuming management demands. Managing a real estate investment requires time for conducting regular inspections of the property, dealing with insurance companies, making repairs, and collecting overdue rents. It's a job.

• Low current income. Expenses may reduce the cash-flow return to less than 2 percent or even generate a net loss in a given year.

• Unpredictable costs. Estimating costs is problematic. Investors cannot control increasing real estate tax assessments or accurately predict when a central air-conditioning unit might break down.

• Interest rate risk. When interest rates rise or unemployment grows, fewer people can afford to buy homes, and this puts downward pressure on prices and rents.

• Legal fees. The services of a real estate attorney will be needed to help handle the real estate purchase, sale, building inspections, zoning issues, tenant problems, insurance disputes, accounting, and any liability issues. Title insurance is a critically important expense to investors, particularly when allegations suggest that lenders may or may not have properly inspected the seller's legal documents.

• High transfer costs. Substantial transfer costs, often representing 6 to 7 percent of the property's sale price, plus money for fix-up costs, may be incurred when real estate is bought or sold.

DID YOU KNOW  

The Tax Consequences of an Income-Producing Real Estate Investment

When you are considering a real estate investment, you use the investment amount (purchase price or down payment) to begin the process of estimating the likely rate of return. This calculation result may then be compared with other investment alternatives. Because some of the many assumptions in real estate calculations could be incorrect, caution is warranted in real estate analyses.

The following table shows five-year estimates for a hypothetical residential property in Denver, Colorado located close to a well-respected high school with a purchase price of $200,000. The building will be purchased with a $150,000 mortgage loan, so the buyer has to make a $50,000 down payment plus pay $8000 in closing costs. The gross rental income of $18,000 annually is projected to rise at an annual rate of 5 percent, vacancies and unpaid rent at 10 percent, real estate taxes at 7 percent, insurance at 8 percent, and maintenance at 10 percent. Virtually the entire payment for the 30-year, $150,000, 6½ percent, fixed-rate mortgage loan is assumed to be interest during these early years. For income tax purposes, the land is valued at $20,000, and the building is depreciated over 27.5 years. The amount of annual straight-line depreciation is calculated to be $6546 ($200,000 − $20,000 = $180,000;$180,000 ÷ 27.5 = $6546).

Note (in line D) how challenging it is to earn current income from rental properties. During the first two years, the total cash flow (line D) is projected to be positive ($976 and $652), but for the following three years, the cash flow is expected to be negative (−330, −$10, and −$305). However, because the income tax laws permit depreciation (line E, $6546) to be recorded each year as a real estate investment expense, even though it is not an out-of-pocket cost, the investor calculates a total taxable loss (line F) for each of the five years of expected ownership (− $5570 the first year).

These losses can be deducted on the investor's income tax returns. Because the investor pays a 30 percent combined federal and state income tax rate, the loss results in a first-year annual tax savings of $1671 (line G). Therefore, instead of sending the $1671 to the government in taxes, the investor can use that amount to help pay the operating expenses of the investment. Consequently, the net cashflow income (line D) of $976 is enhanced by tax savings (line G) of $1671 to result in a net cash-flow gain after taxes of $2647($1671 1 $976).

Estimates for a Successful Real Estate Investment

Assume that the property appreciates in value at an annual rate of 4 percent and will be worth $243,330 (line K) in five years ($200,000 × 1.04 × 1.04 × 1.04 × 1.04 × 1.04).

If it is sold at this price, a 6 percent real estate sales commission of $14,599 ($243,330 × 0.06) would reduce the net proceeds to $228,731 ($243,330 − $14,599).

Now we can calculate the crude annual rate of return on the property, as shown in the second table. A crude annual rate of return is a rough measure of the yield on amounts invested that assumes that equal portions of the gain are earned each year. The total return in this example was substantial. The investor made out-of-pocket cash investments of $50,000 for the down payment and $8000 in closing costs, and we subtract the accumulated net cash flow (line N) of $10,505 (adding all the numbers across line H because the investor already has received that money) for a total investment (line O) of $47,495. The investor has a capital gain (line M) of $53,461. After dividing to determine the before-tax total return (line R) to obtain 112 percent, the crude annual rate of return (line S) is 22.4 percent annually over the five years (112 percent ÷ 5 years).

Crude Rate of Return on a Successful Real Estate Investment

Taxable cost
I.	Purchase price ($50,000 down payment; $150,000 loan)	$200,000
	Closing costs	8,000
	Subtotal	208,000
J.	Less accumulated depreciation	32,730
	Taxable cost (adjusted basis)	$175,270
Proceeds (after paying off mortgage)
K.	Sale price	$243,330
	Less sales commission	14,599
	Net proceeds	$228,731
L.	Less taxable cost (J)	175,270
M.	Taxable proceeds (capital gain)	$ 53,461
Amount invested
	Down payment	$ 50,000
	Closing costs	8,000
N.	Less accumulated net cash-flow gains	(10,505)
O.	Total invested	$ 47,495
Crude annual rate of return
P.	Total invested	$ 47,495
Q.	Taxable proceeds (capital gain from M)	$ 53,461
R.	Before-tax total return ($53,461/$47,495)	112%
S.	Crude before-tax annual rate of return (112 percent ÷ 5 years)	22.4%

 CONCEPT CHECK 16.4

1. Summarize why foreclosures and illiquidity are disadvantages in real estate investing.

2. Comment on why real estate investors often have time-consuming management demands.

16.5 INVESTING IN COLLECTIBLES, PRECIOUS METALS, AND GEMS

LEARNING OBJECTIVE 5

Summarize the risks and challenges of investing in the alternative investments of collectibles, precious metals, and gems.

