Wednesday, May 30, 2012

Investing and Speculating

When you invest for net cash flow the rest is gravy! During inflationary times, stock markets and real estate can appreciate rapidly but during times of low inflation it is the cash flow that makes you into an investor-survivor. Today, when you compare cash flow from stocks (dividends) and from real estate with interest income, the investor salivates but appreciation is next to nothing.

As long term investors, we know that market psychology ranges from outright doom and gloom to exuberant and that is reflected in P/E and cap rates. We know that sooner or later our investments will be fairly valued by the market and it may even become overvalued. But that only matters if you want to sell!

Why would you want to sell? Only if there is a better business to invest in! Because, how else do you generate cash flow to live from and to invest with?  Once you sell your business, you lose your cash flow and you have to find another opportunity to generate that cash flow or increase your cash flow to ever larger amounts.

Just buying for appreciation is plain speculation and if you try to switch from one business to the next to crystallize your short term profits you’re just a trader. Not to mention the capital gains taxes it may trigger! No wonder Warren Buffett claims that he would like to hold on to his investments ‘forever’.  And so he has as in the case with Coca Cola and American Express. But not all investments work out and sometimes you get ‘an offer’ that you just cannot refuse. Then you sell.

You sell when an investment doesn’t perform as well as you expected or when buyers offer such a ridiculous high price that you cannot hope to capture a similar value ever again. Taxes are a consideration – when you sell you have to pay capital gains taxes. In other words, you get an interest free loan from the government until the day you sell!  Even better, if you lose on the investment you don’t have to pay that loan back to the government. Even better-better! If your investment turns sour, the government will give you a capital loss tax credit. Think really careful about the reasons and the impact of your action if you want to sell.
Basically, we’re owners of a business whether it is real estate or stocks or whether you are a private bank lending money to the government or other corporations (bonds). Even better, we’re CEOs of our own investment business – no matter which investment. Your investments differ in how they generate earnings and cash flow and how much you control your investment. Have a look at the two spreadsheets below that show the income statements for a public corporation (stocks) and for a real estate investment. Are they really that different?

Let’s start with the publicly traded company (stock market) of which you own a small slice. That company provides a service or sells a product to create revenue. The provided services or products cost money in the form of operating expenses.  The difference between you revenues and expenses is your NET OPERATING INCOME. These are the profits generated from your invested capital.  In its simplest form, the profits are generated from the company’s assets and thus your profits divided by the value of shareholder equity are your return on equity (ROE).

That ROE may be a modest 4% but like in real estate, we can increase our return on investment if we can find someone to put up money at a much lower rate than the ROE! Let’s say that rather than putting up $100,000 capital we borrow $80,000 (LTV 80%) then instead of making 4% on $100,000 we’re making 4% of $100,000 or $4000 on a $20,000 investment, that is a return of 20%. Eh… not quite because we have to pay interest on the loan say at 3% per year that is 3% on $80,000 or $2400. So our profit is not $4,000 but $1,600 or $1,600/$20,000 = 8%. Not 20%, but an 8% return on $20,000 is a lot better than 4%!
He… that is just like in real estate!  Not quite, because it is the management of your public corporation that decides how much and at what rates the company lends.  Management could even decide not to take out a loan but sell a different type of ownership, ‘preferred shares’ that pay a fixed dividend rate no matter what the profits are of the company.

Management may also decide how much dividend it pays to the owners – well the board of directors which are supposed to represent the owners and management together decide. They often do that by declaring a dividend, that portion of the corporate profits that they feel is not needed for expansion and/or acquisitions (pay-out ratio).
So when you invest in stocks, you share in the profits but you do not control how the company is run, how it is financed and you don’t have a real say in how much of those profits are paid out to you in dividends (your cash flow). You’re mostly on the side lines or in your armchair waiting for your dividend as determined by others.  Even worse, the company may be increasing in value overtime, but you depend on the markets and their ever changing moods to determine how much a buyer is willing to pay for your shares. We call that ‘passive investing’.

Let’s look at the other business. The real estate business. He… isn’t that the same? The property collects rents, i.e. its revenue and then it has expenses such as condo fees, utilities, repairs and management costs to operate. The revenues minus its operating expenses are… Net Operating Income that goes into your pocket and you determine how that income is handled rather than the management of a public corporation. In fact, you determine what expenses are to be incurred and you or a rental manager appointed by you select the tenants and collect the revenue. Yes, you are operating the business or you hire a staff (the management company) to do it for you.
Also, you determine the financing. Maybe you are happy with a Net Operating Income of say $4000 on $100,000 invested! So your return is 4%. But you control that; instead you may decide to use leverage and use a mortgage or a Heloc to take out an $80,000 loan (LTV 80%). Or you take on a JV partner who pays most of the down payment and is the responsible to qualify for and guarantee the mortgage in return for a part of the profits or a fixed return similar to the preferred share holder. This is the big difference between stock market investing and real estate investing. You not corporate management is in control!

When investing in stock, everything is done for you; you have no control and in the end you collect a dividend and a speculative capital gain. When you invest in real estate, you are the CEO of your business and you are the board and possibly the staff! It is you who determines how much you lend or whatever other financing gig you may invent. You control the profits and you decide how much you reinvest and how much profits you keep for living.  Of course, since you do so much for and control so much of your real estate business, you better be rewarded sufficiently for your blood, sweat and tears, i.e. you want a better overall return on your investment than when investing in stocks.  You are the active investor! Get the picture?

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