Plastic isn’t ceramic, and don’t you forget it

The title of this post might seem a bit cryptic. It came to me as I was loading the dishwasher. I am the pro dish washer loader in the household, and prefer to not be disturbed while doing it. That’s because I’ve learned several tactics to essentially fit as many dishes as possible and thus save myself from washing anything by hand.

A key facet of loading the dishwasher is to avoid letting dishes hit each other. This isn’t good and can break your ceramic crockery. But this principal doesn’t apply to plastic ware. Things like plastic bowls, kid’s cups & bowls, and cooking spoons can certainly touch. Hence, I always try and load the frail items first, ensuring they don’t touch. Then I start eyeballing where I slip in “big” plastic items, and finally, layering in the smallest things. I use plastic’s innate lack of a brittle nature to my extreme advantage.

And I realized this is the same thing I do with my wealth building plan. There is a debate that won’t die over at BiggerPockets.com (the most popular real estate investment website). This subject keeps appearing in new blog postings and forum discussions: stocks vs. real estate. Check out these titles:

You can keep going back and finding more. But they often cite different aspects, and reach a conclusion of which one is better at building wealth. Several cited factors in the various articles include: liquidity, leverage, and efficiency of the market (or lack thereof).

Liquidity: good or bad?

Let’s examine some of these. For starters, stocks are highly liquid; real estate is not. You can get in and out of a stock in seconds. Can’t say the same for real estate. Is that a plus or minus? And here comes the proverbial…it depends. Warren Buffett has said, “Our favorite holding period is forever” and “Only buy something that you’d be perfectly happy to hold if the market shut down for ten years”.

This may say that you should only buy stocks if you are highly confident that you’ll be happy with the purchase for ten years or your entire lifetime. But stocks offer an escape hatch that real estate doesn’t. If something goes wrong, such as a dividend cut to your high paying company, you can sell it and move on to the next item on your short list. Real estate requires much more careful thought. When I had a boon of money dropped in my lap from the sale of my previous home, facilitated by the HELOC on my current house, I immediately lunged at the chance to buy a big position in VNR. I knew the dividend payment rate (8.6% at the time) would trump my HELOC’s 4% rate. I quickly computed that with no dividend increase and no interest rate increase, I could pay off the HELOC in 8 1/2 years and then pocket the difference from there on forevah!

Since then I’ve contemplated whether I should have taken all that money and simply bought another rental property, with the intention of using extra rent to pay off the HELOC. I quickly dismissed it on the grounds that my rental wasn’t liquid enough to deal with unforeseen issues with the HELOC.

However, on another note, I have a stock option with my current company. When it goes public, I’ll get a chunk of change. There won’t be any debt connected to it, so it will be a perfect opportunity to ring up Jeff Brown and pick up another unit or two. The liquidity won’t be needed to hedge a risk in that situation. So once again, whether or not to put a pile of money into an illiquid asset like a rental vs. a highly liquid investment such a stock depends on what risk your are mitigating. And hence the reason I often tell people, “Why pick one over the other?” Stocks AND real estate can be good wealth building vehicles.

Leverage

Here’s a good one that people usually slam out of the park. Real estate leverage usually trumps stock leverage. It’s possible to buy stocks on the margin, but the rules are all different.

If the value of your stock position goes down, your broker will be on the phone hitting you up for more cash. This is the famous margin call, and something you don’t want to ever experience. It sounds too analogous to someone upping the ante in a poker game and then asking to either up your own position, or fold.

With real estate and fixed debt, no one will be calling you up if the value of your property drops. As long as rent is rolling in such that you can make payments, there is nothing to worry about. 
Simply put, I own stocks without leverage. I own real estate with leverage. I don’t foresee how my wealth building would be adequate with a stock-only approach. History has shown that the rich invest in real estate and it has also been a strong wealth builder for the middle class.

Efficiency of the market

There is a popular theory out there called the Efficient Market Hypothesis. It says that everything about the stock you need to know is factored into the current price. It also says that you can’t “beat the market” because you don’t have an edge. The EMH is highly controversial and has many supporters and critics. I don’t totally agree with it because all you have to do it point out that Warren Buffett has beaten the market by wide margins for over forty years.

Something not directly stated but that seems to get tied into the EMH is that the market is always rational. Essentially, the price of stocks includes all risk, rewards, and other factors embedded in the price. This one I find hard to swallow. British Petroleum (BP) took a big hit three years ago when their stock price fell 33% from the mid 60s down to the low 40s. This was because people were concerned that BP was going to have to payout tons of money in claims amongst other concerns. Today, most of the claims have been paid. On top of that, BP still has a strong balance sheet with much capital, supplies, and is producing as much oil as ever. And yet the price still hovers around $46/share.

In the first article link up above, the author describes EMH to mean that there is no opportunity to go and buy someone’s stock at a huge discount. There is no way to find someone in distress, buy their shares at a low price, fix them up, and then re-sell them at fair market value. This simply doesn’t exist in the stock market, and hence you can’t make the same profits as real estate. He goes on to point out that real estate is incredible inefficient based on the process it take to complete a transaction, thus making it possible for people to create good value.

But again I look at stocks like BP. Other stocks have similar things happen all the time. Some event happens, people panic & sell, and others buy at a relative discount. Then things recover. From a 10,000 foot perspective, this sounds very similar. And it also sounds a lot like what Warren Buffett has been doing for years.

Whereas I might disagree with the author about the definitions about the EMH, there is a nugget of value in all this. A real estate transaction can cost thousands of dollars. A stock transaction is probably less than $10. That alone can make a difference on slowing down the pace of real estate, allowing one to make much bigger gains. Sometimes for better and sometimes for worse. When the value of your rental drops in value, you aren’t as likely to panic and sell. You realize it will cost thousands to sell it and acquire another. So you are driven to do a more careful analysis of the situation. Sometimes slowing things down can help you not panic, a phenomenon many in the investment industry say causes common people to not do well with investment products.

But being able to drop your stock in a heartbeat because a company stopped paying dividends may be just what the doctor ordered.

If you head is starting to hurt, because efficiency, leverage, and liquidity seem to be different sides of a coin (three-sided?), then you’re right. We are simply comparing the dynamics of each vehicle and seeing that they operate a little differently. But dropping one for some foolish rule of thumb can impair our ability to build wealth.

End result

I like having spare cash from my cheap HELOC put towards growing wealth instead of simply residing within the walls of my home. People seem to relish the value of their primary residence except you can’t eat your home. You would have to sell it to harvest the equity.  I prefer doing that now while I still have time on my side.

But I also like the monthly cash flow from my leveraged real estate. Both of these approaches work together in a synergistic fashion and are making it possible to build a better retirement wealth than shelling out 2-4%/year to a mutual fund house.

All metaphors break down, which is why I can’t say that real estate is ceramic or stocks are plastic ware. They each have their pluses and minuses. For example, ceramic may be more fragile to contact, but it’s more resilient to hot water. Plastic can bump against other things, but tomato-based foods need to be rinsed out before hand.  The important aspect is handle each part of your investment portfolio properly and be sure to guard against the risky things as well as take full advantage of their benefits.

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