Monday, July 26, 2010

Are such returns achievable?

We will just have to wait and see how real estate will stack up against other investments. The 'new' world of greying populations, deleveraging and declining consumerism may look quite different from past investing environments. Neither do we know whether the critical attitudes regarding the environment will persist (e.g. resistance against new oil pipe lines from Alberta to the West Coast or opposition to NE Alberta's heavy oil). How will we fare in a world of high oil prices and limited economic growth?

There are currently too many uncertainties at the horizon to identify major investment and economic trends. We're living in an energy revolution and although we have a low inflation environment, investors may feel that current risks do not warrant low returns and they may decide to rather stay in cash. It seems that cash will be king again and with a possible deflation scenario, just holding cash may be the best way to ensure you'll retain your purchasing power.

I have been selling questionable investments, i.e. those that will only perform under optimum circumstances or whose investment story has gotten muddled and unclear. I tried to offset capital gains with losses in order to reduce taxes and preserve cash. This is the time to get rid of dogs and build up cash for upcoming opportunities.

2nd Quarter earnings reports are, in my opinion, quite decent and a second recession (double dip) is not likely. But the 'wall of worry' we're currently climbing is steep and big; one misstep and... So this is not a time to take risks - I'll be waiting to see what happens in September and October. Knowing myself, the real problem will be 'being able to restrain myself' and not to spend my cash too early in the game. So, unless I see the returns I want, there won't be any movement. I suspect many other investors think similarly right now - hence we're in this nasty trading range.

I will insist on the previously listed returns otherwise, I'll prefer to hold on to cash until the skies clear. In other words, it's my way or the high way for those who want my investment dollars.

What Returns Do I want?

I guess, I am a bit more agressive these days. 

  1. From a non leveraged real estate or stock market investment - long term I expect a 10-12% return per annum.
  2. From MICs I want at least 8%; less I won't touch.
  3. Leveraged real estate requires an annual return of 15 to 22%
  4. Passive JV's depending on risk level and LTV (experience of operating or active partner, investor exposure to mortgageg liability, operating liability, etc) 15% to 30%.
  5. With debt obligations from major banks I am willing to go as low as 6% with inflation protection and less than a 5 year maturity. For higher risk corporate obligations I want at least 10% plus the chance of significant appreciation.
If you think that that is unrealistic, you may be right but those are my criteria. What I will end up getting in the real world is of course a different matter. Overall, though, if I can't get returns like that in this market, why bother?

I don't look at only the cash flow component of an investment. I am mostly concerned with ROI and a minimum positive cash flow (i.e. $100 per month per door). In terms of cap rates, my minimum is 4% - that would mean that with zero leverage I expect as a minimum 4% net cash flow. Same for dividends (4% minimum).

Friday, July 16, 2010

Do I really need 2.5 million to retire?

Your Belize may be traditional retirement with in the early years some travel time and later on, money for grand children’s gifts and senior assisted living. Or, you may decide a more active retirement with a part time career into your 70s.

So you will have to add up your anticipated income:

1 Canada Pension – husband plus wife approx. $22,000

2 Old Age Security – husband and wife approx. $12,000

Total: $ 34,000 (max, insurable benefits– note that there may be claw-backs through income taxes)

4 Pension(s) from past employment or veteran

5 Life insurance pay out upon death of spouse minus loss of pension

6 Part-time income (after taxes, E.I., C.P.P., etc.)

Total Income:

Investment Income required: Cost-of-living minus Total Income.

Do consider that you build in inflation protection as otherwise your ‘Cost-of-living’ will increase and your ‘Net Worth’ will decrease in terms of purchase power.

You could reduce your cost of living by downsizing your residence (there is a consumption component here), replace your vacation property with a time-share, etc.

Asset Allocation is also a planning tool

We have talked about the importance of a diversified portfolio – protecting cash flow and reducing volatility that fits an investor’s temperament. But there is another important aspect to Asset Allocation that is often forgotten.

Remember when we talked about visualizing our life goals and the role money plays in that vision? I am often referring to that as ‘reaching one’s Belize’. To financially define the travel route to reaching your Belize would require you to know how much cash flow and net cash flow you will need to live your personal Belize.

Cash flow used to service your debts and cash flow to pay for property maintenance; etc. Also, and even more important, you need to know the net cash flow that is used (like in any business) for reinvestment and for paying dividends to the investor. The dividends are a different way of saying the costs of financing your lifestyle.