Investors often think of assets as something they would like to own for the long term. When investing in collectibles, precious metals, and gems, the investor owns illiquid real assets, not intangible items represented by pieces of paper. While an asset may be bought for its long-term investment potential, profits might be earned in the short term.

A  speculator  buys in the hope that someone else will pay more for an asset in the not-too-distant future. Speculators often buy or sell in expectation of profiting from market fluctuations. If you put money into these illiquid assets, limit your speculative investing to no more than 5 to 10 percent of your total investment portfolio, and buy only what you truly adore. Don't consider collectibles, precious metals, and gems as part of your savings plan for retirement. When investing for retirement you should only use long-term strategies as outlined in  Chapter 13 .

speculator An investor who buys in the hope that someone else will pay more for an asset in the not-too-distant future.

16.5a Collectibles

Collectibles  are cultural artifacts that have value because of their beauty, age, scarcity, or popularity. They include baseball cards, posters, sports memorabilia, guns, photographs, paintings, prints, ceramics, comic books, watches, lunchboxes, matchbooks, glassware, spoons, stamps, rare coins, art, rugs, fine wine, cars, and antiques. The collectible markets are fueled by nostalgia, limited availability, and “what is hot to own today.” Prices for collectibles often lag other investments and continue to lag. Collectibles won't beat the return of stocks over the long term, but they are lots of fun to own.

collectibles Cultural artifacts that have value because of their beauty, age, scarcity, or popularity, such as antiques, stamps, rare coins, art, baseball cards, and so on.

DID YOU KNOW  

Bias toward Being Reluctant to Invest Again after a Loss

People engaged in real estate and high-risk investments have a bias toward certain behaviors that can be harmful, such as a tendency toward the pain of losing money. People often avoid strong growth investment opportunities because they have lost in investments in the past. Research shows that an investment loss packs twice the emotional blow of a gain and among retirees the impact is tenfold. What to do? Set your focus on how much of a gain or loss you are willing to accept on a future investment and then accept reality by selling when those gains or losses actually occur.

FINANCIAL POWER POINT  

Search for Collectibles Prices at Christie's and Sotheby's Online

The giant auction houses of Christie's ( www.christies.com ) and Sotheby's (www .sothebys.com) offer big selections of prints, photographs, watches, wines, furniture, diamond jewelry, and other collectibles. Check out their catalogs and videos on their websites, and consider signing up for text messages and the ability to bid by phone or online.

Making a Profit on Collectibles Is Not Easy One key to success in collectibles is to invest in quality—the higher the better. Think about the highest value collectibles as being equivalent to blue-chip stocks. Although buying collectibles can be easy, turning a profit may not. The only return on collectibles occurs through price appreciation, and you must sell to realize a profit. That could be hard for you to do if the collectibles give you pleasure. If you sell, the IRS requires that you pay a 28 percent income tax rate (or your tax bracket, whichever is lower) on collectibles rather than a 15 percent tax on capital gains.

Items that are almost certain to lose value include those that are mass produced and marketed as collectibles or limited editions. You often see these kinds of collectibles advertised on television and in newspapers and magazines. Another risk is the wholesale-to-retail price spread, which could be 50 or 100 percent. If you buy from a dealer, you'll probably pay a markup of about 40 to 50 percent. Investors generally get more for their money buying at an auction, but realize that professional dealers are always bidding there too.

DID YOU KNOW  

Scams Abound in Collectibles, Precious Metals, and Gems

The average investor can't tell a diamond from a cubic zirconium or a Monet from a Manet. The values of collectibles, gold, other precious metals, and precious gems rely in part upon the authority of “experts” who purport to determine their worth. Such blind trust invites risk for potential investors. When an asset does not generate a readily quantifiable return (such as rent, interest, or dividends) its value is determined by supply and demand— as well as lies and rumors. Scams, forgeries and frauds abound with these investments, as promoters and telemarketers tell tales about skyrocketing prices and high profit potentials to encourage their purchase. Collectibles, precious metals, and gems are not wise choices for the casual investor.

Prices on collectibles vary greatly from item to item and year to year. Markets are fickle. If the investor needs to convert the asset to cash, a sale may take days, weeks, or months, and the seller may be forced to accept a lower price.

Buying and Selling Collectibles on the Internet You can buy collectibles on the Internet, using eBay for example, purchasing in minutes what you might never have found even after searching for years in magazines, junk shops, flea markets, and auctions. Buying collectibles on the Internet is efficient and convenient, and it is easy to compare products and prices. It is hard to inspect the collectible before purchase, however. Search Google for “collectibles,” but realize that this is a risky way to invest particularly with lots of fakes in existence.

