Thursday, August 26, 2010

What would be a save amount of leverage in a stagnating economy

Thomas Beyer wondered what a safe level of coverage might be for a real estate investment in a stagnating economy.

Investors such as Thomas know that rental rental properties draw their profits from different aspects. They are:
  1. Rental Income
  2. Operating Expenses
  3. Leverage (expressed often as a loan-to-value ratio (LTV)
  4. Mortgage (Interest) Rate
  5. Appreciation
Rental Income minus Operating Expenses make up your Net Operating Income or NOI.
You increase your NOI by increasing rent and/or reducing operating expenses. This does not take into account the effect of major property improvements on rental income.
Dividing your NOI by the purchase price results in your capitalization ratio or CAP Rate. Your total return on investment is determined not only by your NOI but also by the amount your property appreciates per year.  The amount of appreciation usually fluctuates (see the earlier postings such as on comparing stock market and real estate price volatility) but over the long term it goes up. I typically use the avaerage annual appreciation for a a Single Family Property in Calgary over the last 40yrs or so as a guideline (approx. 8%). However, you could use data from different time periods, such as the last 50 yrs, and come up with a more conservative 6%.
Some purist investors consider appreciation as the speculative component of their investment return and do not consider it in the property analysis. This may work for areas with high cap rates as often found in parts of Eastern Canada, but in Alberta and especially in Calgary, cap rates are lower, while the annual appreciation is or better 'was' typically higher - (in the East appreciation rates are closer to 6% rather than 8%).
When including these appreciation numbers in your evaluations and upon entering a stagnating environment, the purists may have the upperhand. Appreciation could in such an economy be a lot less than 8 or even a lot less than 6%. So although  leverage greatly magnifies losses and profits from appreciation or depreciation of a property, in this posting we only examine the effects of leverage on net cash flow and  on net cash flow plus mortgage principal reduction. When expressed as a fraction of the original purchase price these measurements are here referred to as Cash on Cash (COC) return (i.e. Net Cash Flow/Invested Cash) and as Return on Invested Cash (ROI on Cash or ROIC) which is Net Cash Flow plus Principal Reduction/Invested Cash).
It is important to realize that your true return on investment excluding appreciation comprises the cash left over after mortgage payments (Net Cash flow) and the principal reduction. Principal reduction is obviously a part of your profits, however, it is not cash that can be spend readily. To access it, you will have to sell the property or refinance it.
So if you have to live of your rental income during a stagnating economy without needing to sell of assets, net cash flow and COC are most important for immediate survival. In this analysis we will look at the effect of leverage on COC and ROIC.
Using a typical 2 bedroom apartment condo in Calgary as an example, we make the following assumptions: 

  • We got it at a really good price: $170,000

  • Rent is $1050 per month (not too shabby either) excluding electricity, cable and phone.

  • Condofees are $265 per month and excludes water, sewer, heating)

  • Property Taxes are $1084 per year

  • Annual maintenance of the unit $1000 (Condo Corp takes care of exterior and common areas)

  • Property management (which you can pay yourself or a professional manager): $882 per year.

  • Vacancy Rate 5% (even Boardwalk would not mind that!)

  • NOI = $5824 or a cap rate of 3.4%
 With an LTV of 75% and annual appreciation of 5% your TOTAL ROI would be 27% - WOW!
With an annual appreciation of 3%, TOTAL ROI would still be a Whopping 19%
And with 1% appreciation it goes down to an very satisfying return of 11%. Ahh the miracle of leverage!

 But what about COC and ROIC? Well, that is quite different. You may enjoy your 11, 19 or 27% total return, but what if you needed to live of the cash flow or ROIC upon refinancing?  Figure 1 shows the effect leverage has on your ROIC at a typical variable mortgage rate of 2.05% amortized over 35 years on your first year of operations.

Fig. 1 ROIC versus Leverage and for various mortgage rate scenarios.
As you can see, the higher the leverage the higher the ROIC. When mortgage rates increase however there will come a point that you turn negative. So if you don't care about net cash flow and appreciation, what would be your safety limit? The graph shows that even if the variable mortgage rate increased from 2.05% to 7.05% (unlikely in a stagnating economy), that your ROIC would stay above zero with an LTV of 50%.

