Think an additional unit adds value to your property? Think again.
Read moreLow Money Down High Rate Trap
Beeeeeee Careful
October 20, 2023
You should not buy a house right now with low money down and > 7% rates without ample cash reserves.
Why is this? After all, the less you can put down on a house and the more you can finance, generally the better off you are. However, in today’s environment, this can backfire.
For example, let’s say you’ve saved up enough for 10% down. You put 10% down and take out a note at 7.5% and you can make the payments, albeit barely because you just doubled your monthly costs when compared to the house you were renting. But, it’s ok, you can refinance when rates drop everyone tells you.
Now, let’s assume rates drop and you want to refinance. Good idea. Except when it comes to a refinance, you’re looking at being able to borrow a max of 80% of your house value and typically it’s more like 70% to 75%. So, now it gets fun.
You bought your house for $1mm and borrowed $900,000. 3 years have passed but have values risen? Let’s say they have at a rate of 4% per year or 12% (non compounded) over that 3 year period. Your house will appraise for $1.12mm. If this is true and IF you can borrow 80% on a refinance, you take out a loan for $896,000. But, if you’re limited to 70%, you’re limited to $784,000 meaning you would likely need to put another $100,000 of cash in to get the refinance done.
Now, what happens if in the short run your house doesn’t appreciate and stays flat? Now, you’re looking at a max of $800,000 on the loan or even $700,000 meaning you may need as much as $200,000 of cash to get the refinance done.
You could very easily find yourself in a situation in which rates DO fall but you can’t refinance because you can’t put in enough cash to meet the loan to value requirements.
Now, let’s address the variable component. Typically, a variable rate note will price at a spread above WSJ prime or a specific treasury yield. However, the rate you start out with is often not priced at this metric but is priced lower. What this means is that when the fixed rate period is over and you go to the floating rate, the jump in rate may be larger than you expect. Moreover, these loans often have a rate floor meaning if rates fall, yours does not fall accordingly. So, in this scenario in which you have a relatively high floating rate loan, you could find yourself in a situation where market rates fall but your rate does not and you can’t refinance because you don’t have enough equity or cash to pay down the note.
The lesson here is a low downpayment note with a variable interest rate, particularly in a high rate environment is a risky gamble. It’s ok to take that risk but ideally you would maintain ample reserves to cover the risk should it go bad on you.
Now, all that said, if you can borrow 90% of your home’s purchase price, you should absolutely do it if the rate is reasonable in the current climate. Take the excess funds you’d have spent on a downpayment and invest it in higher return investments.
Track is Love
Track is Love
June 12th, 2023
Most of what we see and hear on a daily basis from any number of news media, entertainment media and general conversation is how people hate each other. There are racial divisions, class divisions, political divisions. We are all divided. We are all destined or doomed to fight each other.
But, why? Why are we supposed to hate? Why are we supposed to be divided? Moreover, is this even true?
This past week and weekend I had the opportunity to spend 4 days watching the NCAA Track and Field Championships. Many things struck me as interesting, joyful and fun. Super fast men's 100 meters anyone? University of Texas women’s 4 x 100 relay? Record breaking Triple Jumps? A walk off discus throw for the NCAA title? There was a lot of great running and jumping and throwing to be excited about it.
But, that’s not what stuck out to me the most. Sitting in the stands on the home stretch, lower level, upper level, on the back stretch pole vault side and triple jump side, what stuck out to me was not the great performances. It was love.
Looking around, I saw black people, white people, brown people, Americans, non Americans, rural, city and people from all regions of the country. I saw old people, young people, middle aged people, men and women. I saw gay, straight, indifferent and probably some in between.
What I didn’t see was hate or division. Not amongst all these factions. Not amongst teams. Not anywhere. I saw a whole lot of love and a whole lot of support for the athletes though. I saw people whom, according to what we are told should be hating each other, laughing and talking and catching up. I saw old men and young men of all stripes reconnecting with old friends. I saw the same for women. There weren’t whole clusters by race or by school or much else that I could see. It felt like one big family reunion where there are some different people but at the end of it, it’s still a family and they had a lot of love to go around and track was their common bond, always and forever.