16.5b Gold and Other Precious Metals

There is an allure to owning gold. You can own and hold it with pride, and it is beautiful to look at. Gold is a uniquely private, personal, and portable way to hold some genuine wealth. For purposes of investing, however, the reasons for owning it often do not add up. For example, gold does not generate current income while you own it. Its value is determined solely by supply and demand at the time of sale. Thus, investing in gold is speculating. Some other metals beside gold have a similar appeal to investors.

Fear Pushes Up Gold Prices Fear is what pushes up the price of gold. Some of the world's worried investors purchase gold reasoning that if their national economies crash they will be able to trade gold even if their country's paper currency is devalued. Others who buy gold are concerned about such things as high inflation, rising interest rates, countries seen as printing too much money, economic collapse, possible wars, excessive government borrowing, collapse of the credit system, and international trade wars.

The fear that gripped investors around the globe during the Great Recession has moved “gold fever” from the fringes of the investing world to the mainstream. Prices soared, and gold hoarders, who are often criticized as crackpots, for a while appeared to be smart speculators. They thought that a wave of inflation would overcome the nation due to the growing national debt and the Federal Reserve's actions to stimulate the economy.

Gold Prices Were Stagnant and Then Soared and Crashed Again Back in 1976 when there were serious concerns about extremely high inflation in the United States, gold prices jumped in 4 years from $100 an ounce to more than $800 in 1980. Then the price dropped to $400 before sliding even lower to $280 by 2001.

This roller coaster price ride for gold has happened again. After many years of little change, gold prices began to rise slowly until they hit $1000 in March of 2008 during the worst of the Great Recession and then sharply dropped to $700 a few months later. As the U.S. and world's economies continued to struggle, gold prices climbed to $1895 in 2011. Then gold prices dropped 9.4 percent in one day. Prices have since slipped to below $1200 an ounce. That's about a 37 percent loss in just a few months for those who got in late and bought near the high of $1895.

While the increase over the past ten years in gold prices may make gold sound like an appealing speculative investment, consider further that if you bought $10,000 in gold in 1980, it would have been worth $10,600 in 2013. If you invested the same $10,000 in 1980 in a mutual fund that tracks the S&P 500, you would have over $200,000 by 2013. These are not the kind of data that a gold promoter earning sales commissions wants investors to see.

Can the fear and greed of doomsayers, conspiracy theorists, and gold promoters keep gold prices rising, or is this the same kind of price bubble that happened before? Like any alternative investment, gold is subject to a meltdown. The smart investor proceeds with caution even when speculating.

DID YOU KNOW  

Bias toward Chasing Hot Investments

People engaged in real estate and high-risk investments have a bias toward certain behaviors that can be harmful, such as a tendency toward recent performance. People often see investments as good or bad based on recent performance and chase hot investments expecting to cash in as they continue to rise even higher only to see them drop in price. What to do? Avoid speculation and in the future invest only on fundamentally sound information, not what is hot.

DID YOU KNOW  

Speculate by Trading in Currencies

Investors deeply worried about the economic future of their country or world may find it desirable to put some of their assets in the cash of the world's presumed two safest currencies, the U.S. dollar and the Euro. Individuals may speculate on the changing daily values of the dollar, Euro, Yen, Pound, Swiss Franc, and other currencies in the forex (foreign exchange trading). A “mini” account can be opened for only $300 at Forex Capital Markets ( www.FXCM.com ) where you try out a practice account and then trade up to 200 times that amount by using margin. Currency trading uses a lot of margin and is risky!

16.5c You Can Invest in Gold in Several Ways

An initial investment in gold need not be expensive, although buying gold directly can be. There are many ways to invest in gold or other precious metals.

Gold Bullion  Gold bullion  is often thought of as the large gold “bricks” that weigh about 28 pounds that people imagine are stored in Fort Knox. Each brick is worth more than $100,000 at today's prices. All the gold in the world would create a heavy cube only 67 feet square.

gold bullion A refined and stamped weight of precious metal.

The term bullion simply means a refined and stamped weight of precious metal. Gold bullion is traditionally purchased and traded in 1- and 10-ounce gold bars. Gold as bullion is expensive to own. There are fees for refining, fabricating, and shipping bullion. A sales charge of 5 to 8 percent is common. There are storage costs. When gold is sold, the bank or dealer buying it from an investor may insist on reassaying its quality, yet another cost for the investor. The investor should purchase insurance against fire, theft, and fraud because such transactions are not government regulated.