 You may say, I don't see the variable rate ever, ever going up beyond 5.05%, in that case, an LTV of 65% should do. So you see, inspite of all the number crunching it is still up to you to decide as to what is right.

 Now, with a positive ROIC you still may have to pay cash out of your own pocket. If we truly want positive cashflow, the best you can get is the CAP rate without financing, i.e. an LTV of 0%. In our case, you max COC would be 3.4%. That is still a lot better than a money market fund and nearly as good as a 5 year GIC.  With increasing leverage your net cashflow goes down to zero and even negative. So our safety cut-off is zero or a COC of 0%. The graph in figure 2 shows that at 2.05% interest, you cannot have a leverage of 85% and higher or net cash flow will go negative. But if the mortgage rate increases to 7.05%, net cash flow would go negative at an LTV of 45%, while at 5.05% LTV should not exceed 55%.
Figure 2. COC return versus leverage for various mortgage interest rate scenarios.

 So, although risk tollerance lies in the eye of the beholder, my personal choice would be not to exceed an LTV of 55%. My spreadsheet tells me that, barring unexpected repairs, which always seem to happen at the most inconvenient times, that at 55%, I should be able to hold this property without having to put in cash. Even in the unlikely event of no appreciation, a stagnating economy and interest rates as high as 5.05% I should be able to get by. If we would have a more normal economy with 5% appreciation then my total ROI would be a respectable 16% meaning that if things go better than anticipated, I should still be able to enjoy the ride.

Wednesday, August 25, 2010

How would the investment world look like with a stagnating economy?

Here is a ‘what-if’ scenario that seems to become increasingly relevant. With spending by Baby-boomers on hold and increased savings levels, a world of excess cash, reduced corporate leverage and less consumer debt seems to become reality.

Economic growth is often linked to increased residential construction and sales. The U.S. is far from that situation and some predict that foreclosures will probably not peak until 2013 - reasons to forecast muted economic growth.

Corporations like Apple, Microsoft, Brookfield, Exxon-Mobil and many others sit on huge piles of cash and short term treasuries in the U.S. are in such a demand that interest rates are virtually zero. Banks and mortgage lenders appear to be the major beneficiaries because the spread between their lending capital costs (often borrowed or from deposits and short term funds) and the rate on consumer loans and mortgages is horrendous. Also, because not all loans that were written down in the 2008 down turn were bad, many of them are upgraded and added to the banks' corporate profits. Insurance companies are often dependant on good stock market returns (think Berkshire Hathaway or closer to home, Manulife) and will likely be less prosperous.

So where do we find the returns if these muted economics prevail? Many investors would turn to emerging markets such as China’s and those of other BRIC countries. Yes Chinese and Indian economies will likely grow faster than those of the West and their demands for commodities will be steadily increasing as well. But just like with growth companies, the stocks in these markets are highly priced (because of these well known high growth expectations – it is already build into the market) and so profits will be limited not to speak of other investment risk such as poor disclosure as well as different business and accounting standards, etc.

Dividend paying companies provide attractive yields, but are these yields sustainable? Especially when it seems that every other investor is chasing those deals. Strangely enough, “investors” still act very irrational. Risky companies such as Apple depending on one or a few persons, or depending on ‘being in fashion’ still attract the highest prices. In market value, Apple equals Microsoft. However, Microsoft makes twice the profits, buys back shares and has an enormous stash of cash. In fact on an after cash basis, Microsoft’s P/E is around 8 or 9. It has a dividend yield of 2.2% which it can increase without sweat.

Sunday, August 15, 2010

With all the stimulus are we getting hyperinflation in the U.S.?

There is a contradiction here.
  • Many U.S. corporations are sitting on huge piles of cash. Just think Berkshire-Hathaway, Apple and Microsoft.
  • The U.S. consumer savings rate is at a decade's high and debt is being paid off.
  • Only the U.S. government is recirculating its stimulus money.
  • Corporate U.S., especially the large banks haul in cash with the bucket full. 
  • Consumer spending of the Baby Boomers has peaked and is on the decline. 
  • Housing starts are on the decline. 
  • Housing values are on the decline. 
  • Foreclosures are still on the increase, that means persistent low housing prices for years to come.
 So, there is no hyperinflation even with the current large U.S. deficit.

