How to Invest Money by George Garr Henry (finding audrey txt) 📖

In the same way, equipment bonds vary as to stability of market price. Compared with other classes of railroad issues, equipment bonds are all relatively stable, but the stability is especially marked in the shorter maturities.

Equipment bonds possess little prospect of appreciation in value.

The attentive reader who has carefully followed the foregoing description of equipment bonds, may have noticed a special adaptability on their part to the requirements of a business surplus. Broadly speaking, for such investment, a security is required which will combine perfect safety of principal and interest, a good rate of income, ready convertibility into cash, and unyielding stability of market price. The necessity for insistence upon these requirements in the investment of a business surplus will appear upon a moment's reflection. Safety is required in all forms of investment, but is particularly important in the handling of business funds; a good rate of income is always desirable; convertibility is necessary for a business surplus so that the reserve funds may be converted into cash at any time; and it is of the utmost importance that the security should not shrink materially in quoted price, no matter what changes may take place in financial and business conditions, so that if the need should arise for realizing on the reserve fund, it would be found unimpaired in amount. As explained in a former chapter, this point can not be covered by the selection of securities perfectly safe as to principal and interest, but only by the purchase of short-term obligations.

The point may be illustrated as follows: Let it be supposed that a firm or company has decided to invest $100,000 in the 5-per-cent equipment bonds of a good railroad maturing in three years, which can be obtained at par, merchant's paper then commanding about 5½ per cent. After two years it becomes necessary for the firm to realize on its investment at a time when commercial paper is floated with difficulty on a 6½-per-cent or 7-per-cent basis. Under such money conditions the equipment bonds could be sold on about a 6-per-cent basis, which would mean a price of 99 for a 5-per-cent bond with one year to run. The firm, in liquidating its investment, would therefore lose 1 per cent in principal, but would have received 5 per cent interest for two years, making the net return 4½ per cent. Compare this showing with the result if the bonds when originally bought had had ten years to run instead of three.

After two years, when the firm wished to dispose of its bonds it might experience some difficulty in doing so in the stringent money market which has been supposed, but even if it succeeded in selling them upon a 6-per-cent basis, that would mean a price of only 93¾ and would represent 6¼-per-cent loss in principal. If it were necessary to sell the bonds upon a higher basis or if the firm had purchased a bond with more than ten years to run, the relative disadvantage of the longer bond would be still more apparent. These points sufficiently demonstrate the importance of buying only short-term securities for the investment of a business surplus. Of course, if money conditions improve instead of becoming worse between the dates of purchase and sale, then a greater profit would be made with the longer-term bond. This, however, should not be allowed to influence the choice, first because it is not the object of a reserve fund to make a speculative profit, and secondly because a firm or corporation is only likely to want to realize upon its reserve fund when money is hard to obtain otherwise, and that is precisely the time when any long-term bond would be apt to show considerable depreciation.

The foregoing considerations indicate a special adaptability on the part of equipment bonds to the usual requirements of a business surplus. The points have been brought out at some length because of the importance of the subject to the average business man. The purpose in concentrating attention upon a single instance has been to illustrate more clearly the principles involved and at the same time to acquaint the business man with details of a highly desirable and somewhat unfamiliar form of security.

In the preceding chapter the discussion of railroad bonds was brought to a close. Before passing to the consideration of real-estate mortgages, which is the next form of investment to be taken up, it may be well to review briefly the general principles advanced in the first chapter of this book, in order that the reader may have clearly in mind the main points upon which judgment of the value of investments should be based.

There are five chief points to be considered in the selection of all forms of investment. These are: (1) safety of principal and interest; (2) rate of income; (3) convertibility into cash; (4) prospect of appreciation in intrinsic value; (5) stability of market price.

Keeping these five general factors in mind, the present chapter will discuss real-estate mortgages as a form of investment, both as adapted to the requirements of private funds and of a business surplus.

The average American business man is so familiar with real-estate mortgages that the details may be passed over briefly. A real-estate mortgage, or a bond and mortgage, as it is sometimes called, consists essentially of two parts, a bond or promise to pay a certain sum of money at a future date with interest at a certain rate per annum, and a mortgage or trust deed transferring title and ownership in a piece of real estate, with the provision that the transfer shall be void if the interest is regularly paid and the bond redeemed at maturity. Before advancing money on the security of a mortgage it is necessary to determine whether the title to the property legally vests in the maker of the mortgage; and during the continuance of the mortgage it is necessary to have proof that the taxes and assessments are being regularly paid, and, in the case of improved property, the fire-insurance as well.

