10 Rules To Invest In Equities Like A Real Estate Mogul

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Includes: AAPL, ADP, APLE, ARESF, BCE, BEP, BIP, BTBIF, CL, CMLEF, CSCO, DUK, EPD, GPC, GWW, HASI, IBM, JNJ, KO, MMM, MRCC, MSFT, O, PEGI, PG, PPL, PSA, RY, SO, TD, TXN, VFC, VTR, WEC, WMT, WPC
by: Wayne Hylarides

Summary

Leverage can supercharge returns but introduces cash flow risks.

If you leverage equities, apply the same rules successful real estate investors use.

I suggest you apply these principles regardless if you leverage or not.

Investment Thesis

If a real estate investor were to invest in stocks the same way they do in real estate, they would apply the following rules:

  1. Don't overpay for an asset.

  2. Buy assets where dividends increase over time.

  3. Buy assets you would be happy to hold for 10 to 20 years.

  4. Generate more income in dividends than the cost of capital (i.e. current interest rates).

  5. Identify the risks to cash flows and create a buffer (i.e. interest rates, dividend cuts).

  6. Ignore market prices, only focus on dividend growth and cash flow growth.

  7. Don't sell in market downturns.

  8. Hold for long periods of time to minimize capital gain tax realization.

  9. Constantly pay down debt and/or reinvest earnings.

  10. Never leverage with a margin call.

I recommend that you consider these regardless if you are buying rental properties, stocks, or REITs, with or without leverage.

Primer

How do real estate investors do so well compared to the average equity investor? How similar is stock market investing to real estate investing? Would you create a different portfolio if you treated each stock like a rental property? Would you buy different stocks? What about if you were using leverage to buy equities, would that change your strategy?

To answer these questions, we first need to look at how a real estate investor makes great returns. Let's look at a typical scenario:

  • $300k real estate investment with 20% ($60k) down.
  • 2.7% fixed interest rate
  • 5-year investment horizon

Note: 5-year fixed mortgage rates are in the 2.5-3% range in Canada.

The monthly principal plus interest of a 25-year mortgage would be $1,099.17/month or $13,190.04/year. Therefore, you would need a rental property with cash flow returns of 4.4% to break even on the mortgage. Where I live, you could get around $1,500-1,600 per month in rent on a $300K property, leaving a buffer for taxes, condo fees (if applicable), and maintenance.

If you purchased a property that was cash flow neutral over 5 years (100% occupancy, no rent increases, zero capital appreciation), you would have paid off $36K for an annualized return of 9.9% on $60k invested:

10% isn't bad, and I would say that is the bottom of the likely return. If you consider rent increases and capital appreciation, your return could be in the high teens or twenties. If your investment also saw a 5% annualized price return, your property would be worth $382,884, for an additional $82,884 (24.4% annualized return). But consider this: you have to run ads, show the property, and deal with tenants. That all takes valuable time away from things that matter. If you hired a property manager, they typically take one month's rent, dragging down your returns.

Housing Prices

Although housing prices could go up, they could go down as well. In spite of popular folklore, illiquidity plays an important psychological benefit here. Because it takes a lot of effort to sell a house, landlords tend to ignore shifts in housing prices and focus on being cash flow positive and paying off the mortgage. This means price swings do not really matter to the real estate investor. They just wait it out and continue to collect a monthly rent check and pay off the mortgage.

Therefore, the goal of the real estate investor is to eventually increase rents and improve the total cash flow of the business. That cash flow can be used to pay off debt, acquire more properties, or supplement income. If you keep each property cash flow positive, after acquiring 10-20 properties, you might be able to completely live off the marginal income. Over the years, as rents increase, so does your cash flow. With the rent increases, you can exponentially pay off your mortgage. There are many other strategies that can be employed in this business, such as renovation improvements (i.e. CapEx) to increase rents, but overall the principles stay the same.

Why do real estate investors do so well?

It's because they follow these principles:

  1. Don't overpay for an asset.

  2. Buy assets where dividends increase over time.

  3. Buy assets you would be happy to hold for 10 to 20 years.

  4. Generate more income in dividends than the cost of capital (i.e. interest rates).

  5. Identify the risks to cash flows and create a buffer (i.e. interest rates, dividend cuts).

  6. Ignore market prices, only focus on dividend growth and cash flow growth.

  7. Don't sell in market downturns.

  8. Hold for long periods of time to minimize capital gain tax realization.

  9. Constantly pay down debt and/or reinvest earnings.

  10. Never leverage with a margin call.

By following these principles, they make sure they are buying safe assets that will appreciate slowly over time. The leveraging effect and capital gains push returns into double digits over a long period of time.