In Europe the governments are trying to cut their deficits and debt that were initially increased to help to get the Banks there to recover from the U.S. Subprime crises and the European real estate crash. Buying government and quality government bonds is at an all-time high due to stockmarket shy investors. They don't go into real estate but they do buy debt (do they ever learn?). The only ones holding back are U.S. banks who are skittish on mortgage loans - is that surprising?

So when you ad all this up, I'd say "Hyperinflation? You must mean DEFLATION!"

Many Corporations have seen their productivity fall lately. I guess they got the max out of their workers and will soon be forced to hire. In fact employment is creeping up in the U.S. and it shot up in Canada. Consumers will soon be more confident and start... consuming more. All the screaming this summer about the European Debt Crisis (do we still remember that?) scared the heck out of everyone. So now that that is passing, everybody will become more optimistic. In the mean time, we also delever (reduce debt); this means modest growth, lower credit demand and low inflation. And who will perform best? Alberta because the world needs energy to fuel the modest growing Western economies as well as the booming BRIC and emerging economies. The latter will become more internally focussed due to the increasing prosperity of the increasing middle class.

Thursday, August 12, 2010

Sometimes we forget about our social net worth

These days it is all too easy to get dragged down with the pessimistic mood of the investment markets and to forget that we have many other things to be grateful about. This may be a cliche but it is true!
Last night, we invited our children and some friends over for a BBQ in the backyard along with a citronella soaked log burning in the fire pit to keep the bugs away. The weather was perfect and my son even played a little tune on his guitar. It was one of the most enjoyable evenings I've had in a long time.  I realized what a treasure it is to have friends and kid's to help you enjoy your backyard and life in general.
When pursuing our dreams and trying to reach our personal Belize, we sometimes forget how important it is to enjoy the trip to our Belize as well.

Tuesday, August 10, 2010

These are the summer doldrums

Everything is relatively quiet at the investment front. The quarterly economic data are so-so, while the corporate earnings reports are better than expected. A lot of the summer economic 'malaise' is due to the absence of many investors. Who wants to be driven nuts by the daily gyrations of the stock market numbers or pundit opinions while the sun is shining during the short summer?  Who wants to buy a house, rather than hanging out with the kids on a beach or in a camp ground?

So, if you cleaned up your portfolio earlier on and are waiting for September and October to pass, maybe the best thing you can do is park your money in a short term corporate bond ETF such as XSB in Canada using a discount broker (because otherwise the commissions are too high to justify it). While you are collecting interest and waiting for the investment fog of September and October (usually poor stock market months) to clear you may even enjoy a value uptick if the market heads south.

Then when ready in November, it may be time to use all these cash and short term investments to buy something longer term. So 'wait and see' is the motto. Yes it is not easy to be patient - I see opportunities every day and it is tough to say to yourself: "Wait, wait,... steady as she goes..." But that is how we navigate the shoals and cliffs of today's turbid and treacherous investment waters.

Monday, August 2, 2010

Cash as the real real option -- to do anything

I came accross this posting following the hint of a friend. Since I have written very little about options todate, I thought this may be a good introduction to the topic. It is a piece written by Nick Row of Carleton University.

Option theory was originally about financial assets called options. A put option is a derivative that gives you the right to sell some asset at a pre-specified price. A call option is a derivative that gives you the right to buy some asset at a pre-specified price. They are called options because you have the right , but not the obligation , to sell (or buy). You don't have to exercise the option, if you don't want to. Option theory tries to figure out how much options were worth.

Then people noticed that this could also be a useful way to think about investment decisions in real assets (bricks and mortar etc.), not just financial assets (bits of paper). And "real option" theory was born. Any parent who has told his daughter to get a degree, just in case her career as a rock musician doesn't pan out, is advising her to invest in a real option. She isn't obliged to exercise her option to work as a teacher, but she can exercise it if she decides she wants to, when she has more information about her chances of making it big.

