The Crossover Rules of Investing

Gold is down. So are bond yields. The stock market is tepid, and real estate is going strong … too strong, according to some observers. Hedge funds are having a bad year. Google is having a great year. Oil prices are up. So are natural gas and coal prices. The auto and airline industries are struggling mightily, with GM and United Airlines leading the way. The economy is doing better than expected and the dollar has rebounded a bit, especially against the Euro.

That’s what 2005 has brought to the world of investors … so far.

Clear? I didn’t think so.

This is just one of those years when it’s hard to bet on anything … except real estate. Real estate has been the real star of 2005. The real estate market in many parts of the country keeps on rising. Overall, it’s appreciated an average of 8% over the past three years. And in some red-hot markets, prices have doubled in the past five years.

Here, at ETR, we like real estate. We think it’s a great way to make money. And lots of people have been making lots of money in real estate these days.

Now, I’m no real estate maven. I’m not the one to tell you how to close a real estate deal that brings in a nice profit. For that, you’ll have to look into ETR’s  Main Street Millionaire program. I’m more of a stock specialist. And there are certain basic rules I follow when investing in the stock market. These rules protect me from big losses and help me make money even when times are not so good. I swear by these rules. And some of them … the most important ones, in fact … can be applied to the real estate market too.

Rule No. 1: Don’t invest in a “dot-com” property with a net asset value that doesn’t justify the price it’s fetching.

Invest in what you know. This piece of advice is familiar at ETR. But given the bubbling real estate markets that dot the country these days, I think it bears repeating.

Just today, I was talking to a 25-ish colleague of mine who made some real estate investments about a year and a half ago – and made a bundle. He’s a bright guy and he’s learned a lot about real estate in the past 18 months. But he was a novice when he bought a couple of lower-end houses in unfashionable parts of Delray Beach, Florida. “You would’ve had to be an idiot not to make money,” he said. “Anything going on the market was appreciating.”

Picking and choosing, doing your homework, having a good feel for the local neighborhoods – all of this good advice was rendered obsolete by a red-hot market. But if the market had cooled down a couple of degrees, my young friend might have been facing a loss rather than harvesting a nice profit from his deals. When you buy at inflated prices and your investment consequently must rely on a hot market staying hot, that’s a risky – even speculative – investment.

The stock market is pretty calm these days. I have no choice but to seek out good values and special companies that are capable of growing. But even back in the 90s, when tech stocks were hitting new highs every day, I abstained from the orgy of money pouring into those companies. The price-to-earnings ratios went from obscene to nonsensical. It was speculation, pure and simple.

“Speculation changes the normal market,” says John Vogel, professor at the Tuck School of Business at Dartmouth College. “People are buying a half-million-dollar house not because they have the salaries to support it, but because they think next year it’s going to be worth $600,000.” And for speculators, there’s always a day of reckoning.

Rule No. 2: Think twice before buying property “on margin.” Big gains can turn into big losses, and your ability to “fix” the situation is limited.

Investing with debt is dangerous. You can make a lot of money and lose a lot of money. So don’t leverage your investments unless you have a very good idea of what you’re doing. Even then, only do it with that portion of your wealth that you’re willing to lose. For example, rather than trading options and futures “on margin” (i.e. getting a loan from your broker backed by stocks you own), I prefer to invest long (betting that the stock will appreciate over the long run) with money earned or saved, not borrowed.

Would you take out a home loan and put it in, say, mutual funds? Or in Google stock, for that matter? I hope not. But when you refinance a house and use the equity you have in it to put a down payment on another property, that’s exactly what you’re doing.

Your debt goes up … possibly way up. But so does the paper value of your properties. And in an appreciating market, the value rises faster than your debt. With interest rates remaining low, leveraging property to buy more property in a fast-appreciating real estate market is not hard to pull off. In fact, nearly 2.2 million households used their home equity to buy additional real estate in 2004, up from 1 million 10 years ago.

But if you need special loans, like interest-only loans with balloon payments or option ARMs (Adjustable Rate Mortgages) to finance your property deals, it’s a red flag that you’re being stretched too thin. And here is what can happen. Your interest rate goes up as the Fed pushes banking rates higher. If you’re making minimum payments on this kind of loan, your debt obligations can increase. It’s called “negative amortization,” and it can bleed you dry in no time, especially if the value of your property has stopped increasing.

Rule No. 3: Stick with your “tried and true” system of selecting an investment.

Instead of trying to predict the market, assume the worst. Expect the market to fall and stay depressed. How would your investment do in such circumstances? It’s a fair question to ask.

When I choose a stock to invest in, I have to feel absolutely confident that the company is able to weather bad times. Markets are cyclical … and good times don’t last forever.

For example, I happen to like an energy stock, which I’m recommending in a forthcoming issue of The Skeptical Advisor. Have energy prices peaked? I don’t know. And as far as I’m concerned, IT DOESN’T MATTER. Why? Because this company is inexpensive and has a brilliant growth strategy.

I also like a certain telecom company, an amusement park company, and a media company. Are these sectors headed up or down? I’m not sure. But IT DOESN’T MATTER. Why? Because I would be buying these companies at significant discounts, and each of them has resilient growth and customer acquisition strategies and solid back-end businesses.

So, ask yourself: Are you thinking of buying a middling piece of property that’s being propped up by a hot local market? Are you counting on the market getting hotter, so you can get rental revenue that justifies the purchase? That’s speculation – and it’s risky.

Rule No. 4: Invest in the mutual funds of real estate: REITs. The one I recommend is a good place to start.

Diversify your holdings. In stocks, that means across sectors and types of stocks – including small growth and large value stocks, for example. In real estate, it usually means geographically and by type – office buildings, apartment buildings, malls, residential, hotels, etc. If one local market comes to a grinding halt, there are others still purring.

That’s hard, almost next-to-impossible, for an individual investor to do. So, my advice is to invest in Real Estate Investment Trusts (REITs). These are real estate companies, many of which have geographically diverse holdings or own different kinds of properties. They are legally required to pay shareholders 90% of their (rental) income. I recently recommended one of the better REITs in the pages of The Skeptical Advisor.

REITs are the one place where stocks and real estate merge into one investable entity. Otherwise, you have to make a choice: stocks or real estate … or both. Actually, you face many more choices than that. You can put your money into commodities, options, exchange funds, or mutual funds. You can hedge the dollar, invest in foreign stocks or bonds, coins, collectibles … the list goes on. My old friend Michael Masterson’s sound advice on this subject is that no more than 60% of your net worth should be in equity-building real estate.

To make better sense of all the different kind of assets you can choose from, I strongly suggest you consider going to the Agora Wealth Symposium 2005. It will take place at the Fairmont Hotel in Vancouver, Canada August 10th to the 13th. You’ll hear specialists in a variety of investment areas give you their take on how to make your portfolio grow safely while not giving up on big gains. I’ll be there too, talking about one of my favorite subjects, REITs.