This isn’t the first time I’ve seen this. I’ve seen it in Eugene. In Austin. I’ve seen it in small towns across Texas. And if you’ve never been to the Penn Relays, that’s a stadium full of love.
My take away from this weekend is don’t let people with ulterior motives divide us. There is a lot of love out there. We just need to do some running to find it.
To paraphrase Elle Woods, running produces endorphins. Endorphins make people happy. Happy people don’t kill people.
So, go for a run today. Say hi to your neighbor as you run by. And, support track and field. You’ll find all the love you need.
What about everyone who isn't a W2 employee?
Does the unemployment number tell enough of the story?
The Federal Reserve seems to be fixated on the unemployment number as well as the inflation number of late. The statements from the fed all fall along the lines of we need higher unemployment to curb inflation. The implication is that low unemployment and people working is a bad thing. And, it likely does result in wage inflation as employers compete for employees. However, I don’t think this is a bad thing – except for employers, particularly ones that believe employees should basically work for free or, worse, pay employers to allow them to work there (that’s really a thing). A great organization has a more symbiotic relationship with its team than that. No, low unemployment is good. That means there are opportunities for people. Opportunities create a great society.
However, the unemployment rate doesn’t tell the entire story. The assumption is that work is binary. People go to work for a company. They get a paycheck. They are employed. When the paycheck stops, they are unemployed. There is, however, a huge sector of the economy, perhaps as much as 30% or more, that doesn’t fall within those definitions. These are your small business owners, your independent contractors and large swaths of certain industries. When the economy falters, these people often don’t become unemployed in a literal sense and definitely not in any way that shows up in government statistics.
They don’t have the option of filing unemployment claims. They don’t show up in the statistics. They may even still be working.
How is that bad, you ask?
They may still be working but they are working less and making less. So, they aren’t unemployed but income is down 20% or 30% or more. Often, there is no cushion to absorb a 20% decline in income. They sell 2 houses this year instead of 10 or complete 20 projects of a smaller size rather than the 25 from prior years.
But, these types of numbers don’t show up very well places. You can see macro numbers about real estate transactions or housing starts or permits but this independent economy is far more pervasive than those numbers provide.
So, while the fed is focused on the official unemployment numbers and making sure more people with formal jobs lose them, there is significant collateral damage in the non W2 job sector as people earn less as their sales decline. I see this first hand in the construction business. As this sector of the economy struggles, it will affect the economy on the whole.
By moving rates as fast as the fed has, they haven’t given enough time to assess the impact to the entire economy. Many indicators are lagging in nature but the indicator that isn’t measured very well, underemployment in general and in the independent sector in particular, is showing plenty of stress right now. The fed members need to get out of the office and into the economy and talk to people. Data is great but it only tells part of the story and where the economy is concerned, you need the entire story.
Does the Fed have any idea how the real world works?
2% isn’t realistic.
I think most of us in the business community already know the answer to this but to make it more clear, NO, the fed folks apparently don’t understand how people in the real world work. We have underqualified federal reserve leadership who lack some basic understanding of how people operate.
Seriously folks. The economy is too hot. Employment is too strong. Does a coach ever tell a runner the morning of the Olympic final, you ran too fast in the prelims. You need to slow it down. Don’t win by such a large margin. Hey, don’t even win at all. That’s not what we run the race for. Again, the answer is no. The goal is to run the fastest you can and win. There is no other goal.
The stated goal of 2% inflation is not realistic. Here is why. Inflation ran low (there was even talk of deflation. Anyone remember that?) because interest rates were low. Interest rates were low because the economy blew a gasket. Then housing prices went bonkers as everyone freaked out post pandemic and moved and overpaid because rates were low and the payments worked. Housing makes up a large part of the inflation metrics and this (along with price increases everywhere else) pushed up the inflation numbers.
Not good. This created a large affordability gap between earnings and the cost of housing, primarily. The real issue is this gap, not really inflation. The goal should be close the gap. This can happen by bringing down housing prices or bringing up wages or some combination. The problem is that housing prices will remain sticky due to the low mortgage rates in 90% of these loans, the cost of land and new builds and the unwillingness of sellers to take a loss. So, the only real solution is for wages to rise.
