Thursday, June 17, 2010

Where are some insights in risk or assessment of risk ?

[quote name='Thomas' date='Jun 12 2010, 11:53 AM' post='87475']

Where are some insights in risk or assessment of risk ?

Getting back to Thomas' earlier question. I have done (and posted here on the forum as well as on my blog) some 'research' in comparing real estate and stock market risk. Over the last 30 or 40 years, both real estate and the stock market have appreciated annually between 6 and 8%. Also the cash on total investment (cap rate vs dividend yield) are not that far apart (around 4%).

When you compare the volatility, surprisingly it is similar as well (unless you use leverage which results in an amplification on your net worth - both positive and negative). The perception that the stock market is more volatile than real estate may be caused by stock market prices being reported on a daily basis versus monthly or even slower when dealing with real estate.

In fact, as a result of my 'research', I personally have added some leverage to my stock market holdings. Especially on U.S. stocks. I buy when the Cdn dollar is low with borrowed money and I pay off the loan when the Cdn dollar is high vs the U.S. These dollar fluctutions are short term ( 2 to 3 months) and I can make 4 to 6% profit following this strategy. That is 4 to 6% per 3 months or 16 to 24% on an annual basis ( minus 3.5% interest on the borrowed money).

Right now, the stockmarket is more profitable for me than real estate. Calgary/Edmonton rents are falling and so is my cash flow. Real Estate prices are also still falling. The stock market is in slow recovery with temporary set backs such as last month's European crises - i.e. buying oportunities and high dividend yields.

Risk or volatility are not an issue if you look at your overall portfolio over the long term. If you invest in stock market indexes or REITs it is easy to diversify. The real risk or volatility lies in when you are not enough diversified. When all your money is concentrated in this one dog property or stock. 5 to 10% citywide vacancy is not bad, but if you happen to own the one that is vacant you have a 100% vacancy. To concentrate your money all in BP stock is kind of similar.

With a stock market portfolio it is easier to diversify than with real estate. When you use leverage you need to be able to weather some big net worth or equity swings. So, from my personal experience, I think that real estate is just as risky if not riskier than the stock market. But you are in control of the asset and in the worst case you can actually live in it. I know nobody who because of bad cash flow moved into the offices of the Royal Bank or of any other stock issuing corporation.

It is also a lot easier and cheaper to get loans for real estate than for stocks. Most stock brokerages allow a max LTV of about 50% and at short term rates of around 375%; compare that to variable rate mortages (1.85%) and to investment properties where your LTV may go as high as 80% (with CMCH insurance).

I also think, as Thomas mentioned earlier, that it depends on the investor and his/her investment skills. For me right now, it is a 'toss-up' and it seems that no matter where you go, your return on PASSIVE investments (i.e. not including your labour), always hovers in the 9-12% range these days - that is the market rate in both real estate and in the stock market.

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.

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.

The two profit centers of investments – part I

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

So risk management is about managing the risk of both. Assets fluctuate in value, however over time they reflect they increase with inflation, economic growth, supply and demand. Because paper securities are easier to trade than a real estate property and because it is followed on a day to day basis with extensive up to the minute market news, these securities are more volatile or at least seem to be more volatile than real estate.

That volatility represents market risks to many, in particular day-traders and option traders whose profits and losses stem from this volatility. They use tools such as technical analysis or sheer intuition to make money from monthly, weekly, daily and even hourly price fluctuations. For the long term investor this is often a zero sum activity. But even a long term investor may use market volatility to buy investments at an optimum price – this is especially the domain of the ‘value’ investor.

Over the long term, stocks and real estate increase at approximately 6 to 8% per year. As pointed out in earlier posts, the longer the time horizon, the lower the chance of losses and as such, both real estate and stocks can be considered low risk. Also as shown in an earlier post, leverage amplifies the volatility and the return on investment (ROI) on your investment assets. Fixed income investments behave somewhat different, these investments seem not to appreciate over time, it is strictly considered ‘money rental’. However, the money-rental income is subdivided in an income and an inflation protection component. Also, when tradable, such securities can add capital gains made from the sale and purchase of these debt instruments. In fact, if it wasn’t for taxation investing in debt could be very attractive since the build in inflation protection should protect against loss of purchase power. That is why investment vehicles such as RRSPs and TFSAs are ideal for fixed income; in particular the TFSAs since there are no taxes upon withdrawal as discussed in an earlier post.

So investment assets fluctuate in value, and risk stems from losses incurred when one is forced to sell at a time of low asset valuation. Thus true risk management should focus on this issue, i.e. preventing forced sales often stemming from lack of cash and cash flow. You may have noticed that we don’t worry about the performance of individual business or assets this because in a diversified portfolio, failure of individual investments is offset by success in others. Unless an investor is very knowledgeable about a particular investment, overweighting one’s portfolio in one or only a few investments is a sure recipe for disaster.