As you may have noticed in the allocation spreadsheets, it reports your net cash flow (net operating income minus interest payment – but not loan principal reduction). Of course, this is ‘projected net cash flow’ anticipated based on your net worth AND asset allocation. So you can use it to forecast you future net cash flow, in other words you can use it to estimate the net worth and asset allocation you will need to generate the cash flow required for your Belize.

Suppose to live your Belize, you will need $75,000 disposable income plus another $100,000 for re-investment. By playing with the net worth and asset allocation in your spreadsheet, you can now determine what you have to own in order to achieve that. In our example and using the asset allocation of the ‘5 million portfolio’, you would need total assets of approximately 6.5 million and a net worth of 5.3 million. But you may argue that you only need $75,000 disposable income and that all re-investment will result strictly from portfolio appreciation and rebalancing. In that case you would ‘only’ require assets worth 2.8 million and a net worth of 2.3 million. Something a lot easier to achieve. Next you could look at your debt load by playing with LTV to see if you can achieve your goals with an even lower net worth but with higher risk (increased leverage), or by concentrating on higher dividend paying stocks or only to invest in properties with a higher cap rate (yield column). Once you know this, you can plan how to get there.

Sunday, July 11, 2010

Portfolio for $300,000 Assets

Portfolio for $500,000 Assets

Portfolio for $1 Million Assets

Portfolio for $5 million Assets

Some remarks: Portfolio is expressed in Asset Value - it includes borrowed money). The actual net worth and return on net worth (Return on Equity) is reported in the lower right corner. ROI is return on investment assets.

You can use ctrl plus mouse wheel to enlarge the spreadsheet or click on the image. In that last case you can return to the blog by pressing the left arrow (previous page) at the top of your browser.

Putting together an investment portfolio

Creating an investment portfolio is like gardening – it requires constant weeding. We have to set expectations for ROI and net cash flow; we have to manage volatility or what many people call risk. Risk translates into losses only on three occasions:

1. The investment is sold
2. The investment lost all value (e.g. the share issuing company went broke).

All other risk is usually mitigated by a long term holding time (10 to 20 years) except when dealing with fixed income. Whether it is real estate or stock market investments, the typical long term return excluding leverage is 10-12% per year. So a lot depends on managing cash flow, cash and to have a portfolio volatility that fits our personal sense of risk (i.e. we’re not selling in a panic or under forced conditions). A lot of these factors depend on our personal conditions; in particular whether we are employees, business owners or people who live solely of our investments. It also depends on our investment time horizon. An 85 year old is not likely to have an investment horizon of 20 years. But this again depends on the 85 year old’s expectations and circumstances. Some 85 year olds have sufficient cash flow to allow them to have the lifestyle they want, while they have their holdings in a family trust or holding company that will remain in existence upon on their death – only the shareholders will change.

For me, I want to split my holdings into real estate, fixed income, high dividend yield stocks, and normal dividend yield stocks. Investing solely for appreciation in my books is speculation, whether you do that for real estate or stocks does not matter. When building a stock portfolio, I also want to have an active managed portion and a passive managed portion. What I mean by passive managed is that the portfolio comprises a series of ETFs (exchange traded funds) with low management fees that represent a broad segment of the market. Thus, I like a Canadian ETF that comprises mostly large cap, dividend paying companies of Canada’s stock market (the TSX 60 comes to mind as represented by Ishares – symbol XIU). You could also ‘enjoy’ the fruits of the expanding economies of Asia by buying ETFs for Asia including or excluding Japan.

In the active managed portion, I would concentrate on major dividend paying companies, or large companies in various industry sectors. Companies such as Microsoft, Johnson and Johnson, Walgreen, GE, Canadian Natural Resources, Canadian Oil Sands, TD Bank, BMO, Royal Bank, Brookfield. And high dividend paying companies such as Riocan, CREA, Bell Alliant, Vermillion, Daylight Energy, and Superior Plus.

The dividends provide cash flow along with income from my ‘fixed income’ section of the portfolio and from the real estate sector. During stock market crashes, bond market performance often offsets stock market performance. The same happens as we noticed with real estate. So not only do real estate and fixed income provide cash flow, they also provide protection against volatility. Fixed income would again include an active and a passive managed portion. I would also like to shelter it in RRSP or even better in TFSA accounts. Only if that provides insufficient cash flow then I would move outside the tax shelters and focus on dividend (tax advantaged) paying preferred shares. When dealing with bonds I would buy mostly passive managed bond ETFs both corporate and government. Depending on the interest outlook I would emphasize short, medium or long term bond funds. Right now, short term funds are my preference (up to 5 years). Remember that the chance of real losses increases with the term of the bonds (same for GICs). All interest paying bonds would primarily go into the TFSA and RRSP accounts. Single bonds are too expensive to buy because of the hidden commission structures that favour both full service and discount brokerages. Also, it is more difficult to diversify. The active managed portion of the fixed income portfolio would aim at buying preferred shares especially during market downturns. Preferreds issued by the big banks or companies such as yellow pages or superior plus come to mind.

