Saturday, November 26, 2011

COI and ROI – Assumptions help you design your portfolio

Now that you have defined in some detail the kinds of income you need, we will have to find the appropriate investments to deliver. For that we have to make certain assumptions about the various investment types regarding what they deliver in today’s market. If your portfolio has to keep its purchasing power, the portfolio value needs to grow at least as much as the inflation rate. Also, how is this growth achieved? Through savings from your revenue streams that remain after your costs of living? Through appreciation or a combination of appreciation and savings?
Designing such a portfolio requires all kinds of assumptions which you guess based on your experience and based on current market conditions. What is the current inflation rate or what do you guess is the inflation at the time of your retirement? What is the prime rate? Or what is the prime rate excluding inflation? In other words what is the Real Prime Rate? What is the typical real rate of real estate appreciation in your market? At what real rate do stocks typical grow?
You also need to do an educated guess as to what the current nominal (including inflation) dividend yield  of the S&P/TSX300 is and of high dividend paying stocks such as pipelines, utilities or banks? Etc. All these assumptions affect your expectations regarding cash flow (COI), appreciation and when combined your total return on investment (ROI).


Click on the picture to enlarge
These assumptions are entered by you the investor into the spreadsheet or you can use the numbers as I currently see them and as shown above.
The assumptions for real estate investments tend to interact. For example, your level of leverage (LTV is loan to value ratio) combined with the down payment and...  combined with rental income determine your gross rent ratio (annual rent/ property value) while your cap rate is the ratio of net operating income (NOI) divided by your property value. Elsewhere in this blog we discuss these parameters in more detail so don’t worry if you don’t understand this right now.
Here is the reasoning – an investor wants a rental income stream of $6000 and expects that a typical well priced property purchased in Calgary would throw of 2.6% cash on cash invested (COI). Cash invested is your down payment, which then would have to be $6000/2.6% or $230,769.Since your leverage (LTV) is set at 60%, that requires the total property value to be $230,769/(1-60%) = $576.293. This, assuming a mortgage rate of 4% and assuming that you pay your principal down at 3.3% per year, results in annual financing costs of $25,269.23. That in turn combined with your required net cash flow of $6000 sets your net operating income (NOI) at $31,269.23. NOI divided by property value is the cap rate of 31,269/576,293 or 3.07%.
 If 35% of your total rent typically comprises your rental expense, then the resulting annual effective rent (NOI plus rental expense) divided by the property value of $576,293 results in a Gross Rent ratio of 4.72%. Now, from your market you may know that a gross rent ratio of 4.72% or $6000 per month for a $576,293 property is not unreasonable and neither is the calculated cap rate of 3.07%. If these parameters are not achievable in your market you may have to adjust your real estate assumptions until the numbers come out more reasonable.
The assumption numbers included with the spreadsheet are my current assumptions. When doing your own research you can enter numbers that may be more reasonable for your circumstances or for the economy you live in. The combination of assumptions and your required income streams determine the ultimate composition of your portfolio. This will be shown in the next blog posting.

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