Gold Bullion Coins Some costs of investing in gold can be avoided by those wanting to take physical possession of gold bullion itself by owning modern  gold bullion coins , each containing 1 troy ounce (31.15 grams) of pure gold issued by the various world mints. The most popular coins are the South African Krugerrand, Canadian Maple Leaf, and the U.S. Gold Eagle. Other gold bullion coins are available, including the Great Britain Sovereign, Australian Kangaroo Nugget, and Chinese Panda. Minimum orders are ten coins, and commissions are 5 to 6 percent when buying and 1 to 2 percent when selling. These gold bullion coins do not need to be tested for purity, are portable, and have worldwide liquidity. Investors need to store and insure their coins. Visit  www.usmint.gov  for a list of U.S. Gold Eagle dealers.

gold bullion coins Various world mints issue these coins, which contain 1 troy ounce (31.15 grams) of pure gold.

Collectible Gold Coins People who buy collectible gold coins buy them in part because of their intrinsic beauty and scarcity. They face high markups, difficulty in grading coins (or must pay to hire a grading service), and costs for storage and insurance. Major coin graders include American Numismatic Association Certification Service ( www.anacs.com ), Numismatic Guaranty Corporation ( www.ngccoin.com ), and Professional Coin Grading Service ( www.pcgs.com ). The World Gold Council ( www.gold.org/ ) maintains a list of firms that buy and sell gold. Note that the long-term capital gains tax on collectibles, like gold, is 28 percent (or your tax bracket, whichever is lower).

Gold and other precious metals are highly volatile investments.

DID YOU KNOW  

Bitcoin Is a “Fad” Virtual Currency

Bitcoin  is a peer-to-peer experimental decentralized digital cash currency based on an open source cryptographic protocol. You can buy them at an exchange and you store them in a “wallet” on your computer. Bitcoins can be transferred through a computer or smartphone without an intermediate financial institution. The purchasing power is zero thus Bitcoin has no intrinsic value. It is not protected by a central bank and governments will never confer the status of legal currency on a private currency.

Bitcoin A peer-to-peer experimental digital cash currency based on an open source cryptographic protocol that can be bought at an exchange and transferred through a computer or smart phone without an intermediate financial institution.

Bitcoin is accepted in trade by some merchants and individuals in parts of the world. A large share of its commercial use is believed to be for illicit goods, including marijuana, cocaine, prescription painkillers, and gambling transactions. Promoters say Bitcoin helps users avoid taxes, regulations and government seizures of assets. The lack of regulations allows everything to happen, including fraud.

Many have criticized Bitcoin's highly volatile market value as prices jumped in 3 months from $17 to $230. Then in 2 days it plunged to $68 before returning to a price of $77 a week later. Subsequently it went over $1200, and then dropped to $380 in one day. Critics argue that Bitcoin is volatile, inflexible, and minimally used in commerce. The largest Bitcoin exhange in Tokyo went bankrupt after several hundred million dollars of Bitcoins disappeared. The Internal Revenue Service does not treat Bilcoin as a currency rather it is classified as “property,” hence buying and selling transactions are capital gains.

Gold Mining Stocks, Mutual Funds, and ETFs Investors wanting to capitalize on world crises, economic fears, and rising gold prices by investing in smaller amounts may choose to put speculative cash in the stocks of gold mining companies, in mutual funds that own gold companies, and in specialized exchange-traded funds (ETFs). For example, you may have heard of the now defunct Homestake Gold Mine, one of the early enterprises associated with the Gold Rush of 1876 in the northern Black Hills of what was then Dakota Territory. Today, there are a handful of gold mining companies in the United States and dozens around the world.

Popular gold mutual funds include Van Eck International Investors (INIVX), USAA Precious Metals and Minerals (USAGX), Oppenheimer Gold & Special Metals A (OPGSX), and Vanguard Precious Metals and Mining (VGPM). Gold stock prices are much more volatile than the price of gold itself as they can readily swing up or down 50 percent in a matter of months. During 2013 the average gold stock price dropped 50 percent. The largest gold exchange-traded fund (ETF) is SPDR Gold Shares (GLD). Other popular gold ETFs are iShares COMEX Gold Trust (IAU) and Market Vectors Gold Miners ETF (GDX).

16.5d Investing in Other Metals—Silver, Platinum, Palladium, and Rhodium

Some other metals also appeal to certain investors. Silver, platinum, palladium, and rhodium are metals used industrially and occasionally in jewelry. The values of these metals rise and fall with changes in demand. An investor might reason that since palladium is used in auto production that when demand in China and India for vehicles increases substantially, the price of the metal will soar. Prices can drop, too. When gold prices dropped recently silver declined 25 percent in just 4 days. Illustrative specialized ETFs in these precious metals include iShares Silver Trust (SLV), ETFS Physical Platinum (PPLT), and ETFS Physical Palladium Shares (PALL).

DID YOU KNOW  

Money Websites in Gold

American Numismatic Association

Certification Service ( www.anacs.com )

Kitco gold prices ( www.kitco.com/ )

Numismatic Guaranty Corporation ( www.ngccoin.com )

Professional Coin Grading Service ( www.pcgs.com )

World Gold Council ( www.gold.org/ )

USA Gold ( www.usagold.com/ )

U.S. Mint ( www.usmint.gov )

16.5e Precious Stones and Gems

Precious stones and gems, such as diamonds, sapphires, rubies, and emeralds, are also examples of alternative investments. Investors purchase investment-grade gems as “loose gems” rather than as pieces of jewelry. Wholesale firms, not jewelers, sell the best-quality precious gems. The gem certification process may be touted as a science, but it is not; rather it is educated guesswork. Obtaining two assessments of a stone's quality, particularly on stones of less than 1 carat, is likely to result in a variation of 10 to 20 percent.

