Sunday, June 6, 2010

The two profit centers of investments – part II

Whether you invest in real estate or in paper securities, profits come from two sources:
1. Cash flow
2. Capital Appreciation

Since values of assets nearly always fluctuate we should focus on how to deal with these price movements. Especially when using leverage, because the effects of the price movements result in major volatility of our investment capital (money available to invest) and net worth. We learned in a previous post that in order to prevent wiping out our investment capital in a leveraged (mortgaged) real estate investment we should not exceed a loan-to-value ratio (LTV) of 65% and even this may lead to financial disaster in market such as the current U.S. real estate market – paying the right price is essential to successful investing.

But our financial health is what determines how well we can survive financial valuation crises. In fact, when financial healthy, such crises are buying opportunities. Cash and cash flow are the measure of your financial health – they determine whether you are forced to sell or you can ‘sit out’ a temporary drop in asset value.

When employed or self employed, your wages are cash flow and what is left after your living expenses is your net income and positive cash flow of this part of your financial structure. This net income can be used for nice cars, vacations, etc. or it can be used to build up your investment cash position, they become part of your savings. In corporate parlance these savings are your retained earnings which add to your equity (book value or net worth).

Rental income is also a source of cash flow and when this income exceeds your operational expenses, property taxes and financing costs they add up to your net cash flow. Well not entirely, because part of this net rental income is used to pay down your mortgage every month, so this is not all net income contribute to your positive cash flow.

For fixed income investors, things are a bit trickier. The interest income is cash flow, but since these investments normally do not appreciate with inflation, that portion of the interest equal to the inflation is only to maintain your purchasing power and the remained sometimes called ‘real interest’ is your positive cash flow.

Investors in the stock market get cash flow from dividends at a much more favorable taxation than fixed income. It is pure net cash flow. Stocks that pay dividends that increase on a regular basis (inflation protection of cash flow) often are superior stock market performers and the underlying corporations are often well established and quite stable.

The last source of net cash flow comes from the disposal, maturation or sale of your various investment assets. Here we have a repayment of investment component, an inflation component that ensures your purchasing power does not change, and the remainder being true positive cash flow. Of course, this last source of cash flow will disappear rapidly in a falling market – especially when leveraged.

Both cash flow and positive (or net) cash flow add to your cash holdings; but it is positive cash flow that adds to your net worth and growth of your investment capital. Your investment capital may be further increased by adding loans or debt. If you were a corporation, you might add capital by issuing new shares but this is of course not an option for your personal investing, or is it…?

Cash and cash flow then determine how much you can buy in new investments. These investments are best bought during down turns at the ‘right price’. But opportunities can be found in all types of markets (up or down), provided the price is right. One should focus on cash flowing investments; even better on investments with positive cash flow.

For the retiree, positive cash flow is critical as he/she will not have a salary and only positive cash flow will provide the funds to live off. Some investment advisors use actuarial life expectancies (for North American males until about 82 years; females live a bit longer) and cash flow to calculate retirement income. This is not free of problems as a person may thus outlive their investments and most likely will not have an opportunity to improve/change in lifestyle.

Cash flow and preferably positive cash flow should also exceed any debt servicing costs for existing investments (from the first) and for new investments (from the latter). Also, the overall cash flow level should be large enough to weather unexpected expenditures as well as provide capital for re-investment and new investments.

It is up to the individual investor to decide what minimum level of cash and net cash flow is required for his/her financial well being. Typically, my cash levels fluctuate between 10 and 25%. During times of heated economic activity and high stock markets, I tend to sell investments to raise cash gradually to the maximum level while during bad times, I buy new investments and cash levels drop to 10% (sometimes even less). It is during these slowdowns that I am willing to take on debt for further investment as well, while my tolerance for debt decreases during booming times.

Leverage is a two edged sword that can be used to fine tune your ROI or return on investment. We’ll talk about that during future posts.

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