The third major portfolio component is real estate. This includes your own residence (as it appreciates tax free), vacation properties (appreciates but is taxable and not likely to cash flow), other rental properties. When dealing with personal residences and vacation properties, positive cash flow is nearly impossible to achieve. But they can be the source for investment capital once paid off. A mortgage on your personal residence or recreational property is nearly as bad as a consumer loan, it is for consumption mostly. But once paid off, you could use them as security for lines-of-credit and as such they may fund true investment properties. The primary goal for investment or rental properties is to create a good ROI while having sufficient cash flow to avoid a forced sale. This means the overall ROI is a function of appreciation and mortgage principal pay down. Such investment speculates primarily on the long term appreciation of real estate and ROIs are typically around 20 to 22% per year. Do not overlook the fact that part of this return is compensation for your work which is a lot more demanding than when dealing with stock market or fixed income investing. On the other extreme are rental property investments that are not leveraged. Basically your return comprises of appreciation and the operational cash flow (Net operating income). When investing in single residential units, such cash flow as measured in terms of ‘cap rate’ is approximately 3 to 5% of the property’s market value. Viable commercial or multifamily properties need a minimum cap rate of 5 to 8%.

Regarding the use of leverage, when investing in the stock market, there is some merit. As discussed earlier, over the long term stock market and un-leveraged real estate give similar returns. Because stock market valuations are reported on a daily or minute by minute basis, they tend to be perceived as more volatile. But if leverage is used similar to that of the real estate then in principal there is no significantly different risk. Well... So if you ensure that you borrow not more money so that interest payments do not exceed dividend income, you could play the same game. Banks and other sources of stock market capital won’t let you borrow more than 50% of your stock market account’s value – so your LTV is capped. Also, when investing in the stock market, it is considered prudent to have a certain amount of cash handy to take advantage of stock market down turns. When building up this cash position, the natural question arises, why would I have 10% cash and pay 5% interest on the money I borrow on margin? Thus it is often less practical to use leverage when dealing with paper securities than when dealing with real estate.

So with the above in mind, I have created a series of portfolio spreadsheets with (in my opinion) appropriate asset allocations. The allocations depend of the amount of investment assets:

1. $300,000
2. $500,000
3. $1,000,000
4. $5,000,000

If you are interested in the actual Excel Spreadsheets, just let me know and I e-mail you a copy. You can then run ‘what if cases’ and determine what asset allocation(s) you like best.

So now that you have designed you investment garden, you only have to weed it from time to time to gat/keep it in shape.

Thursday, July 8, 2010

Is natural gas bottoming?

Alberta’s government has lately reversed its stand on royalties and ‘getting a fair share’. They realized too late their mistake that low royalties are offset by high land sale prices. Albertans have paid a harsh price through a higher level of lay-offs than necessary (and to add insult to injury, this resulted in reduced income taxes). That is not say that the low gas prices by themselves would not have resulted in layoffs, but Mr. Stelmach’s energy policies have added significantly to the pain – don’t forget that consultants and contractors, i.e. those oil and gas industry workers not included in the employment statistics where disposed off as soon as the storm clouds gathered. I have friends with decades of experience who are standing by the way-side now for over 2 years; not to mention new graduates who have not been hired. New U of C geology graduates have been 90% unemployed.

But matters seem to brighten and gas demand is improving while supply is on the decline. A slowly improving economy, a warm summer and reports of underestimated decline rates of unconventional gas wells, in particular shale gas, may result in a turn-around of gas prices and with that the fortunes of the gas industry.

This will have all kinds of positive impacts on Alberta’s and in particular Calgary’s fortunes. Other areas to benefit would be Grand Prairie and NE BC’s Fort St. John. Don’t rush out with your investment dollars yet! There is still a lot of uncertainty but see it as encouraging news supporting you in holding on to your gas related investments.

If you sold off earlier the weaker investments in your portfolio like I did, you could start to nibble at some stock market opportunities. Personally, I bought some more shares in a high dividend yielding gas producer (6.8%) which likely will go up in price as well over the next year or two.