For wages to rise, we need unemployment to remain low. This will keep pressure on wages pushing them up, inflating the wage base to meet the new housing cost base. So, we don’t need 2% inflation. And we definitely do not need high unemployment.
High unemployment will simply serve to hold wages down. Low wages will drag home prices a bit but not really enough to close the gap. A strong economy drives transactions. A bad economy ices transactions.
Now, if you have really high unemployment, then people can’t make the mortgage payments, houses get turned back to the lender because there are no buyers at a price where it makes sense for the seller to not give it back to the lender. Then, you have 2008 all over again.
So, stop trying to get inflation to a ridiculous number and let’s shoot for stability. Get the rates down a couple of points and let’s give it 2 or 3 years and things will get back into balance. Stability, stability, stability.
We need fed leadership focused on stability instead of 2% inflation at all costs. 2% inflation with a broken economy isn’t worth it.
5 Investment Commandments
Commandment 1: Don’t blow things up There are very few investment opportunities that will compensate you accordingly if you blow up principal. The reward for a blow up risk needs to be outsized and that investment needs to be a small part of your portfolio. Don’t blow things up and don’t blow up your portfolio!
Commandment 2: Build a strong foundation of diversification and income generation that will stand the test of time. Immediate income is great. But, a foundation that continues to spit out income year after year is a whole lot better.
Commandment 3: Concentrate your efforts while diversifying them at the same time. Don’t get too spread out in the hope for diversification. You can diversify within your geographic area and within your knowledge and interest area.
Commandment 4: Be tax efficient. Again, current income is great. The government likes it too, often to the tune of 40% to 50%. Income that is deferred or is recognizable at one’s discretion can become very lucrative in tax savings or deferral alone. Capital gains income is better than earned income but deferred income is better still followed by unrecognized income being the sexiest of all. Notice I didn’t say NO income. I said unrecognized income. Earn income. Just don’t have taxable income.
Commandment 5: Have fun. Do something you enjoy. There are many investment opportunities that can be profitable. Do what interests you and what you enjoy. Life’s too short to make it a mutual fund, unless of course mutual funds float your boat.
Are Pensions Bad?
Are Pensions Bad?
Pensions are generally looked at as a good thing and a bit of a relic of a bygone era. Not many people get them any longer, but that is considered to be a loss, not a benefit. However, many people do get social security (indeed, most everyone at some point) and that is simply another form of a pension. Should we pine for the days of the pension?
So, why would a pension be a bad thing? It’s not. Well, not totally. A stream of income in retirement until you move on to the next life certainly isn’t a bad thing. However, it does have some broader negative consequences that very likely played a part in the establishment of pensions in the first place.
A pension is, at some level, a clever way to both be an attractive employer by taking care of your employees and helping to ensure your employees are less likely to build up generational wealth that will allow their future generations to join the capital class. You can pass property, a 401k, an IRA, a bank account, etc. on to your heirs. But, you can not pass along a pension stream or social security (except to your spouse or ex spouse). Those die out when you die out. So, having a large social security payment isn’t worth a whole lot. It doesn’t build your capital base.
Historically, many large companies were controlled by one person or a family who was clearly part of the upper class. By creating a pension system, it allowed the company and family or person to essentially control the capital that generates the income for the pension without allowing capital to truly change hands. Maintaining control of the capital allowed them to maintain control of society and their place in it.
Many things have changed today. Employees often have the opportunity to participate in some of the economic wealth and build generational wealth. New companies and industries with new players form in an instant and intellectual capital is rewarded like never before. However, it is important to take note of how enhanced economics were likely used in the past to keep people in their place. Suppression isn’t the only way to maintain class distinctions. We still have vestiges of this with our social security system and, to a degree, the 401k industrial complex. Again, not a bad thing, but that is not building wealth through generations.
The important thing to keep in mind is that the broader system is still not set up for you to truly build wealth. We don’t have pensions or cradle to grave employment but you still have to constantly recognize and work towards creating wealth for you and your future generations. Or, get a trust fund. Those people that seem like they started the race ahead of you? They did.