The safety of real-estate mortgages, in common with the safety of all obligations, depends upon the margin of security in excess of the amount of the loan. In the case of real-estate mortgages the amount of this margin may be determined without great difficulty. It is only necessary to have the property carefully appraised by an expert in real-estate values. It does not follow, however, because a mortgage has been shown to possess substantial equity, that it is perfectly safe as an investment, unless it satisfies also another condition of great importance. A mortgage may not exceed 50 per cent of the selling value of the real estate pledged, and yet be a poor investment. This point involves a serious objection to real-estate mortgages which sometimes escapes notice.

The holder of a mortgage is at a great disadvantage in regard to the changing value of real estate. If the value of the property upon which he holds a mortgage increases, the additional value enhances the security of the loan, but does not add to the principal which he has invested, while if the value of the property diminishes, not only is the security proportionately lessened, but if the impairment be great, the holder is frequently compelled to take over the property and may suffer loss of principal. In other words, he receives no direct benefit from an increase in the value of the property, but has to stand the larger part of the risk of a decline in its value.

This is not the case with investments represented by negotiable securities subject to changing market quotations. All such securities, railroad bonds for example, are acted on equally by changes in the value of the property which secures them. Except for the influences of money-market conditions, railroad bonds advance with an increase in the value of the property and decline with a decrease in its value. Well-selected bonds usually increase in value with time, and all such increase goes directly to the benefit of the holder. The failure of real-estate mortgages to respond similarly to changes in the value of property places the holder of a mortgage at a great disadvantage.

Owing to this characteristic, real-estate mortgages should be purchased only when general conditions in the real-estate market are distinctly favorable. Not only should the purchaser of a mortgage have sufficient margin of security in the particular piece of property upon which he is loaning money, but he should also be satisfied that general real-estate values are relatively low, that there has been no undue speculation, and that conditions favor an advance rather than a decline in real-estate prices.

No class of property is subject to more rapid changes in value than real estate. After an extensive advance the holder of a mortgage may be insufficiently protected by the equity in the property, even if his mortgage represents only 60 per cent of the current appraised value of the real estate pledged. It may be that the 60 per cent which he has loaned represents the total value or more than the total value a few years before. When a rapid advance in values occurs, tho it may be largely justified by the growth and development of the territory, there is sure to be present an element of speculation which is likely to carry prices beyond the point of reason. When the turn comes and a severe collapse takes place, its effects are extremely disastrous, because, unlike speculation in stocks or commodities, no short selling exists in real estate to temper the fall, and the immobile form of capital makes liquidation impossible. These considerations serve to show the need for great prudence in the purchase of real-estate mortgages. If the investor exercises due care in these particulars, he is reasonably sure of obtaining a very high-grade security; if he neglects these precautions, he may suffer severe loss of principal.

No general figures are available which would indicate the degree of certainty attaching to the payment of interest upon real-estate mortgages. Certain classes of mortgages, such as those secured by unimproved real estate or dwellings, afford no direct security of interest payment other than the threat of foreclosure. Other classes, such as mortgages upon stores, hotels, or office-buildings, are often protected by a large income from the direct operation of the mortgaged premises, thus furnishing a security for the annual interest payment. The margin of protection in these cases varies greatly, so that no general conclusion can be drawn.

The other characteristics of real-estate mortgages may be passed over more briefly. It is generally conceded that mortgages return a higher rate of income than can be obtained upon any other form of investment which affords equal security. This constitutes their chief advantage.

Their chief disadvantage, on the other hand, lies in their entire want of convertibility. There is no market for real-estate mortgages, and except in special instances they can not be readily sold. The fact that they are not subject to quotation prevents them also from holding out any prospect of appreciation in value. Their very deficiency in this respect, however, constitutes an important advantage from another point of view. Since they are not quoted they can not shrink in market price in obedience to changes in financial and business conditions. The buyer of a mortgage is assured that he can carry his mortgage at par through periods when it may be necessary to mark down all negotiable securities subject to changing market quotations. This is frequently a matter of great importance.

The general characteristics of real-estate mortgages may be summarized as follows: (1) When carefully selected and purchased under favorable conditions, great safety of principal and interest; (2) a relatively high return; (3) a low degree of