Friday, June 11, 2010

ROI measures the rate of growing rich

Becoming rich is about setting a goal, charting the route towards your goal and moving towards it. But at what rate? Any traveler can tell you that a speedometer is critical, not only to avoid get speeding tickets but also because it tells you how fast you are approaching your goal. If your rate of growing rich is too fast you also can get a ‘ticket’; not issued by the traffic cop but by the market – if you grow too fast you are not likely to keep up, you start cutting corners and bang you hit the wall! You’re forced to sit down clean up your administrative mess, rebalance your portfolio and clear out the investment deadwood before you can resume your voyage to richness. Sometimes the wall you’re hitting maybe your family because you got so caught up in your highflying journey that everything else went to the back seat. Did you know that getting a divorce is one of the worst financial transactions you can do? So, before it is too late put your spouse and kids in the front seat and ensure you and they are fine.

When your rate of accumulating wealth is too fast, you can burn out and that is likely to happen just when you’re about to hit a market peak and right before the crash. So your rate of wealth increase can tell you, “He Bud, this is not sustainable better slow down, prepare for the crash and go into cash!”

So how do you measure your rate of net worth grow? There are different measurements you can use such as the compound rate of growth or the internal rate of return (IRR), or most simple, the return on investment or ROI. Basically the ROI tells you how much money you will make on your investment, what it doesn’t tell you is how fast. That is why you always want to state your ROI per time period, typical your ROI per year. So my ROI is $10 per year. Wow! Now is that per dollar or per hundred dollars invested? There is a difference you know? So in order for your rate of return on investment to be meaningful, you also have to know it in terms of per dollar invested, i.e. it is expressed as a ratio or as a percentage.

The financial literature is not always consistent. For some ROI is the return (profit) on investment divided by the amount invested. Others see ROI as the RATE of RETURN on investment as we use it here. ROI is return on investment per year per dollar invested = Return on investment (the amount of money you made) per year divided by the amount of money invested. You can compare it directly to the (simple) interest rate you earn on a loan. Very simple!

We know by now that there are two profit centers for each investment: appreciation and cash flow. So we have to know how much appreciation we have per year and what our positive or net cash flow is per year. The total is our return on investment and when we divide that by the amount invested we have the total rate of return on investment. The ROI of cash flow is sometimes also called the ‘cash on cash return’ which means positive cash flow divided by your down payment (cash invested). When borrowing money and repaying it over time (amortization), the loan payment often comprises two components: interest due and principal repayment. Often this principal repayment is not considered part of your cash flow because you cannot use it as you please unless you refinance the loan. Hence it is often included with profits from appreciation. Whether this is correct or not is not debated in this post. In real estate your net cash flow is expressed as exactly that, when investing in paper securities, your net cash flow comprises your dividend or other income minus your loan payments.

The second profit center is ROI on appreciation. When investing in Canadian real estate your annual appreciation is around 6 to 8% per year, and stock market appreciation, according to authors like Jeremy Siegel is around 7 to 8 percent over the last hundred or so years. In an earlier post, the Dow Jones appreciated 7.3% over the last 37 years.

Without leverage, your total rate of stock market return is on average then around 9 to 10% depending on your dividend rate, and when you re-invest those dividends using drip programs, according to Jeremy Siegel, your return is between 11 and 12%. Thus for real estate to be comparable, your positive cash flow plus appreciation plus mortgage pay down should be around 10% as well. Without financing, your net cash flow equals your net operating income (NOI). When expressed as a percentage your cap rate (NOI/purchase price) should be between 4 and 5%. In cities like Calgary, right now many properties have a cap rate of 3 to 4% while annual appreciation was 8% over the past 40 years or so.

Real estate investors use leverage to enhance appreciation or to increase positive cash flow. To increase positive cash flow, the investor can look at the cap rate. You achieve positive cash flow when your mortgage payment is less than your NOI. So with a Loan-to-Value ratio (LTV) of 80%, the NOI should equal your mortgage payments, i.e. the payment rate* multiplied with your LTV should equal or be less than your cap rate. Thus in Calgary, you should currently not invest at a loan payment rate higher than 5% (or an interest rate of 3.6%) assuming a 4% cap rate. When using the same logic in stock market investing, if your dividend rate is 3% and the investor borrowed  80% of the purchase money, the payment rate on the loan should not exceed 3.75% (or an interest rate of 1.64% - try to get that rate on your margin account, hahaha!).

So we conclude that having positive cash flow and a prudent LTV are critical for your risk management; to survive the days of economic flue. If you want to know how fast you approach your financial dreams, your Belize, you need to look at your net worth speedometer, your ROI. This analysis also shows you that the higher your ROI, the riskier the investment becomes. If you take on negative cash flow, your ROI will increase significantly but so will your risks. It really does not matter whether you use leverage in stock market investments, investing in debt or investing in real estate. What matters is that each investment class has its own characteristics; owning them all diversifies your portfolio and reduces your overall 'net worth volatility'. It is this volatility and the lack of cash flow to pay your debts that leads to forced sales and losses. Over the long term, your investments in general will increase in value unless our world truly comes to an end.



*Payment Rate is your annual loan payment divided by your principal. The table shows what interest rate (vs. payment payment rate) you pay on a 35 year amortized loan at loan payment rates ranging from 3 to 10%. Note that at higher interest rates you reduce your principal (payment - interest) in the first year(s) at a much slower rate than when you pay low interest rates.


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