Build assets that generate income and those can list through the generations.
Inverse Correlation of Subscription Services
The Inverse Correlation of Subscription Services
Today, August 20th, 2020 I put forth into the world a new theorem. This one states that the value of a subscription service is inversely proportional to the degree of difficulty in cancelling it.
We’ve all had those “services”. The ones we think, what on earth is THAT? Or, I don’t need that? Do I? So, you go to cancel it and it gets challenging. Maybe you can log on to the website. Maybe, if you’re lucky. You find your account. There is no obvious unsubscribe or cancel function. You try to delete the payment method, but alas, foiled there, too. You can’t delete or change your payment method. If you haven’t given up and just agreed to pay this annual invoice and deal with it next year, you can call them. Often, you get to be on hold. Then, you get to listen to what great calamity will befall you if you cancel. You will no longer be in compliance. You have to have this from someone. You need to tell us what you’re going to do before we allow you to cancel..you know..for your own benefit.
Those are services. It’s difficult to cancel because the value provided is not close to the value being taken.
CANCEL.
And be careful to not subscribe intentionally or accidentally in the first place. You must remain vigilant because the auto chargers and annual renewers are abundant now.
Residential Mortgage Asymmetry
Asymmetry in the Residential Mortgage Process
So, most of us have experienced getting a mortgage for a home at this point and most of us have used the mortgage platform that follows the governmental rules for residential mortgage qualification vs using a local bank making a portfolio loan. And, we are familiar with the headaches involved for that oh so cheap money.
But, what is really going on behind the scene there? Have you ever wondered what affects your qualification ability and how people with different scenarios have the same results?
Let’s start with the simple approach - Portfolio lending.
Portfolio Lending
With portfolio lending, a bank lends out its own money. They make their own rules and decide who qualifies and who doesn’t. The result is that this typically follows a formula based on equity in the project or house, income stream and ability to repay and net worth. It’s pretty simple and can be broken down like thus - The more wealth you have, the more willing they are to grant you a loan. While they concern themselves with ratios and such, basically it comes down to whether they think you can repay and if you don’t, how much other wealth do you have that they can come and get. The process is often very quick and rarely involves constant employment checks, credit checks, bank account checks, re checks, etc. etc. For this privilege though, you often pay a bit more in interest rate and the loan is often a variable rate loan. While this is common in commercial lending, most people don’t use a portfolio lender for their home loan as a first choice.
Government backed lending
This is a broad category and not all loans are government backed. But, in this sector, standard rules are followed regarding underwriting the loan in order for the loan to be sold in the secondary market. So, regardless of which bank or broker you go to, the process will largely look the same. This is where it gets fun and funny and I’m going to show you how.
The core goal is to have all your payments under 45% as a ratio to your monthly gross income. Payments include largely the following:
AlimonyChild supportPrincipal, interest, taxes and insurance on your personal and vacation homesCar paymentsMinimum credit card paymentsOther loan paymentsNet rental income/loss as calculated on any personally owned rental properties with individual mortgages. This is loosely calculated using your previous year rent and expenses excluding interest and depreciation and adding back in principal and interest on the note payment.
That seems all fairly logical, right with the goal of assessing payment capability? Well, not exactly. Let’s examine it more closely.
Alimony - All contemplations of marriage should really start with an examination of alimony, right? I’ll save that for another time though. Two people are married and one person makes all the money. They make $200,000 a year and have $40,000 in annual payments for the items above. That’s a 20% ratio. Now, they get divorced. The man is ordered to pay his ex wife $30,000 a year. Doesn’t matter for how long. In this world, that payment is in perpetuity if it exists. So, if he retains the same payments of $40,000 and adds on the $30,000, his ratio jumps 15 points to 35%. However, the reality is he was likely already paying this and more. It’s possible that he even limited his losses by getting divorced and accepting the alimony albatross. Yet, in the eyes of the mortgage system his attractiveness just dropped. A lot.