Can you do the same thing with equities?

Let's look at an example. Imagine an equity holding corporation (HoldCo) or an individual portfolio that invests the same amount as the real estate example:

  • $300k of equities
  • $60k down
  • Borrow a $240k investment loan

Investment loans can have different repayment options just like a house. Some are interest only and some can be loans with a multitude of amortization options. The type of loan you take out depends on your credit, the lender, and the underlying assets you buy. But for simplicity sake, let's assume the same 25-year amortization. Based on good credit, interest rates on investment loans (where I live) run around 3.7-4.7% (prime plus 1 or 2). I recommend to seek investment loans from credible lenders who don't put a margin call on the loan. The last thing you want is to be forced to sell in the event of a market downturn when your portfolio is cash flow neutral.

Here is the amortization of the loan with a 5-year term (assuming interest rates are constant):

The required dividend yield on your portfolio would need to be 4.9% to be cash flow neutral (it would be much less if you used a LoC that was interest only). Based on these factors, after 5 years, you would have paid down $32k of debt. If your investment also saw a 5% annualized market price return, your assets would be worth $382,884. Your net worth would be $175k. Based on an initial investment of $60k over 5 years, your annualized return would be 23.9%. Pretty much the same as the rental property (ignoring tax implications).

You might also see an annual increase in dividends. This cash could be used to further pay down debt, buy more assets, or pay yourself. As the dividend increases, and if interest rates stay the same, your portfolio's net cash flow will increase. Note that no matter how fast interest rates rise, investing in a perpetual compounding business would eventually overcome all interest rates.

Building a Portfolio

Based on an interest rate of 3.7% and a 25-year amortization, we need to build a portfolio that yields at least 4.9% initially. Alternatively, you could get a line of credit with interest only payments and depending on your down payment, your portfolio yield would need to be at most 3.7%. There are several strategies you can employ to build a portfolio:

  • Buy a high yield income portfolio with low compounding (i.e. REITs).

  • Buy a low yield portfolio with high compounding, supplemented by a monthly pay yourself first strategy.

  • Combination of compounding and high yield to have a dividend-interest neutral tax situation.

You can either build a portfolio from scratch, use an ETF, or adjust a portfolio from someone you trust. To make it easy, I'll leverage Dividend Sleuth's "Buy, Hold, Add: A Sleep-Well-At-Night Strategy In A Time Of High Anxiety". These are the types of investments we're looking for. Safe, dividend growth, and cash flow positive. Dividend Sleuth uses a combination of bond ratings and consecutive years of dividend increases (CCC) to evaluate stocks to form his portfolio. I have also added in the 10-year average compounding dividend growth and the stock beta data. I made some adjustments and eliminated some foreign stocks because of withholding tax and a couple others because of the short dividend history. I encourage you to form your own portfolio based on Dividend Sleuth's.

His current portfolio allocations (pure equity) provide an average yield of 3.67%. If you employed an interest only LoC, you could pretty much keep his weightings. We would need to tweak the portfolio to achieve 4.9% to get a 25-year amortization. I arranged his portfolio by yield and gave a growing weighting to get to an annual dividend yield of 4.94%. Note that depending on how often dividends are paid, you might have to supplement cash flows to pay interest. Also, I ignore tax for simplicity, but consider tax depending on what type of account you are using.

Note: I would advise you to put much more work into creating your portfolio, but I would be proud of this one. In practice, I would try to push as much weighting as possible to the compounding machines viz. the high yielders. You will see below how much that matters.

Company

S&P

CCC

Beta

Div Growth

Yield

%

Port

Apple (NASDAQ:AAPL)

AA+

5

1.25

10.67%

1.60%

1.00%

WW Grainger (NYSE:GWW)

AA-

45

0.76

13.30%

2.00%

1.00%

Colgate-Palmolive (NYSE:CL)

AA-

53

0.76

8.04%

2.10%

1.00%

Automatic Data (NASDAQ:ADP)

AA

42

0.86

9.31%

2.20%

1.00%

Microsoft (NASDAQ:MSFT)

AAA

15

1.03

14.58%

2.40%

1.00%

3M (NYSE:MMM)

