Wednesday, March 31, 2010

Comparing ‘apples and oranges’

So there is an important distinction between investing and 'investing in real estate'. Investing in the strictest sense of my definition means that your money is working for you rather than that you are working for money. 'Real estate investing' often entails the running of a business, i.e. buying a house, renovating it and reselling it - hopefully for a profit. Or buying a property, renting the property and creating positive cash flow plus appreciation. Members of REIN who own properties and operate them are running a real estate business; their proceeds are a combination of investment profits and salary. Their salary is not guaranteed, it is performance based just like the compensation of many senior managers in large corporations.

If you truly invest in real estate and you have a JV partner (finder) or operator-owner run the place, the only thing you do is getting a return on money without being involved in the operations. This is not much different from investing in a REIT, a MIC or mortgage investment corporation or just investing in a loan. Hence, the returns, at first sight, should not be much different and are basically determined based on risk and on the comparison with results from other investments. The key word is 'risk'.

Here is another matter to consider when comparing investing and 'real estate investing': leverage. This is often called the major advantage of real estate investing. But it is again an incorrect perception. In some cases the passive JV investor (true investor) qualifies for the mortgage taken out on the property and provides a personal guarantee to the lender regarding the repayment of such a mortgage. This increases the risk level of his investment considerably and consequently so should the returns increase. Furthermore, in a true partnership, the passive JV investor may not only be liable for the mortgage but also for any liabilities regarding operations and regarding the property's liability in general. This is another reason for higher returns on investment.

If the passive JV investor raises his investment capital by taking out moneys from another property, say through a line-of-credit (LOC), he does exactly the same as an investor investing in the stock market who buys on margin or uses money from a LOC to buy the shares. In fact, the passive JV investor is now over-leveraged to a degree that no stock trading brokerage would normally allow. Some mortgage lenders are now asking explicitly whether moneys obtained for a down payment are borrowed. No wonder because the underlying JV property is basically over-leveraged and improperly insured or not insured at all through CMHC.

To complete the corporate investor analogy, the stock market investor uses leverage exactly the same way except for his personal liability. As mentioned earlier, an investor buying stock on margin is in the same position as the passive JV investor borrowing money for a down payment. But also, his corporate asset, just like the real estate property is also encumbered by loans: corporate debt! That is why stock market investors are concerned about the corporate debt/equity ratio and related numbers. The only difference is that the stock market investor is not liable for the corporate debt.

I think, over the last number of posts, it is now clearly demonstrated that investing in corporations through the stock market and (passive) real estate investing have much in common and also that there are essential differences. Comparison of their investment performance is often presented in an incorrect light. Passive JV investors are often exposed to much higher risks than a typical stock market investor due to over-leverage, mortgage liability and operational as well as building liability. A stock market investor's funds are more liquid – i.e. it is easier to sell while liability is generally limited to the size of his/her investment except when borrowing on margin. When comparing 'real estate return' versus stock market returns, the above issues are usually not considered and on many occasions we are comparing 'apples and oranges'.

Friday, March 26, 2010

The path to becoming rich is already known.

When reading all those books on becoming rich there is one common thread. Unless you are the big aggressive ‘Donald Trump’ type who gambles big time, getting rich is a pretty boring undertaking that takes a long time view of things. You live below your means, you save and invest at 8 to 15% per year on average and when you reach retirement age or somewhat earlier when you reach ‘freedom’ 55 then you have hopefully scraped enough together to retire and call yourself wealthy. You may win the lottery or suddenly become a star, but chances are that in that case you do not have the skills to keep your fortune together. There are so many stories of lottery winners who were broke again within a few years.
So, really, it is not only about earnings power, it is a lot about managing your resources and gradually becoming rich while building your investment skills along with it. That was the difference between Rich Dad and Poor Dad. Although poor Dad had lots of earnings power, he did not have investment savvy and spend all his income. Rich Dad had a modest income but through excellent investment skills he builds up a fortune over the years.
It is no accident that only 3 to 5% of Canada’s population can call themselves millionaire. Not that it takes a genius to have a million, but it takes patience and backbone. How many people have not traded away their wealth by continuously selling their residence and buying yet another dream home? All profits were lost in paying commissions and lawyers and movers. It is not that real estate commissions are too high. Realtors work really hard to earn them. My estimate is that the top 20% of realtors, many with 20 years or more experience, make on average $125,000 per year. Not bad, but not great either and it took a lot of shoe leather for them to get there.