Child support - Same scenario as above. The man gets tagged for child support, and, let’s be honest, even if income is nearly identical the man gets tagged for child support. If he has to pay $30,000 a year for his two kids, that bumps his ratios up 15 points. The ironic piece here is two fold. One, this makes it that much harder for him to buy a house in which to keep the kids on his every other weekend schedule. Two, when he was married, he was very likely paying the same amount. But, when you’re married, what you pay to take care of your kids doesn’t factor into any equation. Moreover, how many kids you have isn’t even considered.
Marinate on that a bit. You have a couple making $200,000 a year combined with $80,000 a year in payments. 40% ratio. Couple A has 4 kids. Couple B has no kids. Which one has more free cash flow with which to repay debt? It doesn’t take rocket science to figure this out. Any parent will tell you it’s the couple with no kids. Normally, kids don’t get cheaper as you add them and normally they don’t contribute income. Yet, in mortgage world, these two couples are the same risk.
PITI on your personal and vacation residences. Well, this makes sense. Something had to.
Car payments - Don’t purchase a car and finance it until after you get a mortgage. Car payments calculate as though they go on forever. Have 10 months left on that $500 a month payment. That calculation acts as though you will have it for all 30 years of the mortgage. And, of course, you might - with a different car. But, own the car outright and it acts as though you will never have a payment. Ever. See the problem here? Most people have recurring transportation needs yet you can manipulate the system a bit by placing those costs in place after you get a mortgage.Minimum credit card payments - That’s right. Owing $10,000 is the same as owing $40,000 except for the small difference in that minimum payment. What kind of tortured financial analysis is that? Everyone knows that owing more credit card debt is exponentially worse.
Net Rental Income - Now this gets really fun. If you are working this system to gain loans for rental real estate, pay close attention. A 15 year loan is better than a 30 year in a pure financial sense. The interest rate is typically lower, resulting in lower costs. But, in mortgage world, this penalizes you because it produces a greater cash expense.
For example, you have a mortgage payment of $2,000 a month on a 30 year note. That same mortgage on a 15 year note would be $2,600 (for discussion sake…). The calculation in mortgage world would add a $600 increase to your monthly payments and would adjust your ratio by 3.6 points. So, if you have three of those, you’ve just taken 10 points of your ratio and probably prohibited yourself from any more borrowing. While it is correct to look at cash flow, this alone does not tell the entire story for a lender. All it does is tell them what is happening right at this moment and doesn’t even tell that very clearly.
However, what if you had a rental property that didn’t affect the payments positively or negatively? WHAT???? It’s true.
Let’s say you form a legal entity that buys a duplex. The legal entity takes out a loan with a local bank and it is guaranteed by you. Now, let’s say that duplex generates no taxable profit or loss but produces negative cash flow of $20,000 a year due to principal reduction on the note of $20,000. In mortgage world, this flows through into top line income and has no effect (zero net income) and doesn’t affect the payment ratio. However, had you purchased this individually with a mortgage in your name, you would be hit with a $20,000 annual payment amount on your ratio calculation. With $200,000 in income, that would cost you 10 points on the ratio. Exact same economic effect. However, in the legal entity scenario, you remain attractive for a mortgage on that new house you want. In the second, you are much less attractive.
So what lessons have we learned here?
In mortgage world, payments are everything. Don’t have them if you want to qualify for as much mortgage debt as you can handle. Don’t buy a new car. Know where you are vis a vis the amount of mortgage you will need and plan accordingly.
If you have a lot of kids and think you may get divorced (or, IPO equivalent if you’re the one cashing out), secure any house purchases before divorce because child support and alimony could eat your ratios up such that you no longer qualify.
Alimony is a bitch. Why would you ever put yourself in this position? Think first.
Rental properties. Think through where you are going with a rental portfolio and set yourself up in the best way to allow continued access to debt. Debt is your lifeblood with real estate. Keep your amortization period long. Put any big cash flow drains into an entity and have the entity take out the loan. This is particularly key for development properties where there is high negative cash flow in the short run followed by a sale. If you structure this wrong, you could cut off your lifeblood during the project which could affect your timing on future projects.
So you want to buy an existing VRBO? What should you look out for?