AA-

59

1.08

9.32%

2.50%

1.00%

Johnson & Johnson (NYSE:JNJ)

AAA

54

0.79

6.66%

2.60%

1.00%

Texas Instr (NYSE:TXN)

A+

13

1.23

20.11%

2.60%

1.00%

Wal-Mart (NYSE:WMT)

AA

44

0.14

8.56%

2.90%

1.00%

Genuine Parts (NYSE:GPC)

NR

61

0.94

6.09%

2.90%

2.00%

Procter & Gamble (NYSE:PG)

AA-

60

0.62

6.71%

3.00%

2.00%

Int. Bus. Mach (NYSE:IBM)

AA-

21

0.97

13.35%

3.10%

2.00%

VF Corp (NYSE:VFC)

A

44

0.79

11.61%

3.20%

2.00%

Cisco (NASDAQ:CSCO)

AA-

7

1.42

30.30%

3.40%

3.00%

Royal Bank Can (NYSE:RY)

AA-

6

0.79

6.08%

3.40%

3.00%

Coca-Cola (NYSE:KO)

AA-

55

0.68

7.49%

3.50%

3.00%

Toronto Dominion (NYSE:TD)

AA-

6

0.95

7.78%

3.50%

3.00%

Public Storage (NYSE:PSA)

A

7

0.50

14.87%

3.50%

3.00%

WEC Energy (NYSE:WEC)

A-

14

0.08

14.87%

3.50%

3.00%

Duke Energy (NYSE:DUK)

A-

12

0.19

3.16%

4.20%

3.00%

Realty Income (NYSE:O)

BBB+

24

0.38

4.91%

4.20%

4.00%

PPL Corp. (NYSE:PPL)

A-

16

0.47

2.58%

4.30%

4.00%

Southern Co. (NYSE:SO)

A-

16

0.09

3.42%

4.40%

4.00%

Brookfield Infra (NYSE:BIP)

BBB+

10

1.05

21.77%

4.40%

4.00%

Ventas (NYSE:VTR)

BBB+

7

0.14

4.97%

4.90%

4.00%

BCE Inc. (NYSE:BCE)

BBB+

8

0.37

6.27%

5.00%

5.00%

Enterprise Prod (NYSE:EPD)

BBB+

20

0.87

5.50%

5.80%

5.00%

WP Carey (NYSE:WPC)

BBB

20

0.83

7.97%

6.30%

5.00%

Apple Hospity (NYSE:APLE)

NR

1

-

0

6.30%

5.00%

Brookfield Renew (NYSE:BEP)

BBB

5

-0.10

7.72%

6.40%

5.00%

Hannon Armstr (NYSE:HASI)

NR

3

0.96

0

6.70%

5.00%

Pattern Energy (NASDAQ:PEGI)

NR

3

1.04

0

8.20%

6.00%

Monroe Capital (NASDAQ:MRCC)

NR

0

0.56

0.00%

8.90%

6.00%

Let's do some sensitivity analysis to understand how to best position our portfolio and understand risk:

Case 1:

  • 240K revolving LOC (interest only)

  • Overall portfolio dividends grow based on historic average (~7%)

  • Interest rates grow at 10% per annum

  • All cash flow goes to debt

  • Assume 7% price growth (in line with dividend growth)

Note: I used annual compounding to simplify the analysis.

Year

1

2

3

4

5

6

7

8

9

10

Portfolio Yield on 300K Basis

4.9%

5.2%

5.5%

5.9%

6.3%

6.8%

7.3%

8.0%

8.7%

9.6%

Dividend

$14,826

$15,676

$16,635

$17,723

$18,965

$20,391

$22,038

$23,952

$26,191

$28,826

Interest rate

3.70%

4.07%

4.48%

4.92%

5.42%

5.96%

6.55%

7.21%

7.93%

8.72%

Interest

$8,880

$9,526

$10,203

$10,907

$11,628

$12,354

$13,063

$13,722

$14,282

$14,672

Cash Flow

$5,946

$6,150

$6,431

$6,816

$7,337

$8,037

$8,975

$10,230

$11,908

$14,154

Principle

$234,054

$227,904

$221,473

$214,657

$207,320

$199,284

$190,308

$180,078

$168,170

$154,016

10-year returns

Asset Value: $590,145

Debt: $154,016

Net worth: $436,129

Annual return: 21.9%

Case 2:

If we assumed that interest rates stayed the same, the return would have been:

Year

1

2

3

4

5

6

7

8

9

10

Portfolio Yield on 300K Basis

4.90%

5.20%

5.50%

5.90%

6.30%

6.80%

7.30%

8.00%

8.70%

9.60%

Dividend

$14,826

$15,676

$16,635

$17,723

$18,965

$20,391

$22,038

$23,952

$26,191

$28,826

Interest rate

3.70%

3.70%

3.70%

3.70%

3.70%

3.70%

3.70%

3.70%

3.70%

3.70%

Interest

$8,880

$8,660

$8,400

$8,096

$7,740

$7,324

$6,841

$6,278

$5,625

$4,864

Cash Flow

$5,946

$7,016

$8,234

$9,627

$11,225

$13,067

$15,197

$17,674

$20,566

$23,962

Principle

$234,054

$227,038

$218,804

$209,177

$197,952

$184,885

$169,688

$152,014

$131,448

$107,486

10-year returns

Asset Value: $590,145

Debt: $107,486

Net worth: $482,659

Annual return: 23.2%

Another option would be to buy more equities with the cash flow. This would increase our cash flow through more dividends. If the interest rates remained low, it would make more sense to buy more equities. But it really depends on your 10-year goal.

Case 3:

Let's assume that a really bad situation happened: zero dividend increases for the 10 years and interest rates increase 10% year over year. Also, assume that the market value of your portfolio didn't change:

Year

1

2

3

4

5

6

7

8

9

10

Portfolio Yield on 300K Basis

4.90%

4.90%

4.90%

4.90%

4.90%

4.90%

4.90%

4.90%

4.90%

4.90%

Dividend

$14,700

$14,700

$14,700

$14,700

$14,700

$14,700

$14,700

$14,700

$14,700

$14,700

Interest rate

3.70%

4.07%

4.48%

4.92%

5.42%

5.96%

6.55%

7.21%

7.93%

8.72%

Interest

$8,880

$9,531

$10,253

$11,059

$11,968

$13,002

$14,191

$15,573

$17,199

$19,137

Cash Flow

$5,820

$5,169

$4,447

$3,641

$2,732

$1,698

$509

-$873

-$2,499

-$4,437

Principle

$234,180

$229,011

$224,564

$220,923

$218,191

$216,493

$215,983

$216,856

$219,356

$223,793

Your 10-year returns would be 2.42%. This is a disaster scenario. As long as you make a reasonably safe portfolio, I would be very surprised to see this happen. Some individual stocks in your portfolio might be winners and some might be losers, but overall with the portfolio outlined above, I expect to perform reasonably well over the long run. But good to know that if it did go bad, we wouldn't necessarily lose our shirts.

Keep in mind a crash might take down the price of our portfolio, but most of the stocks we selected made it through the financial crisis without affecting the dividend. Therefore, we would have been able to pay off the interest ignoring the market's speculative price decline. If you stay in the market, the dip would have not affected you.

Case 4:

Let's look at another hypothetical case where you actually buy high yield real estate investment trusts. The thing to understand about REITs is they aren't great compounders. Some REITs can be okay compounders, but high yield REITs are generally paying out close to 100% of the AFFO and reinvesting very little into growth. REITs are very capital intensive and grow slow over the long term. Many achieve growth through additional equity offerings. This dilutes your units, but can be neutral from a per unit AFFO perspective as the raised funds go towards buying more properties and increasing revenues.

Let's build a portfolio that yields over 7%. I'll propose the following one for my Canadian readers (assume equal portfolio weightings):

  • Cominar (OTCPK:CMLEF) (TSE:CUF.UN) Yield: 10.43%
  • BTB (OTC:BTBIF) (TSE:BTB.UN) Yield: 9.09%
  • Artis (OTCPK:ARESF) (TSE:AX.UN) Yield: 8.34%
  • Agellan Commercial (ACR.UN) Yield: 6.83%
  • Crombie (CRR.UN) Yield: 6.59%
  • OneREIT (ONR.UN) Yield: 8.33%
  • Morguard (MRT.UN) Yield: 6.32%
  • Average Yield: 7.85%

We know that some of these REITs are close to a distribution cut, but even if they cut 40% of their dividend, you would still be okay in the long run. Since we have 7 REITs, each one represents about 14% of the total portfolio. Therefore, a 40% cut to one would represent about 5.6% reduction in the overall portfolio. Let's assume that you knew that at least one distribution will get cut in the future, representing an average of -5% total portfolio yield/year.

