03 June 2007

Personal Investment Strategy



A.C. Writes:

I live in XXXX and bought my first property 14 months ago. I have done well in the 14 months that I have owned it. It has appreciated in value somewhere between 20 and 35% if the comparables are to be believed. It may have even increased by more. I am looking to move and I wonder whether I should remove equity from the property and purchase a second home and rent out the first all be it at a loss, or sell the first and purchase a substantially more expensive property and only own one. The XXXX market is difficult to read and I suppose if enough people / journalists / commentators tell us the market is over valued and will crash it will eventually become a self fullfilling prophecy but what would you do? Stay put for 12 months and see what the market does, remove equity and purchase a second home or sell and purchase?

What I'll do here is share the questions that I ask myself as well as the information that I prepare for myself when evaluating a property investment decision.

This should not be taken as investment advice or any recommendation on what to do with your own money. My goal here is to highlight some concepts that, I believe, are essential for making smart investment decisions.

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First up, what is the expected yield on the investment -- there are a lot of different ways to look at yield.

Gross -- when people are selling to you, they will quote Gross Yield and they will define that as Total Annual Rent divided by Purchase Price. As an example, if you are paying $550,000 for a property with a $2,500 per month rent then your estate agent might quote a prospective yield of (12 x 2,500 / 550,000) = 5.5% per annum.

Now that might sound pretty good, 5.5% per annum plus the potential for capital growth. However, Gross Yield on Purchase Price isn't what you really get as a landlord. What I like to consider is my net yield.

Net -- when I buy, I want to calulate my Net Yield and I define that as Net Annual Income divided by Gross Acquisition Cost.

To calculate Net Income you need to factor in... insurance; advertising; letting agents fees; maintenance; accounting; void periods; and all other costs. You also need to consider the time commitment that you will make, which can be material if you try to self-manage.

To calculate Gross Acquisition Cost you need to factor in... purchase price; acquisition costs (legal, valuation, bank fees, finders commissions, stamp duty); renovation costs (we redo most of our flats before letting); and furniture.

If you are running things as a business then you also need to consider an allocation of your central overheads. We have a team of 15 that works full-time in Edinburgh and that _excludes_ our development partner's group (contractors, sub-contractors, site management) as well as our lettings agent's group (letting, cleaners, accountants). There is a considerable amount of effort that goes into managing a residential portfolio. It's no wonder that most groups prefer to focus on commercial property.

When you start to factor all these points in... that 5.5% per annum that you were promised starts to look much less -- in some cases you'll 'lose' up to 50% of your Gross Yield. For this reason, many residential portfolios operate with a net yield lower than their cost of debt.

When we started investing in the mid-90s, it was the other way around, our net yield was 2-4% above our cost of finance. It was a great time to be investing. 20% down and our net yield serviced the mortgage with a little extra left over.

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With the yield you are in a position to calculate the total return (IRR) on the equity component of your investment -- explaining my views on capital structures as well as equity IRR calculations will have to wait for a future edition.

A quick scan on google turned up some options to help you if you want to read more -- this one looked interesting. Remember that, when we forecast growth, we will have a bias towards what's happened over the last three years.

With my investing, I want to consider a range of outcomes (likely and unlikely) and weight their likelihood. If I am comfortable with the implications of each outcome then I'll invest.

There are investments that have a great expected rate of return that I have passed on because I was concerned about the "implications" of a highly remote event. In finance, "implications" can include personal bankruptcy or a material reduction in standard of living. Our photo this week is Monica in Paris, being able to visit France is a luxury that we want to be able to keep in our lives.

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Now that you have a grip on the yield/total return -- you need to consider your alternative uses for the capital. I'll illustrate some examples...

Credit Card Debt -- this could be clocking up at 15-25% per annum. Your greatest investment is often paying down your most costly debt -- then cutting your cards into pieces. Credit cards are the bane of financial prudence -- Monica started a company in Colorado and we get 2-3 credit offers per WEEK.

Money Market Funds and Bank Deposits -- depending on your currency, you can earn 4-6% per annum for short term deposits. I never search for the last 0.1% and only invest with the largest banking groups. Seeing as I don't have any capital upside with this investment, I want the lowest possible capital downside.

Business Ventures -- I keep an allocation of my portfolio reserved for "exceptional deals" -- things that pop-up at short notice that have the potential for a large capital gain. When a great opportunity presents itself, you want to be able to take advantage of it.