Sales commissions on precious stones are high, and reselling is very difficult. Novice investors often buy at retail and then wind up trying to sell at retail, and then selling at or near wholesale. This approach is the opposite of smart investing—that is, buying low and selling high. Losing 20 to 50 percent of one's investment in precious stones upon selling them is not uncommon.

 CONCEPT CHECK 16.5

1. Identify one collectible that might be an interesting investment, and explain why it might be difficult to make a profit.

2. Explain why some investors buy gold and other precious metals, and tell why choosing one type of investment might be appealing or unappealing to you.

3. Identify some risks of investing in precious stones and gems.

LEARNING OBJECTIVE 6

Explain why options and futures are risky investments.

16.6 INVESTING IN OPTIONS AND COMMODITY FUTURES CONTRACTS

A derivative (or derivative security) is an instrument used by people to trade or manage more easily the asset upon which these instruments are based. Derivative securities are available for commodities, equities, bonds, interest rates, exchange rates, and indexes (such as a stock market index, consumer price index, and weather conditions). Investors choose derivatives to either reduce risk by hedging against losses or taking on additional risk by speculating. The investor's returns are derived solely from changes in the underlying asset's price behavior. Two of the most common derivative instruments are options and futures contracts.

DID YOU KNOW  

Your Worst Financial Blunders in Real Estate and High-Risk Investments

Based on others' financial woes, you will make mistakes in personal finance when you:

1. Assume that real estate prices will go up and interest rates will not increase.

2. Do not set enough money aside for maintenance, repairs, unanticipated capital improvements, and rising real estate taxes on rental property.

3. Invest some retirement money in these risky investments: margin trading, short selling, options, commodity futures, gold, precious metals, and gems, currencies, and timeshares.

16.6a Options Allow You to Buy or Sell an Asset at a Predetermined Price

An option is a contract to buy or sell an asset at some point in the future at a specified price. The most common type of option is a stock option. This derivative gives the holder (purchaser) the right, but not the obligation, to buy or sell a specific number of shares (normally 100) of a certain stock at a specified price (the striking price) before a specified date (the expiration date, typically three, six, or nine months).

Two types of option contracts exist: calls and puts. A call option gives the option holder (buyer) the right, but not the obligation, to buy the optioned asset from the option writer at the striking price. A put option gives the option holder (buyer) the right, but not the obligation, to sell the optioned asset to the option writer at the striking price.

DID YOU KNOW  

How to Make Sense of Option Contracts

The two principal players in the options game are the option writer and the option holder.

Most option contracts expire without being exercised, and the option seller is the only person to earn a profit. The profit results from the option premium charged when the option was originally sold. Buying and selling options are techniques used by all types of investors.

Conservative Investors Make Money on Options Selling a call option can be a fairly safe way to generate income by conservative option writers who own the underlying asset (the stock). When they sell a call, it is described as a  covered option  because the writer owns the underlying stock. If the writer does not own the asset, it is a naked option, a speculative position. When used effectively by conservative option writers, calls can potentially pick up an extra return of perhaps 1 to 2 percent every three months and minimize risk at the same time. In effect, this conservative investor protects himself financially by hedging his investment against loss due to price fluctuation. You also can conservatively profit by selling a call on stock already owned, giving the buyer the right to purchase your shares at a certain price any time during a relatively short period at a fixed strike price, which is higher than the current price.

covered option Occurs when an option writer who owns the covered option sells the call.

Aggressive Investors Profit with Options Aggressive investors in the options market attempt to profit in two ways. First, the investor can hope for an increase in the value of the option. For example, if the price of a stock is rising, the holder of a call option might sell it to another investor for a higher price than that originally paid. Second, the investor can exercise the option at the striking price, take ownership of the underlying securities, and sell them at a profit.

16.6b Buying and Selling Commodities Futures Contracts

A  futures contract  is the obligation to make or take delivery of a certain amount of a commodity by a set date. A futures derivative contract requires the holder to buy the asset on the date specified. If the holder does not want to buy the asset, he or she must sell the contract to some other investor or to someone who wants to actually use the asset.

futures contract The obligation to make or take delivery of a certain amount of a commodity by a set date.

DID YOU KNOW  

Money Websites in Options

Informative websites for investing in options, including suggestions from professionals are:

Options Industry Council

( www.optionscentral.com )

Chicago Board Options Exchange

( www.cboe.com )

OptionsXpress ( www.optionsxpress.com )

TradeKing ( www.tradeking.com )

DID YOU KNOW  

About Hedge Funds

Hedge funds  are freewheeling risky investment pools for the extremely wealthy that use unconventional investment strategies. They are global companies, beyond most of the regulations of the U.S. government. Hedge funds trade options and commodities sell short, use leverage, risk arbitrage, buy and sell currencies, and invest in undervalued mature companies, often those in or nearing bankruptcy. Hedge funds can profit in times of market volatility as well as in a falling market. The investors are partners.

hedge funds Freewheeling risky investment pools for the extremely wealthy that use unconventional investment strategies such as trading options and commodities, selling short, using leverage and arbitrage, buying and selling currencies, and investing in undervalued mature companies.