Year

1

2

3

4

5

6

7

8

9

10

Portfolio Yield on 300K Basis

7.85%

7.46%

7.08%

6.73%

6.39%

6.07%

5.77%

5.48%

5.21%

4.95%

Dividend

$23,550

$22,373

$21,254

$20,191

$19,182

$18,223

$17,311

$16,446

$15,624

$14,842

Interest rate

3.70%

4.07%

4.48%

4.92%

5.42%

5.96%

6.55%

7.21%

7.93%

8.72%

Interest

$8,880

$9,171

$9,497

$9,868

$10,295

$10,795

$11,388

$12,100

$12,965

$14,029

Cash Flow

$14,670

$13,202

$11,757

$10,323

$8,886

$7,427

$5,924

$4,346

$2,659

$813

Principle

$225,330

$212,128

$200,372

$190,048

$181,162

$173,734

$167,811

$163,465

$160,806

$159,993

Based on this, you would see about an 8.8% annualized return, assuming zero capital growth.

Case 5:

If you were lucky and didn't see any distribution cuts to your portfolio, you would see:

Year

1

2

3

4

5

6

7

8

9

10

Portfolio Yield on 300K Basis

7.85%

7.85%

7.85%

7.85%

7.85%

7.85%

7.85%

7.85%

7.85%

7.85%

Dividend

$23,550

$23,550

$23,550

$23,550

$23,550

$23,550

$23,550

$23,550

$23,550

$23,550

Interest rate

3.70%

4.07%

4.48%

4.92%

5.42%

5.96%

6.55%

7.21%

7.93%

8.72%

Interest

$8,880

$9,171

$9,444

$9,694

$9,913

$10,091

$10,218

$10,279

$10,254

$10,120

Cash Flow

$14,670

$14,379

$14,106

$13,856

$13,637

$13,459

$13,332

$13,271

$13,296

$13,430

Principle

$225,330

$210,951

$196,845

$182,989

$169,352

$155,894

$142,562

$129,291

$115,996

$102,566

The annualized return would be $300,000 - $197,434 = $211,141 on an initial investment of $60,000, or a 12.65% annualized return.

Case 6:

If you were really lucky and saw no decrease in distributions and no increases to interest rates, you would see:

Year

1

2

3

4

5

6

7

8

9

10

Portfolio Yield on 300K Basis

7.85%

7.85%

7.85%

7.85%

7.85%

7.85%

7.85%

7.85%

7.85%

7.85%

Dividend

$23,550

$23,550

$23,550

$23,550

$23,550

$23,550

$23,550

$23,550

$23,550

$23,550

Interest rate

3.70%

3.70%

3.70%

3.70%

3.70%

3.70%

3.70%

3.70%

3.70%

3.70%

Interest

$8,880

$8,337

$7,774

$7,191

$6,585

$5,958

$5,307

$4,632

$3,932

$3,206

Cash Flow

$14,670

$15,213

$15,776

$16,359

$16,965

$17,592

$18,243

$18,918

$19,618

$20,344

Principle

$225,330

$210,117

$194,342

$177,982

$161,018

$143,425

$125,182

$106,264

$86,645

$66,301

The annualized return would be $300,000 - $66,301 = $233,699 on an initial investment of $60,000, or a 14.56% annualized return.

It should be obvious that high yield REITs are not the best long-term investment. Although you get a better initial cash flow, it is usually better to invest in a perpetual compounding machine with a solid track record. Eventually, the dividend growth will outperform the high yield. Also, the additional tax exposure will limit your loan pay down. Therefore, it is generally recommended to match yield and interest to supercharge compounding.

Note: I ignored the effect of tax. Since a high yield portfolio generates more income in your hand, your cash flow would be more affected by tax. Therefore, it is generally recommended to grow through internal company compounding and match dividend yields to interest costs. Companies pay tax on income too. The government always gets their money.

Summary

There you have it. Leverage, when used properly, can achieve great returns while mitigating and directly assessing cash flow risks. This is what real estate investors do and why they get great returns. Now, yes, there is no risk free leveraged scenario. No free lunch. Therefore, I don't recommend leverage to anyone, especially if you don't have a great psychology. Your head is why you don't perform well in the market. Rather, I recommend to buy investment as if you are entering a leveraged scenario. Over time you will still be greatly rewarded!

Cheers,

Wayne

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.