I see a lot of properties for sale that are currently operated as VRBOs. These usually come with revenue numbers (unless the revenue numbers are bad) and some expense detail. Invariably, the net income always looks great relative to the list price. This is true for all businesses for sale but we will break apart VRBOs only right now and save business brokers for another day.
The first thing to do after assessing the value of the property in you own eyes and with your own comps is to decide if there is a business premium. Often, these properties are sold (or attempted to be sold) at a higher price because of their income abilities. So, how much more is the property listed at than it is worth?
Next, break up the revenue number. How solid is this? Is there a multi year history supporting this number? Is there booking data supporting it? A tax return? What I often see here are excuses. Oh…the owner used it more last year so revenue wasn’t all that good. Really? Or, did they use it more because it wasn’t booked? Remember, you are paying for what exists, not what the owner thinks can be. If it could BE easily, it already would be.
After that, are the costs legit? I routinely see properties in which the owner does a lot of the work..the maid service, the maintenance, etc. Those are jobs. You don’t pay a premium to get a job anyone can get. It’s good if you want to do that work and have the time, but don’t pay for it. You should see the following costs on any P&L you receive.
Cleaning
Maintenance
Insurance
Property Tax
Supplies
Hotel Tax (possibly, depending upon how they are accounting for it)
If you don’t see these items, you need to add them in when calculating your expected return.
You can make money with a VRBO just as with long term rentals and other investments. But, there are more variables at play than with a long term rental demanding a higher rate of return and make sure you understand the time and cost it will take to operate it successfully. If you are completely hands off and outsource everything, there likely will not be much left unless you purchase at a bargain price.
Additionally, keep in mind that if the income from the vrbo activity is supporting a price in excess of market price for a residence, if your income declines, so too will your value. Your downside risk is greater in this case, just as theoretically, your upside possibilities are greater too. However, often what I see is a downside risk that is greater than the upside from increased bookings and asset appreciation.
Do you understand your business model? A VRBO example.
In every business in every industry, there are a variety of actors and participants. A business model is simply an outline and clarification of how you make money offering the product that you offer. When diving into any business, though, it is important to understand where the money is flowing and who the elephants in the industry and supply chain are. Often times, where you think the money is is not actually where it is.
Let’s look at VRBO activity today as an example. These take many forms but the two basic models are I have an extra house I don’t use all the time and I want to rent it out and make a little money. I don't really care about the profit and the returns because I don’t have to worry about the cash flow and my main goal is to use it. The other form is I am going to buy this house and rent it out ad hoc, make a profit and maybe even get to use it for free too. The latter is a business intent. Before you get into it, understand who is making the money where you are.
Central to any real estate purchase, from a financial view, is cap rate. I’ve written a previous brief on cap rate. Be sure to read that. With a VRBO, you have new tenants every few days. The risk level is higher than with a straight long term rental. As such, your returns should be higher for accommodating that risk. So, the first question is can it generate enough revenue to generate enough net income to hit the cap rate required?
Many people purchase a property without actually calculating likely, max and min potential revenue based on logical occupancy rates for the area. $200 a night sounds good but if reasonable occupancy is 20% of available room nights, it might not be that good. So, understand your revenue potential and likely numbers. Understand what it will take to get that revenue and who the intermediaries are that you may have to go through. Stress test your model at varying occupancy rates. If you are being told the occupancy rates are high (75% for example), test out why that is. Don’t take it as fact. Are there any demand drivers in your area during the week? Consistently during the week. Two festivals a year does not a profitable rental make.
Next, what are your costs. This gets into understanding who makes money. To generate your revenue, you are going to almost certainly have to use a booking site like vrbo.com or airbnb.com. They take their cut. It’s large. Yes, you can put that on to the customer but it does add heft to your bill. It’s not an invisible cost any more than real estate broker fees are invisible.
After that, what do you have? Electricity, gas, water, cable, internet, maintenance on the hot tub, supplies. But, what supplies? Towels, pillows, toiletries, etc. These wear out much faster than the ones at home do, particularly if you want to maintain a good guest experience.
