It is common to hear that “diversification is key” when building a portfolio. However, most financial advisors fall short when they attempt to implement this strategy. In most investors’ minds, this means investing by purchasing a mix of tech stocks, medical stocks, and energy stocks. This is a very short-sided definition of diversification as all of these investments are all linked to the same general stock market, as well as the risks associated with investing in liquid assets that can fluctuate with great volatility.
When looking to diversify, it is important not only to consider asset class, but also to analyze risk, tax shields, and even the payout structure.
One of the most underappreciated methods of diversification is the mix between amortized and non-amortized investments.
Amortized Investments – During the duration of the investment, the investment is paying itself down. Example: When you invest in real estate notes, you put up cash in exchange for monthly cash flow. You get a yield on your investment, but as the homeowner is paying you, he is paying down the principle owned on a mortgage. If the mortgage is a 30-year mortgage, at the end of the 30 years, the monthly checks are going to stop and your note will have paid itself off. Therefore, if you have been spending your cash flow like it was all a gain; at the end of the 30 years, you will be left with nothing.
Mobile Home Note
Monthly Payments: $752.68
Cash on Cash Return: 32%
After three years and two months, you have your money back.
Amortized investments are a great way to supercharge your cash flow. You have to be careful that you don’t overspend, but if you are attempting to provide yourself with a monthly cash flow cushion, amortized investments can help you tremendously.
Non-Amortized Investments – These investments provide cash flow without reducing your asset’s value; this is usually the structure of most real estate investments. For instance, you buy a $100,000 house that rents for 1,000 a month. You receive the monthly rental but, when you are ready to sell the property, you still have the $100,000 house.
Syndicated Commercial Real Estate Investment
Projected Quarterly Payment: $1,560
Cash on Cash Return: 12%
Sale of property with 5% annual appreciation after 5 years: $64,167.93
Total Return: 17%
As you can see, these two investments provide different risks and returns from a cash-on-cash perspective. Because the cash on cash return of the mobile home note is 32%, you are getting your money back rapidly because of the amortization payment structure of the investment. Compare this to the commercial syndication that, at a 12% cash on cash return, would take 8 years to get your money back if the property wasn’t sold. However, at the end of the 5-year term in the real estate syndication, the projected return is 17%, compared to 13% mobile home note. Understanding the difference between amortized and non-amortized investments is crucial when it comes to financial planning. Both provide specific benefits and risks and it is important to analyze these forms of investment vehicles separately.
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- Hunter Thompson