Real Estate investors should take note as well, because with improved gas prices, higher interest rates (some 6 months or a year ahead) the rental market is likely to improve as well. The combination of bottoming real estate valuations and rent increases could prove quite powerful. I wouldn’t say ‘Ready, set, go’ yet, but in my mind ‘Ready and get set’ is in my books justified.

Sunday, July 4, 2010

I am from nature optimistic, but that does not mean I'm blind

The recovery is stalling. After the initial realization that there won't be a depression right in March 2009, the markets made a remarkable U-turn and recovered at near neck break speed. All forecasts about a slow recovery were thrown out. Nobody mentioned Harry S. Dent's latest book predicting a depression in 2012.
Although Harry's initial forecast was somewhat too detailed and pessimistic, elements of his story remain standing. We were/are an overleveraged society and as Warren Buffett points out, all those derivatives form a time-bomb that is indeed difficult to diffuse. Harry's prediction that government stimulus would not pull the economy out of a tail spin was kind of right. Not because the baby-boomers have lost their purchasing urges, but because of deleveraging and the absence of purchasing funds by a severely indebted consumer. Yes we got a bunch of new roads, but all this stimulus was insufficient to give stocks like Finning or Bombardier the boost many analysts have predicted. Steven Harper was right to keep the stimulus program modest, because in the end it seems not to be more than a fizzle before it could give us a big bang.
Now governments in Europe, Japan and the U.S. are deeply indebted, corporations are paying down debt while banks are hesitant to lend money to the public. Europe and many other nations are so deep in debt that bond investors don't want to lend them anymore. After the initial economic boost, which led Mark Carney of the Bank of Canada and many others to believe interests were once again on the rise, the opposite seems to be happening.
If one is a believer in technical analysis, one might state that we are in a trading range about to turn around into a crash. It definitely looks like a possibility. For many older people who are within a few years of retirement the question will come up whether it is better to miss out on some near term potential games or batten down for a possible upcoming storm.
It is not that the market is overvalued but it is more that we as a society have to pay down our debt. We seem to transition into an economy without significant inflation and without significant population growth; an economy with a greying population that is more interested in scaling back consumption than to increase it. Yes China is still growing, but it is only a 5 trillion GDP economy while the U.S. is close to 14 trillion and you may look down on Europe and on the EU, but the European Union has a combined economy even larger than the U.S. So if China is to grow, where does that growth come from if in Europe and the U.S. demand is stabilizing or declining?

I feel this is a time to get rid of weak investments and taking profits (and thus offset your cap gains with losses). This is a time to aggressively build up your cash position because the risk of falling equity markets and a contracting economy is high. Especially with governments no longer able to raise funds to stimulate their economy. They're out of gun powder no-matter how badly they want to spend.

Right now, getting rid of weak investments, collecting dividends from solid companies and build up cash seems to be a prudent thing to do. Yes you can sit through yet another downturn, but why do so if the risk level right now is so high?

Friday, July 2, 2010

Inspirational video (and audio clips)

You may have seen some links to inspirational videos at the top of this blog. I came accross another video like that. Something definitely worthwhile to view: "Steve Jobs at Stanford". Here is the link which I also will embed with the other links at the top of this blog/

Thursday, July 1, 2010

Another diamond in the rough

It has been a busy June and not a lot of time for blogging. Today I met with a fellow investor and we discussed stock market versus real estate risk. I pulled out a previously posted graph showing real estate performance versus stock market appreciation (without leverage, rents or dividends) since 1970 (see below). He quite astutely noticed that real estate and stock markets are counter correlated, that is that when the stock market was performing better than average, real estate performance was subdued. Visa versa when the real estate did outperform average investment return, the stock market underperformed.

This is good for those investors that look at diversifying their portfolio. In the past, stock market investors tried to invest into countries whose stockmarket performance differed, i.e. whose stock market performances did not correlate well. With globalization, stock market performance of most countries is much more synchronous, i.e. they are well correlated. So when stocks in country A perform poorly, those in country B tend to do poorly as well. Several stock market gurus suggest that it is now bettter to diversify by investing in different industries rather than countries to achieve uncorrelated performance - at least that is the idea.

As observed by my fellow investor, investing in both the stock market and real estate also provides excellent diversification.

One caveat, the real estate appreciation curve shown above is for single family dwellings in Calgary, Alberta. Real estate markets are local markets and the correlation between the stock market index and your type of real estate investment property in your local market may differ.