Fees charged by the hedge fund manager typically are 2 percent of assets under management and 20 percent of the upside (the “performance fee”) of the fund. Most managers assess no full fees until the profits are above 8 percent. None of the 8000 hedge funds can be offered or advertised to the general investing public in the United States. They are limited to “accredited investors and purchasers” who have incomes over $200,000 and a net worth over $1 million and who own more than $5 million in investments. The small investor can buy shares in publicly traded firms, like Blackstone (BX) or Kohlberg Kravis Roberts (KKR), which are parent companies of hedge funds. A number of hedge funds have had catastrophic losses and have gone bankrupt.

Conservative Economic Needs Creates Futures Markets Farmer Geraldo Esperanza who planted a 10,000-bushel soybean crop in Chana, Illinois, might want to sell part of it now to ensure the receipt of a certain price when the crop is actually harvested. Similarly, a food-processing company might want to purchase soybeans now to protect against sharp price increases in the future. And an orange juice manufacturer might want to lock in a supply of oranges at a definite price now rather than run the risk that a winter freeze would push up prices. These economic needs create futures markets. You can trade futures on an organized market for lots of commodities, such as coffee, sugar, corn, pigs, plywood, metals, energy, foreign currencies, gold, and other precious metals.

DID YOU KNOW  

Turn Bad Habits into Good Ones

Do You Do This?

Avoid investing in real estate

Buy collectibles, precious metals, and gems

Invest in options and commodity futures for quick profits

Do This Instead!

Do the math to see if it might be profitable

Never put long-term investment money into these assets

Be prepared to lose money

Speculators Trade in Futures Markets The speculative investor who buys or sells a commodity contract is hoping that the market price of the commodity will rise (or fall) before the contract matures, usually 3 to 18 months after it is written. These derivatives offer the potential for extremely high profits because such contracts often are highly leveraged. Depending on the commodity, the volatility of the market, and the brokerage house requirements, an investor can put up as little as 5 to 15 percent of the total value of the contract. Some contracts require a deposit of only $300. Commissions average about $20 for each purchase and sale.

Futures Are a Zero-Sum Game In each futures transaction a winner and a loser will emerge. A buyer of a futures contract benefits if the price of the commodity increases, but the seller suffers. When prices decline, the reverse is true. An estimated 90 percent of investors in the futures market lose money. Five percent (mostly the professionals) make profits from the losers and the remaining 5 percent break even.

Trading in futures is a zero-sum game in which the wealth of all investors remains the same. The trading simply redistributes the wealth among those traders. Each profit must be offset by an equivalent loss; therefore, the average rate of return for all investors in futures is zero. The return actually becomes negative if transaction costs are included. Most investors do not belong in commodities.

DO IT NOW!

You know more about personal finance after reading this chapter, so get started right now by:

1. Imagining what you would do if you came into $50,000 that you could invest without any concern about losing the money. Would you invest all or some of it in alternative investments? Explain why or why not.

2. Searching your local newspaper for opportunities to buy a house as rental property, assuming that real estate is an option for your investment. Find out the price-to-rent ratio for an average home in your community and then estimate the asking price for a particular property, the rate of interest you could expect for a mortgage, the likely rent you could charge, and other factors.

3. Then calculating the net present value of the property to determine the price you might offer for the property.

 CONCEPT CHECK 16.6

1. Distinguish between a call and a put for the options investor.

2. Summarize one way a person with a conservative investment philosophy can profit in options.

3. Explain how a speculative options investor can make a lot of money.

4. Offer reasons why futures contracts are not appropriate for the average long-term investor.

WHAT DO YOU RECOMMEND NOW?

Now that you have read the chapter on real estate and high-risk investments, what do you recommend to Britanny on:

1. Investing in real estate?

2. Putting some of her money in an alternative investment, like a collectible or gold?

3. Investing in options and futures contracts?

BIG PICTURE SUMMARY OF LEARNING OBJECTIYES

LO1 Demonstrate how you can make money investing in real estate.

The key questions for real estate investors are: “Can you make current income while you own?” and “Can you profit when you sell the property?” To help find answers, investors calculate the price-to-rent ratio and rental yield.

LO2 Recognize how to take advantage of beneficial tax treatments in real estate investing.

The Internal Revenue Service offers the investor five beneficial tax treatments, including depreciation, interest that is deductible, low tax rates on capital gains, tax-free exchanges of real estate, and special tax breaks on renting and vacation homes.

LO3 Calculate the right price to pay for real estate and how to finance your purchase.

The discounted cash-flow method is an effective way to estimate the value or asking price of a real estate investment. It takes into account the selling price of the property, the effect of income taxes, and the time value of money. There are various ways to finance a real estate investment.