Why do we prefer ETFs over Mutual funds? Because, the administrative expenses of continuously buying and selling stocks (”active management”) is cutting in your returns big time. That is why the ‘buy and hold’ strategy is so efficient: you don’t pay commissions and you don’t pay capital gains taxes and you only pay a bit of taxes on your dividends. That is why guys like Warren Buffett state that if possible they like to keep a stock for ever.
So investing is not exciting, in fact it should be boring and you need the backbone to stick with your plans and strategies. That is easy to do when everything is hunky-dory, but in tough times, you may have to hold on to your stocks while you’re sick in the stomach. Even worse, you need a stomach strong enough to buy good companies while everybody around you runs like a chicken without a head.

Buy low and sell high is something nearly impossible to achieve consistently. You may luck out a couple of times, and then you may suddenly get hit by setbacks (to say it nicely). My earlier post on Godfried’s Ten Rules of investing is not coming out of the blue. These rules are the result of many runs to the washroom.

Although 2007-2010 was my 8th or 9th major downturn, it was still difficult to keep my cool and it was even more difficult to have sufficient cash for buying those ‘once-in-a-lifetime’ opportunities while seeing your net worth running south at an alarming rate. Every downturn though I handle a bit better. You may have read my numerous comparisons between real estate and stock market investing, and here again nearly all my observations in this post are applicable to both asset classes.

There is a bit of a market timing trick you may want to keep in mind. As you know, I don’t time markets but this may work. The real estate market ‘lags’ the stock market by several months if not up to half a year. If you were considering taking profits and felt that you should have cash ready for future opportunities, when you see the stock market tank you might use that as an additional argument for selling that fully valued real estate property. Because you know that real estate prices are soon to follow the stock market. Visa versa, if you see that the stock market has improved significantly and the real estate market hasn’t yet, you know that this might be a good time to expand your real estate portfolio. Not fire-proof, but if you are ready to do a buy or sell transaction it is something to keep in mind.

I don’t invest based on technical market analysis, I invest based on fundamentals. But if the fundamentals are right, I don’t mind trying to use some technical trends to see if I can buy at an even better price. I don’t depend entirely on the technical stuff. I may buy first a bit at the 'right price', and then at the next try I buy it bit more on technical reasons, and then when the fundamentals are still good I buy again a bit using the technical analysis as guideline. Thus you can combine fundamentals and market trends to get something for an optimum price.

When all is said and done, with investing you want to keep things simple. If you don’t understand how an investment works don’t use it. So, KISS (keep it simple stupid), save, live below your means, build investment skills, a strong stomach, buy on fundamentals while not forgetting that the ‘trend is your friend’ are the elements of becoming wealthy. Not at all difficult to understand; if you truly want to become a millionaire though you have also to handle that what so few can do in real life: “Stick with It”.

Wednesday, March 24, 2010

A common form of corporate ownership – Capital Structure

When raising investment capital for a corporation, it is all based on the cost of money. If you raise capital by issuing a corporate bond, the ‘rent’ you are paying is the interest rate of the bond.  So what would be more expensive, borrowing money at 6% or...

Issuing shares, i.e. selling part of the company’s ownership, and paying a dividend on those shares of 3.6%? At first sight, you may say the dividends, but dividends are paid on after tax profits and are not tax deductible. The interest on a bond is tax deductable as a business expense. On an after-tax basis and a corporate tax rate of 40%, the real cost of money would be 60% of the interest rate or 0.6x6% =3.6% after tax. So from the corporate perspective there is no difference.

However, the investor who buys those dividend paying shares can claim the dividend tax credit and makes on an after-personal-income-tax basis 3.2% . The 6% interest rate would be taxed at the top margin rate of say 50% and he/she makes only 3% after-tax. Thus the investor prefers the dividends and the company will likely sell the shares easier than the corporate debt.

It is these kinds of number games and all those ratios we discussed in the previous segment that determine a corporation’s capital structure. Often shareholder rights and ownership are just pipedreams, with management only acting in its own interest. Either way through share equity or lending, the corporation will raise capital when needed for its operations or yet another acquisition.

This is why many investors feel so frustrated and powerless when investing in the stock market. In theory they own the company, in real life they only provide a different form of capital than lenders. Real Estate investors feel they have more control over their investments and that is true to some degree. But they forget two essential factors:

1: They are only in control if they run the real estate operation. Single property owners and true partnerships are indeed in control. But this, in my books is not investing but the running of a business. So basically they are the management and employees of this real estate investment company.

2: Typical joint venture (JV) investors have little or no say in the operation of a real estate investment. They just collect a monthly cheque for 10 to 15% return per year, while the rest of the profits remain with the partner(s) in charge of the real estate purchase and operations, sometimes called the finder(s). What other than risk is the difference with a mortgage or debt? None! The finders are similar to the management of a share trading corporation.

Basically, whether you run a corporation or a real estate joint venture, you are management and typically you are in control. While when you are the corporate share holder or the financing partner of a JV you are the source of rented capital.

