There are basically two ways to increase the value of your retirement account: (1) select investments that appreciate in value, and (2) select investments that can be leveraged. Appreciation is the increase in value of an asset over time. Leverage is the use of borrowed funds to achieve a higher rate or return.
Of the top five investments for retirement accounts, only income-producing real estate can provide both appreciation in value and leverage to enhance your return on investment. Most investments for retirement accounts miss the critical factor of leverage. Here’s a summary of each of the top five investments commonly used in retirement accounts and an illustration of how leverage impacts your return on investment.
First, mutual funds. A mutual fund is an investment fund that pools money from many investors to purchase a select group of securities. The advantage of a mutual fund is diversification, which reduces risk. The disadvantage is that returns are averaged among winners and losers which generally cause the overall return to be lower. As for leverage, a mutual fund is not a leveraged investment. You can buy a dollar’s worth of stock for a dollar.
Second, individual stocks. A stock is an equity investment that represents part ownership in a corporation and entitles you to receive part of the earnings and assets of that company. In reality, you receive a small return in the form of dividend distributions and hope that the stock appreciates in value based on the successful management of the company.
The advantage of purchasing an individual stock is that it can dramatically increase in value over time. The disadvantage is that it can also drastically decrease in value. If the company is managed poorly, the company goes bankrupt and the value of your stock is zero. That’s what happened to Delta Airlines and General Motors and several other great companies. Few investment advisers have been able to accurately predict winners and losers. As for leverage, an individual stock is not a leveraged investment.
Third, gold. Gold is a precious metal that has value when its fashioned into coins or jewelry. Some coins can be purchased with retirement account funds while jewelry and other coins cannot. Gold is a countercyclical investment. The price of gold rises when the economy is doing poorly and falls when the economy is doing good.
The fact that gold is a physical asset rather than a piece of paper is comforting to some investors, however, it can also be a problem. The television commercial with the paid actor asking the question, “What’s in your safe?” may be the dumbest question of all time. If you buy gold and put it in your safe at home, you become the target of burglars. Who wants to be robbed at gunpoint and forced to open their safe and turn over their gold? Most lenders won’t take gold as security for a loan, unless they physically hold it. As for leverage, gold is not a leveraged investment.
Fourth, annuities. An annuity is a fixed sum of money paid to an insurance company who agrees to pay you a stipulated sum of money beginning at a certain date and continuing on throughout your lifetime. If you live longer than the average life expectancy, you win. If you live shorter than the average life expectancy, you lose. Your principal is never returned. It belongs to the insurance company. As for leverage, an annuity is not a leveraged investment.
Fifth, real estate. Real estate is property consisting of land and buildings. It can appreciate in value and it can be leveraged. The National Association of Realtors did a 30-year study that showed the average price of a home increased in value at the rate of 6 percent per year. In commercial real estate, the value of an asset is based on the income that it generates. Over time, as the income on a property goes up, the value of the asset increases proportionately.
Real estate can also be leveraged. Banks and other financial institutions view real estate as a safe investment and are willing to lend money based on its value. Typically, you can purchase a real estate investment with 25 percent down and borrow the other 75 percent from a financial institution. If an investment is returning 6-to-8 percent on an unleveraged basis, it stands to reason that if you can borrow money at 4-to-5 percent, that return would go even higher than 6-to-8 percent you were previously receiving. Leverage accelerates your return on investment.
Leverage also benefits your investment in another way. Not only does your initial investment (your down payment) increase in value, but your entire investment appreciates in value. So, if you purchase a $400,000 investment with $100,000 down and $300,000 in debt, the entire $400,000 investment appreciates in value, not just the $100,000 investment. This can dramatically increase the value of your retirement account.
For example, say you invested $100,000 in a stock that increased in value at the rate of 6 percent per year over 20 years. The value of the stock would grow to $320,000 over that period of time. Now say you take the same $100,000 and leverage it in a $400,000 real estate investment. Assuming the same 6 percent per year growth, the real estate investment would appreciate in value to $1,280,000. That’s an increase in value of over 3.5 times the value of the stock investment, even after the remaining balance of the $300,000 loan is paid off.
The only way to use your retirement funds to invest directly in real estate is to set up a self-directed retirement account. Most banks, investment firms and insurance companies don’t permit you to self-direct your retirement investments, unless it’s in products they offer and on which they can earn a commission. By the way, a real estate investment trust (REIT), is not a real estate investment. It’s a stock that earns its return by investing in real estate. It operates like a stock, not like a real estate investment.