LO4 Assess the disadvantages of investing in real estate.

There are many disadvantages in real estate investing, such as large initial investment, lack of diversification, dealing with tenants, low current income, unpredictable costs, illiquidity, and high transfer costs.

LO5 Summarize the risks and challenges of investing in the alternative investments of collectibles, precious metals, and gems.

When investing in collectibles, precious metals, and gems, the investor owns illiquid real assets, not intangible items represented by pieces of paper. The investor's only return comes from price appreciation, as they do not pay interest or dividends. While prices are set by supply and demand, promoters hype these alternative investments. Changing investor tastes and rumors also influence prices.

LO6 Explain why options and futures are risky investments.

Derivatives, such as options and commodity futures, are instruments used by market participants to trade or manage more easily the asset upon which these instruments are based. While all types of investors can profit in options, only speculators with an aggressive investment philosophy should consider trading in futures. Most investors in derivatives lose money, and losses can accumulate quickly.

LET's TALK ABOUT IT

1. Invest in Real Estate. Describe what would encourage you to invest in real estate given that in recent years many communities prices have declined severely.

2. Two Questions. Which of the two questions in real estate investing is more important? Explain why.

3. Beneficial Tax Treatments. Review the five beneficial tax treatments of real estate and explain which one seems most important to you as a real estate investor.

4. Reasons to Invest. Assume you have $30,000 in cash. Give reasons why you might want to invest that money in a real estate investment. Offer two reasons why others might not be willing to invest in real estate.

5. Manage Tenants. Do you think you could successfully deal with tenants and the management demands required in real estate investing? Why or why not?

6. Disadvantages of Real Estate. Review the list of “Disadvantages of Real Estate Investing,” and identify one that you think is most important. Explain why.

7. Timeshares as an Investment. Explain why timeshares should not be considered an investment. Why do some people buy timeshares?

8. Put Some Money into Alternative Investments.What percentage of your portfolio, if any, do you think should be invested in alternative investments? Explain.

9. Invest in Gold? Would you invest in gold today? Explain why or why not.

10. Options and Futures. Both options and futures are risky investments. Identify one that seems like an unwise idea, and explain why it is unappealing.

DO THE MATH

1. Price-to-Rent Ratios. Calculate the price-to-rent ratios for the following properties arranged by price of home followed by likely annual rental income: (a)  $400,000/$40,000;

(b) $300,000/$36,000;

(c) $200,000/30,000.

DO IT IN CLASS PAGE 483

2. Real Estate Investment Returns. Austin Sandler, an electrician and his teacher spouse Emily from Laramie, Wyoming, are interested in the numbers of real estate investments. They have reviewed the figures in  Table 16-2  and are impressed with the potential 50.12 percent return after taxes. Austin and Emily are in the 25 percent marginal tax bracket. Answer the following questions to help guide their investment decisions:

DO IT IN CLASS PAGE 487

(a) Substitute the Sandler's 25 percent marginal tax bracket (his state has no state income tax) in  Table 16-2 , and calculate the taxable income and return after taxes.

(b) Why does real estate appear to be a favorable investment for Austin and Emily?

(c) What one factor might be changed in  Table 16-2  to increase their return?

(d) Calculate the after-tax return for Austin and Emily, assuming that they bought the property and financed it with a 7 percent, $175,000 30-year mortgage with annual interest costs of $11,971.

3. Review the math in  Table 16-3 , on page 489, Discounted Cash Flow to Estimate Price, and give your opinion on which part of the assumptions (price increases or sales price) is more subject to poor thinking.

DO IT IN CLASS PAGE 489

FINANCIAL PLANNING CASES

CASE 1

The Johnsons Consider a Real Estate Investment

Harry and Belinda Johnson are considering purchasing a residential income property as an investment. The Johnsons want to achieve an after-tax total return of 7 percent. They are considering a property with an asking price of $190,000 that should produce $27,000 in gross rental income and $15,000 in net operating income.

(a) Calculate the price-to-rent ratio on the property.

(b) Calculate the present value of after-tax cash flow for the property, assuming that the after-tax cash-flow numbers are $8000 for the first year, $8400 for the second year, $8800 for the third year, $9200 for the fourth year, and $9600 for the fifth year, and that the selling price of the property will be $210,000 in five years. Prepare your information in a format similar to  Table 16-3 , using Appendix A-2 or the Garman/Forgue companion website to discount the future after-tax cash flows to their present values.

(c) Give the Johnsons your advice on whether they should invest in the property at its current price of $190,000.

CASE 2

Victor and Maria Consider Selling Maria's Mother's Home

Victor and Maria Hernandez are thinking about selling her mother's home, which she recently inherited, and use the proceeds to enhance their investments for retirement. It's price declined about $30,000 in recent years to today's value of $170,000. The home is fully paid for.

(a) If the rent is $1000 a month, what is the rental yield?

(b) If they sold the home, should they invest the proceeds into any alternative investments, such as gold?