One of the neatest concepts in real option theory is the option value of doing nothing. Suppose you can earn an expected rate of return of 6% by insulating your house, and can borrow money at 5% to finance the investment. It sounds like a profitable investment, which you should undertake. Not so fast, says real option theory. Maybe you could earn an even higher expected return by waiting a year, and then deciding. You might find the cost of heating oil is higher. So you would want R30 instead of R20 insulation. Or maybe the cost of heating oil will be lower, and so you want R10 or don't want any insulation at all.

If you knew in advance what the future cost of insulation and heating oil would be, you could decide today whether to insulate or not, and how much to insulate, even if you decided to postpone the actual investment until next year. But if you can't predict the future, there's a benefit to postponing the decision until next year, when you will have more information on how much insulation (including none) would be the best investment. There's also a cost of postponing the decision of course, since you are losing the first year's profits on the investment.

Uncertainty is necessary for the option value of postponing the decision to be worth something. But it's not sufficient. If you never learn anything by waiting, you might as well decide to roll the dice now. And if what you choose to do isn't affected by what you learn (because you can only fit R20 into the attic and R20 is profitable for any conceivable price of heating oil) there's no value in waiting either. It's when you learn a lot just by waiting a short time, and what you do depends a lot on what you learn, that the option value of postponing a decision is highest.

And the investment decision has to be irreversible of course. If you could take the insulation out and get your money back, or add an extra R10 to your R20 at no extra cost compared to installing R30 originally, there's no point in waiting.

Real option theory sounds really neat. But there's something missing, or left out, or just assumed to be there in the background but otherwise ignored. It's cash.

It's not surprising really. As far as I know, most people doing real option theory are at Biz Schools, or are microeconomists. Not that there's anything wrong with that. But they are not monetary economists, so it's not their job to look at the other side of the coin.

You can't just do nothing; you must always be doing something, even if it's lying on the sofa staring into space. If you don't invest in real assets, what are you holding instead? What do you compare the returns of real investment to? What's the alternative? What's the opportunity cost?

You can't just do nothing with your income; you have to spend it on something. If all things you could spend it on were irreversible, then you can't talk about the option value of doing nothing, or postponing a decision. You have to decide now. You could insulate your house with R20, or buy a new car, or buy a holiday, but none of those expenditures is fully reversible. You can't return the holiday after you have enjoyed it; you can't re-sell the new car and get anything like what you paid for it.

There is one thing you can spend your income on that is very reversible: cash. In fact, if we spend our income on cash, we don't even think of that as spending it at all. We think of that as not spending it. We think of holding cash as doing nothing. In fact, since we live in a monetary exchange economy, our income comes to us as cash anyway. So it's not like we make a decision to invest in cash today, and then reverse that decision next year. We have the cash already, and can decide to spend it now, or decide later to spend it later. Holding cash keeps our options open. Cash is the real real option -- to do anything.

Talking about the option value of doing nothing only makes sense in a cash economy. If we invest in insulation we cannot reverse that decision next year. If we hold cash, we can reverse that decision next year. Holding cash is to hold the option. Holding insulation is to exercise that option, so you no longer hold the option.

Cash is the most liquid of all assets. We measure the liquidity of all other assets against cash. One measure of liquidity is the cost of a round-trip, from cash, into an asset, then back into cash. What percentage of our cash do we lose by making that round trip? And that definition of liquidity is just another way of measuring whether an investment is reversible or not.

Suppose we live at a time when uncertainty is high, but we expect a lot of that uncertainty to be resolved soon. Just by waiting a short while we should learn a lot. That is when the real option value of doing nothing should be highest. That is when the demand for real investment should be lowest. But, compared to what? Compared to cash of course. Doing nothing means holding cash. That is when the option value of holding cash should be highest.

I think we have been living in such a time, and are slowly coming out of it.

Lots of people, Keynesian fundamentalists especially, will say "Of course! Didn't Maynard say that uncertainty creates liquidity preference?" And they are partly right, but mostly wrong. It's not uncertainty, but uncertainty that you expect to be resolved quickly, that creates liquidity preference. You can't learn anything about the dice by waiting, so you might as well place your bets and roll them now, and learn whether you win or lose. It's not the level of uncertainty that matters for liquidity preference, but the expected rate of change of uncertainty.

Maybe that's why investment is always the last thing to recover after a financial crisis. It doesn't recover as uncertainty gets resolved. It recovers when uncertainty stops getting resolved. That's when there's no point in waiting and seeing any more. Until then, people and firms will want to hold cash.