When investing in an investment class, asset value fluctuations should not be the focus of risk management – value fluctuations are a fact of life. When an investor is aware of those fluctuations and their temporary nature, he/she is truly capable of ‘buying low and selling high’. Thus the key of successful investing lies in cash and cash flow management. Asset value fluctuations are like having the flue – flues can be deadly especially for those who are in poor physical form, but if one has the constitution to get past these few days of flue, a person can live happily and prosperous for many years to come. The same is true about surviving value declines in bad markets you need the financial health to survive them and once you recover, you’ll be in better shape than ever before. But when financially unhealthy you could go broke or incur financial scars which may haunt you for years to come. Your financial health is your cash and cash flow.

Tuesday, June 1, 2010

All kinds of Risk

Many authors have defined numerous risk categories such as:
• Market risk (volatility)
• Interest rate risk (changing interest rates)
• Equity Price Risk (pricing volatility of shares in individual companies)
• Foreign Currency Risk (exchange rate variations)
• Commodity Price Risk (changing commodity prices)

Reality is that many of these risks are temporary and disappear with a long term investment horizon – minimum 5 years. The earlier posted graph by Bernstein (Fig. 1) comes to mind as well as our discussion regarding price volatility which disappears over the long term as shown in figure 2.

Figure 1 shows Berstein's Probability of loss table.

Figure 2 shows that investments made during down markets over time rarely fall back below the initial purchase price.

Changes in interest rates can be nastier because interest rates appear to be roughly cyclical with many years of rising interest rate trends alternating with falling interest rate trends. These periods may last for decades and thus interest rate related losses are difficult to recoup. However, these risks lie in the eye of the beholder and depend greatly on the investment horizon. Ironically, interest risk increases with the length of the investment horizon. If you locked in a GIC rate for a year, your risk is very low while locking it in for 30 years in a rising interest rate environment may be an outright disaster, especially when inflation rises simultaneously (as often is the case). With GICs you’ll lose in purchasing power and you lose in opportunity costs when compared with higher rate paying GICs. When dealing with bonds, you may sell prior to maturity of the bond, but the bond’s value change will then be realized immediately.

So if as long term investors price volatility is not an issue and when dealing with fixed income a shorter (maximum 5 years) risk is muted (provided you hold until maturity), then what are the major concerns or risks an investor should focus on? For me the answer is found in the two profit centers of each investment: Cash flow and Appreciation. Cash flow, although variable, is more predictable on the short term than appreciation and it is part of your insurance policy against nasty consequences of a more volatile appreciation. The other component of your insurance policy is cash. So each investment portfolio should be seen in terms of 3 components: Cash flow, Appreciation and Cash. We will address each separately in upcoming postings.

Are we investors or speculators?

We have talked about different investment classes such as stocks, bonds, GICs and real estate. But what is really a big issue in people’s minds is risk. Stock are considered by some as more risky than real estate, while others see it completely opposite and consider real estate high risk. Some authors claim you would do better if you stick with GICs and that the rest is just designed to provide income for stock brokers, realtors, banks and fund managers.

Risk is an elusive concept and of course, I have my own ideas about risk. I suggest that risk as traditionally defined by academia or stock market analysts is not necessary the same as how you may perceive risk. So over the next while, I think we should talk about risks incurred by investors.

In the oil industry, risk is common and although we call investing in appreciation often speculative, putting money in the oil industry we do not seem to consider speculative. If we invest ‘gambling’ on the price increase of a particular stock, say Google, risky and speculative, we call putting money in BCE an investment although we count both on its dividend and appreciation. The long term investor considers trading in options, day trading and momentum investing speculative and that is meant in the derogatory sense. Yet, from time to time, I write covered call options to supplement my dividend income and I don’t consider that risky at all. Real Estate investors look down on those that invest in pre-built condominiums, but then what is investing in raw land?

When people talk about investing they seem to say that there is no uncertainty involved. You have a predictable positive cash flow or dividend stream. The question is then are dividends and positive cash flow streams constant and 100% certain? The answer is ‘No’! If vacancies rise, rents may decline and you may go from positive to negative cash flow; in recessions, dividends may along with falling earnings be cut. We buy stocks, because earnings increase over time (we hope) and at least keep up with inflation. Not only that, we expect dividends to increase, that is one of the main attractions for dividend investors is that not speculation? While real estate investors do hope their rents increase overtime.

Well, but then maybe we should only invest in GICs and money market funds. Oops, remember 2008, when some U.S. money market fund actually lost money? And what about those money market funds that paid 0.03% interest compared to 3 or 4% just a few years back and 13 to 14% in the early 1980s? What about investing in GICs of the Principal Group, which investors thought where ‘insured’ until the company when broke?

So, clearly, with all investments risk is involved and the difference between a ‘speculator’ and an ‘investor’ becomes increasingly fussy? It seems to me that the terms are fluid but overall, a speculator seems to take on ‘higher risk investments’ often hoping on above average asset appreciation.