Investments that cost you money and why I don’t like them
A mouthful of a title for sure, but it says it all. I frequently find myself dealing with people who get into “investments” that cost them money. By “cost them money”, I’m not talking about an investment that went south and ended up at a loss. That happens all the time and is part and parcel of all investing. Rarely do investors find themselves without any losers. No, that’s not what I’m talking about.
What I am whining about is typical of amateur real estate investors. Not that all real estate is always a bad investment. I’m not saying that at all. And I’m most definitely not saying that amateurs shouldn’t invest in real estate. On the contrary, real estate can be an excellent investment- especially for amateurs- with a little know-how. Here is an example of a typical conversation that gets me riled up:
Amateur: “I bought some swampland a few years ago thinking it would get developed in 5 years and I’d profit”
Me: “go on”
Amateur: “but I lost my job and didn’t have the money to pay the taxes. Now I owe $X,000 in back taxes. What can I do?”
Me: “Well, let’s look at your options. Option 1) sell the land, but of course real estate is depressed which means selling at a big loss if you can even find a buyer right now. Option 2) Cough up the taxes, which means selling other good investments or taking an IRA withdrawal- not a good choice either. Option 3) borrow to pay the taxes which increases leverage and risk, while requiring more future payments.”
You have to be VERY careful about any “investment” that may require payments to sustain it. You obviously need to be sure you can make the future payments or risk losing the investment. If setting aside cash reserves for this purpose, then that cash has an opportunity cost of not being invested itself. That means the investment better be really good or the return including the reserves is likely to fall short of your expectations.
Illiquid investments (like real estate) are particularly troublesome. You can’t get out quickly; you usually can’t sell just a portion of it to cover costs; there are high transaction costs; and the price it commands is typically going to be correlated with overall economic strength and thus your employment prospects. This last point is highlighted in the story above: lose your income and you lose your ability to maintain the investment.
Another typical scenario I run across is when someone buys a rental property. It might be a condo or a duplex and they put their 20 or 30 percent down, borrow the rest on a decent fixed mortgage. The new amateur landlord thought they figured it out: the rent will cover the mortgage payments plus a little extra. They figure that “essentially someone else is buying the property for me”. Nothing wrong with this- until we take a closer look at the numbers. It often turns out that they neglected to account for a few things, namely the cost of insurance on the property, property taxes, snow removal, routine maintenance, that new roof or boiler, etc. Before you know it, that “investment” is costing them a grand per month. Build that into the numbers and you end up with a lot of risk, a big headache and a mediocre investment at best (and one that won’t pay off for decades). And that doesn’t even consider when you have a vacancy (which will happen from time to time).
My personal rule of thumb is that investments must “cash flow” from Day 1. When we say an investment “cash flows”, we’re using investment slang for producing a positive return right out of the gate. Take your typical stock for example. Buy it and you start collecting the dividends immediately. The investment pays you, not the other way around. Aside from the initial nominal brokerage commission (trades are so cheap these days!), there are no calls for more cash just for the privilege of owning the stock. If the investment is paying you, you shouldn’t be forced to sell in a bad market.
I’m grossly simplifying, of course. There can be great illiquid investments that may require additional capital before cashing out. The difference is knowing and understanding this fact, planning for it and being highly confident that you’ll be appropriately (read: generously) compensated for the additional risk in the end.
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