Having made these important distinctions, you as an investor should now be able to look at your investments being it real estate or stock market investments in a much different light. Either way, you are not executing the business and you are not the board of directors. You are just supplying money in the hope of making more money without getting really involved with running the business – this is true investing.

Whether you are corporate management (including the board) or whether you are the ‘finder’ of a JV, you are not an investor. You are trying to increase the value of an investment for others (sometimes including your own equity) through your work and expertise. Your compensation is exactly that, compensation for your work and expertise. Of course this compensation can be in all kinds of forms ranging from share options to dividends or bonuses or plain salary.

When investing in real estate, the suppliers of capital

Thursday, March 18, 2010

Does anyone do any stock investing with drips? Dividend reinvestment plans?

I do drips on my US stocks since I have little use for converting every little U.S. denominated dividend into Cdn Dollars.

Some of the advantages are that you don't pay brokerage commissions.
Sometimes you get a slight discount on the market price.
It is a painless form of cost averaging.

If you invest in good (not exessively high) dividend yielding companies that on a regular (or even better anual) basis increase their dividends, some historical studies show that on average you make around 12-15% per year. The dividend increases provide inflation protection that no GIC will provide.

John Drehman claims that investing in dividend paying stocks at average Price Earning ratios or Price over Book Value ratios results in better long term results than in Growth or Momentum Stocks. Jeremy Siegel calculated that over the long term, dividend reinvested stocks perform better with market crashes than without. During the crashes, they paid out dividends (although sometimes temporarily reduced) and allow you, unemotionally to buy lots of shares at undervalued market prices. You buy only a few when the market is overpriced. Jeremy went so far as to conclude that if you bought $1000 S&P500 stocks and their survivor stocks, at the market peak of 1929 and reinvested the dividends every year, including during the Great Depression then by 1954, your investment value would be $4440. If there had been no Great Depression and the market had moved at a steady pace to the same 1954 market level, your investment value would have been $2720.

Here is an another example of how important dividends are: If you bought in February 1987 a share of the Royal Bank at 5 dollars, today coming out of the recent Great Recession, it is valued at just under $60.00. So that is a nearly 12 fold increase in value. Dividend yields of the RY hover typically in the 3 to 5%. So in 1987, RY paid $0.25 per share per year. Today that dividend is: $2.00.

Assuming a gradual increase without crashes (the less favorable scenario according to Siegel), with reinvested dividends your investment value would be: $142.6 where $60 is the appreciation of your original $5 share and a whopping $82 comes from the reinvested dividends.

If, instead you had invested $5 in a growth stock like Nortel in 1987 today's investment would be zero. Or if you had invested that amount in high flying Bombardier you would today have: $30.00

Does this make you a believer in investing in dividend paying stocks and reinvesting the dividends? It is one of the strategies I have followed. But you know, I diversify and I invest also a lot in oil and gas - only large companies though and preferably ones that pay a bit of dividend. I did invest in juniors through a flow through share fund. I fell flat on my face.

Rather than investing and reinvesting in dividend paying stocks, you can also invest in exchange traded funds (ETFs) that mimmick the TSE300 or TSE60 and reinvest dividends that way. This is investing for dummies and you probably do better OVER THE LONG TERM than investing in a mutual fund.

Sunday, March 14, 2010

Buying Whole Sale

For many small investors it is difficult to find properties with positive cash flow. When buying one unit at a time, in Calgary, it is normal to pay over $200,000 for a 2 bedroom apartment.


Have you thought about buying together with others and acquire an interest in a multifamily property?

When interested, contact Godfried Wasser at 403-880-3275 or e-mail godfried.wasser@royallepage.ca. We already have $100,000 in down payment money. We’re looking for investors with $30,000 down and a long term investment horizon.

Sunday, March 7, 2010

A common form of corporate ownership – Valuing Shares

Both companies and real estate are assets; they are financed through debt and equity. The mortgage/down payment ratio or Loan to Value ratio (LTV) is a common parameter used in real estate, while corporations use a debt/equity ratio. Upon closer examination you may realize that real estate and corporate financing have a lot in common.

A company’s total asset value is the sum of its equity and debt; just like that of a real estate property. The capitalization ratio or cap rate used in real estate is the fraction of net operating income over property value. You could do the same for corporations – here net operating income is referred to as EBITDA, i.e. earnings before interest, taxes, depreciation and amortization. Sometimes EBITDA is compared with funds from operations.

You may consider determining the ratio of EBITDA over Total Assets Value which would be equivalent to a cap rate. If the ratio is greater than the weight averaged interest rate paid on its corporate debt, there is a positive effect of leverage on corporate earnings just as in case of the cap rate being greater than the combined mortgage interest rate in real estate. When the interest rate is higher than these ratios, we have negative leverage and the shareholders/real estate owners are actually subsidizing the operations in the speculative hope that corporate assets or real estate value will somehow appreciate. This is an unhealthy situation.