What else? CLEANING. You have to clean the property. You can hire people or a service or you can be the maid yourself. But, did you buy a VRBO property so you could be a maid? You can get that job for free and people will pay YOU to do it. That’s a hard job. But, be careful. Here is where the business model gets fun. This can get very expensive. Particularly if the service is charging a percent of the revenue. Particularly if you are in an area that sells this dream to people who don’t live in that town. The locals will fleece you so, you have to understand this component well.
In my experience, the biggest determinants to your profit outside of Revenue are as follows
Booking costs
Cleaning costs
Property tax
Maintenance
To generate max returns, you have to bring as much of this internal as you can. For example, in the cleaning service fee, why would you pay a percent of revenue? A three night stay becomes 3x as expensive as a 1 night stay but with the same work for the cleaning team. Break their costs down to the hour and make it a checklist. Make sure they earn enough to justify their travel time to your place. Make sure they earn enough from you each month to make it interesting. Hire individuals and not a service. Regardless, break down their costs and control them or it will eat you. If too many people are taking their cut, there won’t be anything left for you to eat.
The same is true for maintenance and booking, to an extent.
You may not be able to control all but if you don’t control a majority, you’ll be in sad shape with your financials and there will be no profit left. And, that’s sad. It makes me sad when there is no profit.
PAY ATTENTION TO YOUR PHONE, CABLE, AND OTHER BILLS!
Profit doesn't happen. You make profit happen. Some businesses are fortunate and money just rains down upon them. But, for the other 98%, profit is something you have to make happen. It doesn't just come to you.
One (of many) of the reasons profit doesn't just come to you is sneak charges. I just got one of my three AT&T bills this month. This one is for internet service. In looking over it, I noticed this....TS360 Backup and Support = $17.61. Furthermore, there is a separate phone number to call for questions about this charge. What is this, you ask? I don't know either. So, I called. And called again. Finally, I did get a nice lady on the phone from this AT&T product unit who explained that this was a backup system for my computer. Yeah, I never subscribed for that. Yeah, that's kind of expensive even if I wanted it. She was nice enough to remove the charge that I didn't subscribe to.
The point here is that you have to pay attention. Every month. Every bill. AT&T is not the only offender. I've seen this with utilities, cable companies, phone companies, etc. If you don't recognize a charge, call and investigate. Don't let it go because it is small. Small adds up. Eventually, those layers of expenses will eat away your profits.
If AT&T eats your profits, where is the fun in that?
POP MUSIC AND MUTUAL FUNDS
Back in the day, the radio played songs by people or by bands. You had Madonna or Guns n Roses or Billy Joel or Yaz. Ok..no one listened to Yaz.
Today, all top 40 songs are collaborations. Madonna/BillyJoel; BillyJoel/GunsnRoses, etc.
How do mutual funds come into play here?
I look at today's top 40 as essentially a mutual fund. The songs are basically factory produced. To reduce risk and ensure a certain level of sales and airplay, two or three top 40 artists combine to “make” the song. It's essentially a mutual fund of music. They aren't trying for a 20% return but rather a steady 6.54% with a standard deviation of the ROI of about 1.24 points.
Mutual funds are boring.
Pop music is a mutual fund.
Using that valuable transitive property, Pop music is boring.
Now, what's next?
Obviously, index funds. Future pop music will no longer be a two or three party collaboration. but rather a collaboration of all artists currently deemed top40. The return will be 4.2% with a .15 point standard deviation. I don't know how we will deem top 40 but I presume this will be via a popular vote on a pseudo-reality tv show.
Now, some index funds are good. Think Band Aid. However, for every do they know it's Christmas, we will have 39 other songs in the top 40, each comprised of the same 40 artists in rotation all sounding essentially the same.
Then, there will be a music revolution. In 25 years, some upstart band will come out with an insane "new" song and blow everyone's minds with just a simple artist's name. At Christmas, the 10-year-olds will be listening to it and saying Great Uncle Jeff, Great Uncle Colby listen to this awesome song. And we'll dutifully listen, because we haven't turned on the radio in 7 years and then we'll blow their minds with our intricate knowledge of Sweet Child O Mine and regale them with tales of seeing the original band (they didn't know the song was a cover) in 1992 (they also didn't know time went back that far).