***When you are paying off a large mortgage, car payments and/or credit cards then you will have to pass on opportunites that have the potential to give you the financial freedom to do what really matters to you -- generally, the things that we truly like cost very little.

For many of us, the true cost of leverage lies in opportunity cost as well as the emotional burdens. The interest rate is often the least of our worries!

Phew, a bit of a long winded way to say... Consider what else you can do with the money and consider the time/energy/emotions that each of those investment opportunities requires from you. Residential letting can be an intensive investment on many fronts.

Kicking back with a low risk portfolio is "boring" but over a 15-45 year time horizon boring starts to look pretty good!

Maybe I should have been an actuary...

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Now let's touch on some of your specific questions...

Q -- Should I rent at a loss? Double my exposure? Move into a massive house?

A -- Can you support three-years of your projected financial loss? Can you support one year of zero rental income? How long will your family remain financially solvent if you (or your partner) lose your job? Have you looked at your likely "total return" (equity IRR) across a variety of capital growth scenarios?

It's only been the last few years that investors (and bankers) decided that they would tolerate property deals that didn't cover their cost of finance. This is a relatively new phenomenon (outside of start-up VC) and should provide you with an insight into where current valuations are relative to historical norms (super high).

In 2005, I had more than 100% of my net worth invested in property -- at that level, I was seriously uncomfortable. So, I took actions to reduce my exposure to a level that I felt comfortable with. I think it was JP Morgan that advised a worried young investor to "sell to the sleeping point".

I sleep a lot better in 2007.

So... I was comfortable with the nature of my investment (prime Scottish residential) but I was uncomfortable with the quantum of my exposure (>100% of Net Worth).

What would I do?
I would likely purchase a house in the best neighbourhood that I could afford that had a price well _under_ the maximum that I could afford. With my personal investment, I need to stay well under the "sleeping point".

What should you do?
I have no idea but bear in mind that certain elements of the property market appeal directly to the way our minds are programmed. More concepts...

Envy -- in a rising market there are plenty of transactions that lead us to feel good about holding property. In a declining market, there are less transactions and we tend to fool ourselves about the true value of what we are holding.

Stories -- people love stories -- the property market abounds with stories of folks making money -- as well as characters that are experts at taking advantage of our desire to dream about easy money. We only hear about the good deals -- people don't brag about their dud investments.

Nominal returns -- NOBODY talks about the true cost of investing. We bought a condo in Boulder in 2004 for $360,000 and sold it for $409,000 this year (~5% return across the period).

Sounds like a good deal?
When you factor in cost of ownership, transaction costs (massive in the USA) and alternative uses for the capital -- it was my single worst investment across that period and Monica's family took a lot of the management hassle off our hands!

Still, it was a good deal "for me" -- there's more to consider that just the pure financial return.

Cycles -- if you are in your 20s, or even if you are in your late-30s like me, then we have no REAL memory of a truly crappy property market. 1989-1992 was poor in the UK and the 70s were a disaster all over (I am told). Going further back (see Irrational Exuberance, 2nd Edition) you'll see that property markets (like all markets) have periods were they snap back to trend.

Within my own investing, I want to make sure that I'll be OK if the target market/asset class snaps back to trend and overshoots way under trend. I have missed a lot of great deals because of my financial prudence. However, I've done enough decent deals to outperform my goals.

Security & Guarantees -- when markets turn down, I want to make sure that I'm not the first port-of-call when the banks start calling their security. In the early 90s, many US banks decided to exit the UK market -- remembering this lesson, we pay more to bank with people that are unable to leave our markets, providing money is not a commodity business and we choose our partners carefully.

Not exactly black and white, eh? For me it is a lot like athletic training -- best guesses based on imperfect and changing information. As well, there are exceptions for most of the "rules". Still, the rules have served me well.

Bottom line -- at this stage of the cycle, I wouldn't leverage past my ability to comfortably service the debt in an economic downturn.

Be patient -- you'll be saving and investing for the rest of your life. At some time over the next 10-15 years, there will be great deals that nobody wants to buy. When that happens, you will want to have the capital to take advantage of those opportunities.

As an investor, one of our greatest fears is missing out -- it's tough to sit on cash when everyone is leveraging up to the eyeballs.

Cheers,
gordo

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