Sunday, May 12, 2013

What is better Microsoft or Real Estate?

A month ago we started our discussion on intrinsic value of an investment. Next we used Microsoft as an example. We also discussed that the reliability of a cash flow forecast depends to a large degree on Warren Buffett’s moat around the business an we touched on leverage.

Normally, when using leverage, in particular mortgages, you think of real estate, for me it would be rental apartment units or a rental town house. But, really, there is a lot of leverage build into stocks and publicly traded companies as well. The difference being that you the investor are not in control of the debt load of a public company whose shares you bought, but you are in control of the debt load if you are a real estate owner.

Fig. 1. Microsoft Balance sheet courtesey GlobeInvestor Gold for 2012. (Click on table to magnify).
 Note that Microsoft’s current Assets such as cash, short term investments (due within one year) are close to $63 billion and that Microsoft’s debt and other liabilities such as income taxes are only $54 billion. Basically, Microsoft has no debt and about $9 billion in surplus cash (after settling all liabilities). That is like a real estate investment. There are many companies that use leverage as high as 30 to 40% of their total market value. Banks and insurance companies use often even higher leverage. But Microsoft has none! Its competitor Apple, for that matter, has no debt either.

So, just, like a piece of real estate, you could buy Microsoft shares with a ‘down payment’ and a ‘mortgage’. There really is no difference as long as Microsoft does not take on debt on its own accord. So in figure 2 below you see a simplified APOD (Annual Property Operating Data) for a typical 2 bedroom apartment in Calgary. We show rental income and operating costs without specifics. Subtracting Income from operating expenses, we have a Net Operating Income (NOI).
With Microsoft, we call the dividend payments NOI, in spite of the fact that Microsoft reinvests a significant portion of its net earnings back into its business and into share-buy-backs (which helps increase Earnings per Share). Hence we use the dividend income as NOI for stocks.
Fig 2. APOD of a typical apartment unit in Calgary. (Click on table to magnify)
The Apartment APOD shows your NOI as well as the purchase price ($200,000). Dividing NOI by the Purchase price results in the Cap Rate (3.9%) which is comparable to dividend yield. Now we have to finance the apartment – we’re using a mortgage with a Loan to Value ratio (LTV) of 63% resulting in a down Payment of $74,000 and monthly mortgage payments of $525.39. Part of this money goes toward paying down debt and is thus part of your net income. The rest ($ 4,460 per year) is interest payment using a 35 year amortization and 3.59% interest rate. Now assuming your property appreciates 4% per year, your Return on Investment (ROI) = 15% and your net cash flow (in your pocket is $1,521.34 per year) or 2.1% cash-in-your-hand/ down payment (the money YOU invested).

Let’s use the same logic to invest into Microsoft. Because the company has no debt, we can treat it as an unlevered investment where dividends represent your net operating income. Earnings not paid out as dividends and which are reinvested in the company will (hopefully) be reflected in the company’s annual appreciation.
Fig. 3. An APOD analyzing 1000 shares of Microsoft as if it were real estate. (Click on table to magnify).

In our calculations we ‘buy’ 1000 shares of Microsoft at $28.04 per share and with an annual dividend of $0.92 per share or a yield (cap rate) of 3.3%. Since we occur no other ‘operating costs’, our NOI = 1000 x 0.92 = $920.00. Our purchase price of the asset (1000 shares) was $28,040 and we’ll pay just like in the apartment example 37% down by taking out a loan amortized over 35 years at a 3.59% interest rate. The loan is renewed every 5 years. Our annual 'mortgage payments' are $883.91 of which $258.62 goes towards debt repayment (and the latter is thus part of net income). Since no other costs are involved, we keep $920 minus $883.91 = $36.09 in our pocket – this also goes towards net income.

Now, even if the stock would only appreciate at 5% per year, our annual appreciation is $1403.00. When this is combined with our other net income then our annual total net income is: $1403 plus $258.62 plus $36.09 or $1696.71 on an investment of $10,374.80 or an ROI = 16%. In the first 4 months of this year, Microsoft has already appreciated over 10%, so you can see that the upside potential is enormous.
Many investors claim that stock market investments are much more volatile than real estate. In earlier posts I have demonstrated that this is not the case. Just look at the recent real estate crash in the U.S. Stocks can fall 50% or so in a bear market and in 2008-2009, Microsoft traded as low as $18.00 – talking about a buying opportunity! But, I have seen real estate losing 50% of its value in under three months back in 1982 and many home-owners in the U.S. have recently experienced similar pain.
The big thing you have to keep in mind though is that many publicly traded companies already have significant leverage. So only use leverage on stocks such as Microsoft and rather than using a LTV= 63% use 50%. Especially since Microsoft is already trading at a low P/E, you have this way a lot of downside protection. Over time, Microsoft’s dividends, just like rent, will increase, while your loan not only is paid down but it will also lose in purchasing power due to inflation. So over time, your LTV will decrease, your net cash flow will increase and provide you cash flow at yields on your original investment price that is probably many times higher than you can imagine.
So, what is better, real estate or stocks? From an investor’s point of view they are two different investment classes both capable of creating excellent profits and contributing to a well-diversified investment portfolio. Both classes can produce similar losses and gains. Leverage will increase both.

Please, NOTE that I do not recommend specific stocks, I am just showing you examples from the real world. I do own often the investments mentioned on this blog. You should do your own due-diligence prior to acquiring any investment. In the end it is your money and the buck stops with you. Any action you undertake based on ideas presented on this blog are done at your own risk. I do not take any responsibility for anyone’s investment performance other than my own.

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