[Ed. Note: Wealth Weekly Readers! Please welcome Mr. Joseph Hogans of Georgia Tech, who will help us out at WW by contributing articles for the site. This is his first, (with a little analysis from me). This article will appear in the next Hueman Press. Thanks to Joseph for giving us a sneak peek!]
There are two basic types of investments: growth and income. This article will present some income investment opportunities that are available. In case you are unsure about the difference between growth and income, the following examples should help clarify.
Growth vs. Income
Growth: On June 2, 2006, I invest $1,000 by buying 10 shares of AASU Inc. at $100 per share. On June 2, 2008, I sell my 10 shares of AASU Inc. for $140 per share for a total of $1,400. My total profit from my ASSU investment was $400. I earned this $400 because the price of AASU stock “grew.”
Income: One June 2, 2006, I invest $1,000 by buying 10 shares of GTSBE Inc. at $100 per share. On June 2, 2008, I sell my 10 shares of GTSBE Inc. for $100 per share for a total of $1,000. However for the past 2 years, GTBSE Inc. has paid a quarterly dividend of $5 per share. Every three months, I received a check for $50 ($5 per share* 10 shares). Over the span of 2 years, I have received $400 income from my GTSBE investment.
Bonds
Whenever a corporation or government needs money, a preferred method of raising cash is to issues bonds. In the simplest definition, bonds are IOUs. You give me $1,000 now; and I’ll pay you interest on your money until the bond’s maturity date. At maturity, I’ll stop paying interest and just write you a check for the original $1,000.
Bonds issued by the government are considered the safest investments possible. However because of this low risk, you can expect a low return on your investment. Bonds issued by corporations having varying degrees of risk and therefore varying rates of return. To help you determine which companies are safe and which ones aren’t, companies are assigned credit ratings that range from AAA (Lowest risk) to C (Highest risk). When buying bonds from a company with a high credit rating, you can comfortably assume that you will receive your payments as agreed. This high comfort level translates into low returns. When buying bonds from a company with a low credit rating, there is a good chance that you may never get your money back as originally agreed. However because you are taking on more risk, there is the potential to get a higher return on your investment.
The key to bond investing is determining your level of comfort when it comes to risk and reward. I hesitantly mentioned bonds with low credit ratings, known as junk bonds, because only experienced, educated, wealthy investors should even consider them. For everyone else, the only reason to invest in bonds is because you want a safe, low risk method of making money. It is just important to remember that you will not earn much income from low risk investments such as government bonds.
Mortgage-Backed Securities (MBSs)
If I want to buy a $200,000 home today, do I need to have to $200,000 sitting in the bank? No. Whenever a potential homeowner wants to buy a home, they place a small down payment on the house and borrow the remaining amount in the form of a loan known as a mortgage. A later article will discuss the various types of mortgages, but for now, let’s assume it is a 30-year fixed rate mortgage. This means that for the next 30 years, I will be making fixed monthly payments to my mortgage lender. A portion of this monthly payment goes towards paying principal (the original $200,000) and another portion goes toward interest (the price you have to pay for borrowing the money).
Investing in mortgage-backed securities allow you to become a mortgage lender. When you invest in a mortgage-backed security, your money is pooled with other people’s money to lend to homebuyers. In essence, you are financing other people’s mortgages. Every month when these homeowners make their monthly payment, you will receive a check in the mail. In this situation, the bank merely acts as a middle man. The home owner makes a monthly payment to the bank; the bank passes the money onto you. Of course, this is America so the bank takes a little cut of the money for all of its hard work and trouble, but you still receive a steady source of income. Because there are slight risks associated with this investment, you can expect a rate of return that is a couple points above that of a bond.
The easiest way to invest in mortgage-backed securities is to do so through a mutual fund that invests in MBSs or GNMAs. If you want to buy a MBS directly without going through a mutual fund, you’ll need to have a minimum investment of at least $25,000.
Real Estate Investment Trusts (REIT)
What’s the one thing your parents always told you about renting an apartment? “Don’t rent because when you do, you’re making somebody else rich.” Instead of blindly taking this advice, the prudent investor would figure out how to make money off of other people’s rent payments. Real Estate Investment Trusts are an opportunity to do just that.
A REIT is a company that owns income-generating commercial and/or residential property. A commercial example of such a property is a mall. Each store and kiosk in the mall pays monthly rent to the mall owner. A residential example of such a property is an apartment complex. (FYI- Post Properties, owner of apartments in the Southeast United States, is a REIT).
By law, REITs are required to distribute 90% of their taxable income to shareholders. These distributions occur quarterly in the form of dividends. REITs provide a unique opportunity that other investments do not because they usually perform well in multiple economy environments and provide both growth and income. When the economy is booming, interest rates are low, and real estate prices are rising, REITs do well become their primary asset is real estate and property. As the price of real estate increases, the value of the REIT’s assets increases which will usually cause the stock price to increase. On the other hand, when interest rates are high and people cannot afford to buy homes, REITs benefit from increased income because many people are forced to rent instead of owning.
The best way to invest in REITs is to do so through a REIT mutual fund. The average annualized return of these funds has been over 20% for the past three years. In case you’re wondering, 20% is considered a good return.
[Editor’s Note: 20% return, over three years, is a good return, however, we at Wealth Weekly encourage our investors to look to then long term. How do REITs work over a 5 year term? Or 10 years? Consider the fact that while REITs have returned about 13% over the past 20 years, index funds have returned about 15%. We look over long periods of time so that we can see how mutual fund managers handle volatile markets (like Real Estate) through the ups and downs.]
Bottom Line
The 3 income investments outlined above are by no means the only ones available. However if you are truly interested in investments, they are three with which you should be fairly familiar. Income investments are attractive investments for retirement accounts because the income generated from the investments are not taxable. You can take $1,000, put it in a savings account earning 0.5% interest, and still have to pay taxes on the minimal interest you earned. Alternately, you can take $1000 in your IRA, invest it in a REIT earning about 20% in growth and income, and never have to pay taxes on the money. The better choice is obvious.
[Ed. Note – Careful readers. When investing in any mutual fund, when you take the money out of the investment, you are charged capital gains taxes of about 20% on any profit you make on the investment UNLESS you invest in a tax-deferred retirement account known as a Roth IRA. (And would you invest in anything else?) And, you have to hold the REIT for at least 12 months for favorable tax rates.]
If you have any questions, feel free to write jwhogans@gatech.edu.
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