CAP RATE - A BRIEF INTRODUCTION
Cap Rate and Desired Returns in Real Estate
One of the key measures in a real estate investment is the cap rate or capitalization rate. What exactly is this and what does it mean? And, what does it mean to you?
The cap rate is simply the return being generated by a property based on a 100% equity scenario. For example, if a property is being marketed for $500,000 with a cap rate of 7% based on existing rents and expenses, it will yield $35,000 in profits annually. Cap rate is profits (exclusive of depreciation) / value of the property.
Knowing this number allows you to compare a particular investment with other investment returns from a mutual fund to a dividend yielding investment to other private investments.
But, really, what does it mean?
The cap rate will vary based on the tenant risk of property, location risk, seller’s delusionality and any number of other factors. Generally speaking, the higher the cap rate, the higher the risk and the lower the cap rate the lower the risk. That risk may be long-term impairment, tenant vacancy risk, repurposing cost risk if a tenant leaves, etc.
Let’s say you have two single tenant buildings both marketed for $1mm. One building has a Starbucks with a 20-year lease (18 years remaining) guaranteed by the Starbucks corporation (yes, THAT one). Its cap rate is 6%. The other has a local tenant with a 3-year lease and 1 year remaining. Its cap rate is 10%.
Now, the local tenant may turn out to be a great long-term tenant. Only your knowledge and research will help unearth that. But, the seller is implicitly stating with the higher cap rate that they believe there is tenant risk of default or vacating that is some level greater than the Starbucks building. Otherwise, if they were as confident as the Starbuck’s landlord, they’d price their building and income stream at a 6% cap rate, too. We know Starbuck’s is successful and the corporate entity can support the lease if they close the location. But, with the local group, we can’t be as sure.
So, the cap rate can help show you the inherent risk of a property.
But, what if your desired return is 20% on your equity? A 7.5% cap rate isn’t going to cut it. But, searching for a real estate investment with a 20% cap rate might well be a foolish and risky endeavor to your financial well being.
However, you can get there through leverage. Next week……
MEMORIAL DAY BBQ AND RENTAL PROFITS
Have you ever been at a neighborhood gathering and your neighbor regales you with tales of his passive investment property making $2,000 per month?
Sure you have. We all have. But, really now, what does “making” really mean anyway? Have you asked your boastful neighbor that question? To an accountant, it seems simple. However, as I often say, four out of three people can’t do fractions and I’m here to correct that.
Let’s take the above $2000 profit per month example. Definitionally, this is calculated as follows:
Rent less (Interest, Insurance, Repairs, Taxes, Management fees and other expenses) equals PROFIT.
Notice that nowhere in the above do you see the phrase mortgage payment or principal payment. There is a good reason for that. Those are not expense items but rather balance sheet items. Principal is important but it is an element of cash flow, not of profitability and is a function of the debt level, note length, and interest rate. All are important but that is a financing transaction. Notice also that nowhere above do you see return. Not all $2,000 per month profits are created equal.
In determining whether to be impressed with a rental or passive income stream, there are several key factors to look at.
Is profit being calculated correctly?
What are the equity and debt levels?
What is the cost basis of the property or investment?
Now, let’s look at this further. Let’s say your friend calculated this correctly (they almost never do - typically the banknote is treated as an expense). What does this mean? $2000 in profit means nothing without context. If I have a $1mm building, no debt and I netted $2000 that qualifies as a pretty poor performance. If I have a $100,000 building with $80,000 in debt and I netted $2000, that qualifies as an outstanding performance.
The key here is the level of equity and debt. To determine whether $2000 is good, you need to know the level of equity (essentially the cash invested) in the project. This allows you to calculate the return on equity. After all, the returns are what you’re after, right? To calculate this, you divide the annualized profit ($2000 * 12) / Equity. The answer is stated in terms of a percent.
In the above example, $2000 in monthly profits on a property with $1mm of equity yields a return of 2.4%. In the other, $2000 in monthly profits on $20,000 in equity yields a return of 120%.
This isn’t golf. Highest score wins.
So, the next time the neighbor talks, ask how he calculates profit and what his equity level is and then decide if the neighbor is a wizard or just a guy wearing a funny hat.