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Sunday, June 17, 2012

Where Should I Invest?


“Where should I invest?” is probably the single question that is asked of me with the greatest of frequency. The question is an easy one, but the answer is not so easy.

Unless you’re able to create a car that can travel back in time like the vehicle in the movie, “Back to the Future,” or a time machine in the movie, “The Time Machine,” your assurance of making the right call is certainly not guaranteed. Think how easy it would be if we could see next week’s financial news, today. Unfortunately, other than in the movies, I have not met anyone with that ability.

In an article I wrote for the “Bottom Line” in the winter of 2007, I recommended that you needed to diversify your investment assets into many different investment classes. Sometimes, buying an asset class that has been hit the hardest is the best asset to acquire at a particular time (and sometimes not). Sometimes, buying into an asset class that has upward momentum is the best asset to acquire (and sometimes not).

History has shown that in most cases when one type of investment goes up or down, another type might move in the opposite direction. Covering as many investment classes as possible might minimize your upside, but it should help counter the downside of your investment portfolio.

Let’s look at some history that illustrates how you or people you know may not have always made the best decisions. How would you have fared during “The Great Depression” (1929–1932) where there was an 88.3% decrease in the stock market? How about the 2000 “Internet Bubble” (2000–2002) where there was a 77.9% decrease in the NASDAQ? How lucky were you during the “Great Recession” (2007–2009) with a decrease in stock prices of 56.8%?

If bonds were your investment of choice, how did you fare during the “Inflation Years” (1977–1981) where a long-term bond yield went from 7.56% to 15.21% (a 50% decrease in your long-term bond portfolio, not including the interest you would have made)?

The ups and downs of investments do not only relate to stocks and bonds. How about commodities, collectables or real estate? Real estate has more ups and downs on a recurring basis than any other asset class that I am familiar with. However, when times are good, they are very good; when times are bad, they are very bad.

In the summer of 2002, I wrote an article for the “Bottom Line” about minimizing your chances of losing money in real estate by doing a great deal of due diligence—not only on the property but, more importantly, on the manager (General Partner). It really takes both (the property and the manager) to have the potential for a successful investment in real estate.

I have been involved in real estate partnerships with investors who are friends, relatives and clients in many real estate opportunities. When the investments were made, the upside looked great, the manager looked great, the projections looked great, then… the subprime loan disaster occurred in mid-2008.

Almost all real estate investments were hit hard and, as a result, real estate in many areas decreased 50% or more in value. A lot of this makes no sense to me or my managers because of one of the key reasons that occurred.

More restrictive banking regulations have recently been adopted due to the heavy losses that lenders were incurring. This put the “fear of God” in financial institutions and forced them to concentrate on removing the old loans off their books, even if losses were required to be taken immediately as compared to waiting for the downturn to stop and start reversing to a positive trend.

This created large discounts and the potential for high profits for the new buyers, huge losses for the lending institutions, and losses for the property owner. This was done even if a simpler (and less costly) solution would have been to extend the loan maturity dates instead of taking the large discounts.

The lenders were required to get their “bad” loans off their books and redistribute the proceeds into safer investments, such as U.S. Treasuries (which are virtually risk-free). This created even more real estate problems, as economically sound projects could not get reasonable financing. With rates falling to an all-time low, an institution could make higher, risk adverse [net] income by lending to the government instead of to the public. They were forced by regulations not to take any new risks even though the other side of the government was trying to stimulate the economy by making more funds available for lending purposes.

Two of my office building investments in Phoenix have good cash flow and had knowledgeable, well-experienced property managers. While the properties have significant vacancy (which creates upside to increase cash flow), there was sufficient “cash flow” for the property managers to make timely mortgage payments and to pay all operational expenses.

Nonetheless, the loans were put into default by the lender as the mortgages came due. The lenders decided to sell the notes at large discounts rather than just extend the period of the due dates. From an economic perspective, it made little sense as the lender could have continued to receive its more profitable full payment.

Until the meltdown in 2008, no one could have seen this as a possibility. By the way, the lenders have also been receiving a higher than fair market interest rate which it would not be able to replace on a new loan.

Any good business person would have been happy to extend the due date of the loans; however, regulations put enough fear into the financial institutions that they went against good business judgment and, instead, made an illogical economic decision.

I have been making investments in various asset classes since I was in high school. If you were to look at my “batting average”—and most importantly my “slugging percentage”—it reads very well. But I have taken some serious hits recently in my current investments, especially in my leveraged real estate investments.

I have done all that I can to support my managing partners, but found that we have no choice but to ride out these investments made in 2008 and prior until they die or come back to life. I hope to make up for these losses with the new investments that start with a current much lower cost basis.

If I had access to that car that could go “back into the future” or a time machine, I would never have invested in any type of real estate if debt was a major part of the investment. Looking at my investment life, I could have avoided many pitfalls if I had the power to see the investment future, but you can only use good judgment based on what the “rules” are at the time of the investment.

Although, in hindsight, I am disappointed and feel that maybe I should just have invested in U.S. Treasuries, I realize that too will have a day of reckoning because interest rates will rise sometime in the future and cause bonds to drop in value.

So when I am asked, “Where should I invest?” I will have to find that time machine or vehicle to make sure that I give the right answer.

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