CASE 3

Julia Price Wants to Try Alternative Investments

Julia continues to be a hard worker and, at age 50, has saved and invested wisely for her planned financially successful retirement. She has an extra $15,000 in a cash management account beyond what she needs for emergency savings. She rejected options and commodity futures as too risky but is considering gold. Julia wonders if the price volatility of gold over the past few years will continue, and she has always thought about investing in antique furniture. Offer your opinions about her thinking.

CASE 4

Real Estate or Stocks?

Junhee Chang, a senior research analyst in St. Clairsville, Ohio, has bought and sold high-technology stocks profitably for years. Lately some of her stock investments have done quite poorly, including one company that went bankrupt. Emily, a longtime friend at work, has suggested that the two of them invest in real estate together because property values in some neighborhoods have been rising in anticipation of a large manufacturing company's plans to substantially increase its workforce. Emily has looked at three small office buildings and some residential duplexes as possible investments.

(a) Contrast the wisdom of investing in commercial office buildings versus the attraction of investing in residential properties.

(b) List three of the advantages associated with real estate investments.

(c) List three things that can go wrong for real estate investors.

CASE 5

From Real Estate to Options and Futures

Jonathan Williams and Cody Richardson, longtime partners in Lawton, Oklahoma, have bought and sold real estate properties for ten years. They have profited on many transactions, although they did have some substantial losses during the Great Recession. Their portfolio of real estate is worth about $4.7 million, on which they owe $2.9 million. Jonathan has read about investing in options and futures contracts, and last week, he talked with a stockbroker about the possibilities.

(a) Offer some reasons why Jonathan want to invest $100,000 or more in options and futures contracts.

(b) List some of the risks of options trading for Jonathan and Cody.

(c) From an investor's point of view, contrast trading in futures contracts with buying highly leveraged real estate.

BE YOUR OWN PERSONAL FINANCIAL MANAGER

1. Foreclosure and Short Sales. Given that there are so many foreclosed homes on the market, tell why you might or might not be interested in buying one as an investment. Write a summary of your conclusions.

2. Before Investing in Real Estate. Review the information in the Did You Know? Box titled “What to do Before Investing in Real Estate” and identify two suggestions that you definitely would follow if you invested in real estate. Write a summary of your conclusions.

3. Disadvantages of Real Estate Investing. Review the list in the “Disadvantages of Real Estate Investing” section and identify two disadvantages that you think might keep you from personally investing in real estate. Write a summary of your conclusions.

4. Real Estate ETFs. Go to the “Real Estate ETF” page for  StockEncyclopedia.com  ( etf.stock-encyclopedia.com/category/real-estate.xhtml ) and select three illustrative companies, such as ProShares UltraShort Real Estate Fund. Write a brief report comparing those three ETFs.

ON THE NET

1. Research Home Prices. To find prices on homes in your community, go to Zillo ( www.zillow.com/ ). Input addresses of homes on five nearby streets and summarize your price information findings.

2. Research Mortgage Rates. Find out current mortgage rates for 15- , 20- , and 30-year loans for both residential and investment loans. See  LendingTree.com ,  Quickenloans.com ,  BankRate.com , and  Loan.com . Write a brief report on your findings.

3. Current Prices of Metals. Find out the current prices of five popular metals, such as gold, silver, nickel, aluminum, cobalt, copper, lead, palladium, platinum, and silver, at websites like Kitco ( www.kitco.com/ ) and USA Gold (www .usagold.com/). Write a brief report on your findings.

4. Gold ETFs. Go online and search “gold prices per ounce” on Google or Bing. Click on five websites, including Wikipedia's “Gold ETFs,” and review what is written, especially about predictions of future prices. Prepare a report summarizing your findings.

5. Collectibles Websites. Search the Internet for two websites featuring one type of collectible that interests you (such as coins, toys, watches, or sports memorabilia). Write a brief report comparing the types of information and features available for buyers of these collectibles.

6. Research Hedge Funds. Go online and research two large hedge funds (such as JP Morgan Chase, Bridge-water Associates, Paulson & Co., Brevan Howard, and Soros Fund Management) by inserting “hedge fund” after the company name. Write a report comparing what services the two funds perform, participation requirements, and investment returns.

ACTION INVOLVEMENT PROJECTS

1. Community Real Estate Prices. Telephone two real estate brokers to determine if the prices of single-family dwellings in your community have been decreasing or increasing over the past four or five years, and ask why. Inquire about homes located near your college as well as those farther away from campus. Prepare a brief report of your findings including reasons for the change in prices.

2. Invest in Commercial Real Estate. Research current commercial properties for sale in your college community by reviewing the real estate section of newspapers. How many listings do you find? How many duplexes? How many small apartment buildings? Select one and prepare a report analyzing the property using the price-to-rent ratio and rental yield.

3. Tax Consequences of Real Estate Investment. Select a possible commercial real estate investment in your community and make a “first attempt” to prepare an analysis similar in format to that in the Did You Know? box titled “The Tax Consequences of an Income-Producing Real Estate Investment.” Make any reasonable assumptions you desire and calculate the numbers. Prepare the table and a brief report of your findings.