God forbid they ever announce that reliable crystal balls will be cheaply available -- next year. That would cause an instant collapse of investment, and a recession. Every student would wait till next year before deciding what subject to take. All the professors would be unemployed.

Yep, I've been deliberately vague by what I mean by "cash". Sorry. Also, I confess I can't have spent more than 10 minutes of my life actually reading any real option theory. Sorry again. How much did it show?


Here is a link to Nick's blog.

Sunday, August 1, 2010

Cash-on-Cash Management for a rental property

When determining the attractiveness of a real estate investment there are various measuring sticks one can use. In past posts, we often talk about ‘Positive Cash Flow’, which is the same as remaining cash from a rental operation after paying all expenses including the mortgage payments.


When looking at a real estate income statement, sometimes referred to as APOD (Annual Property Operating Statement) it comprises several components:
          1. Effective Rent (Gross Rent minus Incentives minus Vacancy Charge)
          2. Operating Costs (Property taxes, Utilities (when paid by landlord), Maintenance/replacement, Condo fees, Management fees, etc.)
          3. Net Operating Income (NOI) = Effective Rent minus Operating Costs.

Capitalization Ratio (Cap Rate) is NOI divided by the Purchase Price.

To Arrive at Net Cash Flow, one deducts from the Net Operating Income the Debt Service Costs (both Interest and Principal Repayment). For a landlord to be able to keep a property in ‘perpetuity’ the Net Cash Flow should be positive – i.e. the property is self-sustaining.

When buying stock, we often compare Net Operating Income with Dividend. If the stock investment is purchased with borrowed funds, Net Cash Flow would be the Dividend minus the Debt Service.
For some investors, receiving positive cash flow is important; this is what they often live off when ‘retired’. Thus, they want to know what the Cash-on-cash return is. This can be simply expressed as the ratio of Net Cash Flow divided by the cash they have sunk into the investment –  in real estate this is typically the down payment (d= equity/purchase pirce. Note, 'd' is the counter part of LTV (loan to Valio ratio).

Cash-on-cash return (CoC) can be bolstered or diminished by the amount of leverage being used (d = 1-LTV) and the mortgage rate. When the Cap rate (CAP) is less than the interest rate paid on the mortgage, Net Cash Flow will go down (i.e. it is negatively leveraged). When the Mortgage rate (i) is less than the cap rate, the Net Cash Flow is enhanced (i.e. it is positively leveraged). On the REIN forum, an equation was published that expresses the relationship between Cash-on-cash return, the mortgage rate and the amount of leverage applied. The equation is as follows:

CoC = {(CAP-i)/d}+i

I used this equation to create the graph below on EXCEL. The graph illustrates some important issues related to Cash-on-Cash return, mortgage rate and leverage. With increased leverage the Cash-on-Cash return does go up, but not in a linear fashion. It increases exponentially!


Using a cap rate of 4.5% (pretty high for Calgary) and a (variable) mortgage rate starting at 2%, I graphed the Cash-on-Cash return for various down payment/purchase price ratios (d=1-LTV). The following was observed:

First, when using a high LTV (95%) you will need a lot of properties in your portfolio to have a significant impact on the overall performance. Say you have $100,000 and your Cash-on-cash return is a very attractive 20% with a LTV of 95%, you would need to own ten $200,000-properties to earn 20% on your entire portfolio. That is a lot of work, hassle and risk (leverage).

Secondly, if your (variable) mortgage rate increases from 2% to 3% (on the graph that is 'plus 1%’), your Cash-on-Cash return (COC) goes down significantly. When the rate increases further, you may get even a negative CoC (and not just a little bit). If the mortgage rate goes from 2% up to 6% ('Plus 4%'), at a 95% LTV you suddenly have a negative COC of 24% and at a rate of 7% the CoC goes down to -43%,

Thus, if apart from an overall good return on investment (ROI), the amount of cash you can draw from a property is important, Cash-on-Cash management is important. This little exercise shows how Cash-on-Cash management is significantly impacted by the amount of leverage, the mortgage rate and Net Operating Income as expressed by the Cap Rate.