Cost-Basis Reduction

Dividend paying stocks have always attracted a high percentage of stock investors.  The idea that you can simply own a stock that sends you a paycheck each quarter creates a sense of security for those who fear the volatility of the market.  After all, why care about share price when you know a nice dividend payment is being deposited into your bank account.

Cost basis reduction is appealing because it allows the investor to start taking their money off the table.  This means that you’ll eventually own the stock for free.  But if cost basis reduction is your goal, there are other strategies shown to generate far higher levels of cash flow than simply waiting around for a 2% or so yield to pay you back.

 

Considering Rental Properties

I’ve hear many investors compare the dividend payment from a stock, or the interest payment from a bond to the positive cash flow of a rental property.  But this is really comparing apples to oranges.

One consideration in owning a dividend paying stock is that when the distribution occurs, the price per share adjusts accordingly.  In other words, if a $10.00 stock pays a $0.30 dividend, the share price will be adjusted down to $9.70.   The market has the potential to elevate the stock back up again, but initially you are robbing Peter to pay Paul.

In comparison, the positive cash flow generated from a rental property is the surplus cash after all expenses are paid.  A rental property’s appraisal won’t be reduced after each payment of cash flow is received by the investor.

The other major difference is that you can’t have somebody else pay for your equity in a dividend stock.  You have to front the cash, and you’re only source of returns are dividends and potential capital gains.

However, a rental property inherently means the renter is building equity in addition to any positive cash flow produced.  To gauge actual ROI for a rental property, one must add increased equity to the positive cash flow.  The math usually means your true ROI is drastically higher in a rental property.

The major downside to rental properties is vacancy risk.  Dividend stocks don’t drain your portfolio to cover property taxes, maintenance, and upkeep.  Meanwhile a vacant property can easily transform into an expensive liability.  But vacancies are usually a minimal risk provided the property is acquired under the right terms, and managed effectively.

 

REITs

Real Estate Investment Trusts or REITs are similar to dividend paying stocks, but with certain advantages.  REITs, like any other Trust, are essentially entities for owning assets rather than pursuing profit as a regular business would.  That’s why REITs are not required to pay tax on corporate earnings so long as they pay out at least 90% of their taxable earnings to the shareholder.

REITs are given tax advantages and incentives to pay out far higher dividend yields compared to stocks.  While your average dividend paying stock generally has 1% to 3% dividend yields, REITs are commonly shown to yield 5% to over 10%.

However, while REITs pay higher yields, they also experience greater adjustments based on distributions.  But if your goal is to get your money off the table as fast as possible, and to own an asset for free, REITs tend to accomplish that goal far more quickly.

 

Selling Options

Hands down, this is our most preferred method of cost basis reduction.  One way of drastically increasing your rate of cash basis reduction is to sell Put Options and Call Options against an underlying stock.

Selling a Put Option means you get paid to promise a purchase price for a certain time period.  Let’s say GLD is trading for $100.00 per share. I could sell a Put Option where I promise to pay $97.00 for GLD if the shares decrease to that price or lower over the next month.  And for making that promise, I’ll get paid $1.00.  This creates a wonderful position form me, because I’ll either generate 1% ROI in one month, or the stock will drop low enough where I get a assigned the stock.  And even if I get assigned the stock, my actual cost is $96.00 because of the $1.00 in premium I received.

This creates a “heads I win, tails you lose” scenario.  If the stock stays high, I make 1% in a month, or a 12% annualized return on capital.  If the stock goes low, I’m getting the stock 4% cheaper than I would have anyway if I bought the stock outright.

Wait it gets even better.  Once I own the stock, I can start selling Call Options.  When I sell a Call Option, I get paid to promise the sale price of my stock for a period of time.  Let’s say I acquire GLD at $96.00.  Now I will sell a Call Option that promises to sell GLD at $99.00 if the stock price rises to or above that price over the next month.  And now I get paid another $1.00.

With the $1.00 received, my cost basis has been reduced to $95.00.  If the stock goes up to $99.00, I will have effectively made a $4.00 profit, or over 4%.  If the stock stays low, I have reduced my cost basis further which reduces my risk.

If you were to buy GLD at $100.00, the stock would have to rise above $100.00 to make any profit.  But through cost basis reduction, the stock could actually drop a $1.00 and I’d still be at a $4.00 profit.

Our preferred method of cost basis is to sell Puts and Calls.  The rate or return is shown to outpace almost all other strategies for cash basis reduction, and it creates a way to drastically improve our probability of profit.  In fact, this method can be implemented on stocks and REITs that already pay dividends.  This means you can potentially be generating option and dividend cash flow as you enter and exit the stock.

 

About The Author

herbertkoehler

I am a college drop out who found my passion as an investor. I love the many facets of finance, investing, and business. But even more than that, I love sharing what I learn with others.

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