Many a corporation uses the interest coverage ratio

A common form of corporate ownership - Sharing the Loot

When a company makes a profit, the after-tax profits, owned by the shareholders may be used in a variety of ways for the benefit of the shareholders. First of all, the company may re-invest the profits to upgrade its operations or use it for the acquisition of a new production facility or another company that adds to its value(for a variety of reasons such as additional earnings, increased market share or technological innovation).

To invest after tax earnings or net income into corporate expansion requires that shareholders probably will benefit from this re-investment. If the company does feel that not all profits need to be reinvested, it may pay the remainder of the profits to shareholders as dividends. The company’s board proportionally divides the earnings between reinvestment and dividends and the dividend/earnings ratio is often called ‘payout ratio’. The ratio of dividend paid per share versus the share price is called dividend yield.

Paying out dividends triggers income taxes for investors and to mitigate this, a company may decide to buy back outstanding shares of the company instead. As a result, in following years the earnings will have to be divided amongst fewer shares and the share value will rise accordingly. This will not trigger income taxes or it will trigger capital gains taxes if the investor decides to sell some or all of the appreciated shares, where capital gains taxes are less than taxes paid on dividends.

A common form of corporate ownership - Introduction

A business needs start-up capital, working capital, capital to expand. Public and non-public corporations can raise this capital in various ways. The two most often used forms of raising capital are debt and equity financing.

Debt financing we addressed under ‘fixed income’. It is borrowing money from various sources. Basically the money is ‘rented’ and the rent or interest and principal are paid and repaid, respectively, through various arrangements that we will discuss in later postings.

Equity financing is done by selling a portion of the corporation’s ownership usually through shares. The thus sold equity gives the investor a say in how the company is run, provides the right to elect a board of directors that is to look after shareholders interest in the company, including the hiring of management. Finally equity holders share in the corporate profits, hence the name shareholder.

Investing in equiy also entails sharing of risk. If due to economic circumstances and/or poor management decisions, the profits of a company decline, so will the shareholders portion of the corporate profits. Just like in real estate, corporations use leverage or loans and when the value of a company increases over time this value increase will go to the shareholders, while lenders will only receive a repayment of principal.

On the other side of the equation is the possibility that a company’s value may decline and the shareholder’s equity may then decline accordingly all the way to zero. In some cases the company’s value is less than its debt and then lenders may take control of the company in order to recover their loans, while equity investment value has declined to zero. The losses of shareholders in public companies is normally restricted to the funds invested, however, in non-public corporations, owners and management may be held responsible for debt repayment beyond their original equity investment.

A common form of corporate ownership

What follows is a 4 part posting series on common and preferred shares

Monday, March 1, 2010

More fixings for income!

In the previous posting ‘Fix(ed) Income’ we evaluated bonds, in particular government bonds. I have built the evaluation calculations into a small spreadsheet, a copy of which you can request by e-mail (Godfried.wasser@royallepage.com).


Upon reading the last post you may wonder how it is possible to make 10% or more profit on a bond that yields only 5% until maturity. The critical factor is here is the time to lock in your profit. Here is a screen shot of the little calculator for a 5% Bond with 10 year maturity. Two years into the loan, interest rates dropped from 5 to 2.5% for 8 year bonds. The ‘Little Bond Evaluator’s screen shot shows that the current value of your bond has shot up to $116.67. So over 2 years you collected 5% on $100 = $5 per year. Total interest earned $10. If you sold the bond now, you’d also make $116.67-100=$16.67 in capital gains. Total proceeds: $26.67 over 2 years on $100. That is a total Return on Investment (ROI) of 26.67% or 13.34% per year.

The key question is what you are going to do with your now cashed-in bond money. If you would reinvest in a similar 8 year bond at today’s 2.5% yield, your average ROI would have reduced it to the original 5% coupon rate. On the other hand, if you would reinvest in better-returning-investments during the 8 years following your bond sale you could do a lot better. The Key is whether you can invest in another higher yielding investment.

Let me illustrate this point in a different fashion. Say you invest $100 in a lottery tickets. 2 years later you win the Jack Pot and your ROI on lottery investments was 26.67%. Next you invest the money for another 8 years at 2.5% and in spite of the initial spike in profits, on average that 10 year investment yielded you only 5% for a total value of $160.

If you had found other investments that yielded also 13.34% per year, the total return after 8 years would have been more than tripled to a total value of $376.78. So investing is not only about getting a maximum return during a short time, but about having excellent returns all the time. So, you have to ask yourself what is better, the occasional ’10-bagger’ or a consistent decent return over the long haul. By now you should know the answer to this rhetorical question. Duh!