How to guarantee a higher return on real-estate …

About 10 years ago, my wife’s two nephews came to visit their “Uncle Adrian” to discuss potential investments.

They had decided to buy two apartments (in the USA, called ‘condominiums’) together – I advised them to buy one each, but they decided to go 50/50 on one, then another one a short while later.

I remember being quite proud of them, because they were both still in their early-to-mid-twenties at the time and were already investing in real-estate rather than taking the easy options of either not investing at all or speculating on stocks.

My wife’s nephews have since each married, and they each have two children under the age of 5 …

… and, they still own the two condo’s together.

I was taking one of my grand-nieces [AJC: makes me seem VERY old; I’m 53, which is only SLIGHTLY old] swimming this morning, and we got to discussing how the apartments are going.

My nephew-in-law said: “we’ve made a profit, but I don’t think they’ve been a very good investment”

Let’s examine this in a bit more detail, because I think it explains my last post quite well …

He (and, his brother) bought 2 apartments for about $200k each about 10 years ago; they are now worth about $400k each (they were worth as much as $500k each about 12 months ago, but prices have pulled back from their peak).

The apartments are still generating a small loss on a monthly income v costs basis, but he’s comfortable with a small level of negative gearing … and, he has an interest-only loan, so has not paid off ANY principal in the ~10 years that he’s owned 50% of each apartment.

He has calculated his return as about 7% (before tax) compounded, which I feel is pretty good but he feels that “opportunity costs” are such that he could have done a little better, elsewhere.

All in all, it doesn’t sound impressive …

… to him.

To me, the return is outstanding and explains what my last post is all about!

You see, I asked him how much (a) his loan is, and (b) how much cash he has put in so far (since the property has been making a small loss each month for 10 years).

He says that he put in a 25% initial deposit (interest-only loan), and has put (including the deposit), about $100k in cash (before tax costs/benefits).

This is how I think it breaks down (these numbers are now approximate):

– Property purchased for $200,000 (let’s assume this includes closing costs) with a 25% (i.e. $50k) deposit.

– Loan is interest only, so still stands at $150,000

– Total cash put in to date is $100,000 (made up of the $50k deposit plus another ~$50k negative-gearing losses over 10 years)

Now, let’s look at the analysis:

Cost to my Nephew-in-law:

1. $50k deposit

2. $50k losses

Profit if property sold today:

3. Property is worth $400k

4. Property purchased for $200k

5. Loan to pay off is $150k

Total Return:

6. Cash OUT is: 1. + 2. = $100k

7. Cash IN is: 3. – 5. = $250k

[AJC: notice that the price that he paid for the property doesn’t even figure – directly – into the equation; all that matters is what he owns (current value) less what he owes (current loan + the cash he puts in)]

This is no different to putting $100k in the bank (or some other investment) and getting $250k back after 10 years.

Using a compound growth rate calculator, this is  a 9.5% annual compound return, not 7% as first thought!

You see, he was making the common mistake of thinking that the apartment ‘only’ doubled in value in 10 years (from $200k to $400k, which is a still amazing 7% return in today’s depressed investment climate).

But, you simply need to look at how much cash you put in, against how much cash you get back out when you eventually sell (or, you can still do this calculation on the likely selling price, if you want to keep the investment) to find your real return …

… i.e. the less cash you put in, the greater the return.

It’s usually as simple as that!

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How to manage your life with just $19 Billion …

After the recent Facebook float, how did Mark Zuckerberg fare, and – more to the point – how is he going to live?

According to the online business media:

The founder sold 30.2 million shares out of his entire holding, leaving him with a $US1.1 billion payout. It’s a huge amount of money, even after taxes, but it doesn’t come close to his final stake, somewhere in the region of $US19 billion.

So, the answer to the “how is he going to live?” question is: very well, thankyou!

Instead, let’s take a look at a hypothetical Internet business owner whose company IPO’d for mere millions in value, instead of Zuckerberg’s billions:

Let’s say that our hypothetical founder sold 30.2 million shares out of his entire holding, leaving him with a $US1.1 million payout. It’s a lot of money (let’s pretend that it’s after taxes), but it doesn’t come close to his remaining stake in his company, somewhere in the region of $US19 million.

How is our founder to live?

It would be tempting to say that he has $20 million, so a typical ‘safe withdrawal rate’ of 4% [AJC: which could be achieved through a combination of dividends and selling down small amounts of stock each year] would suggest that he has a massive $800k disposable income each year.

But, spending anywhere near $800k – even spending anything more than 25% of this amount p.a. – would be a huge mistake.

You see, the bulk of his money is in stock … and, risky stock at that: 5% of his net worth in cash and 95% in one relatively small, ‘hi tech’ company …

… and, we know what happens in tech: it can be boom/bust [AJC: remember MySpace, anyone?].

This is no different to an athlete trading off his contract, and spending money like it’s forever … except when it isn’t, which is why 78% of NFL players and 60% of NBA players are bankrupt within two years of leaving the game.

The second – less aggressive – temptation, then, would be to live off the dividends from the stock held …

…. let’s say that the company pays 2% dividends [AJC: which would not be unusual for a tech. company seeking to reinvest in itself, or acquire other companies, even though many – such as Apple – would pay zero dividends], which would deliver $400k per year.

But, again, what happens if the company stops paying dividends?

Instead, what our founder needs to do is realize that he is merely potentially very rich, but right now is a very valuable employee (and, controlling shareholder) of a company that is rewarding him with (a lot of) stock that may – or may not – one day convert to cash.

So, what our founder needs to do is count his blessings … I mean, assets:

1. He probably has a very healthy $400k+ annual salary, he should live off no more than 50% of this (indexed for inflation) and invest the rest.

2. He probably receives $400k in annual dividends; he should add 100% of these to his nest egg.

3. He has a starting nest egg of $1.1 million, which he should invest in ‘passive’ income-producing investments [AJC: real-estate is ideal for this]

As he starts to convert more stock to cash (i.e. through sale of small amounts of stock each year, as the law & his board may allow, and/or dividends) eventually, his nest-egg will grow to $4 million …

… which is his lifestyle break-even point i.e. the Rule of 20 says that your nest-egg should be 20 times your required annual living expense, which is currently $200k.

The good news is that anything converted to cash – hence, into passive investments – over $4,000,000 allows our founder to increase his annual living expense.

You’ll find that if you follow this system:

a) Sure, you’ll be living well below your ‘paper means’, but once you realize that your wealth is merely on paper, you’ll get over it, and

b) You’ll slowly-but-surely be transferring your ‘paper wealth’ into real wealth (i.e. passive investments), and

c) If you choose income-producing real-estate as your vehicle for holding your ‘real wealth’, you’ll pretty quickly find that you are able to support an even more quickly-increasing standard of living, no matter what happens to your tech company, and sooner than you may think.

This is how to bullet-proof your future …

… unless you’re Mark Zuckerberg, who can probably already survive on 4% p.a. of $1.1 billion 😉

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How to ruin your return by paying off principal …

A while ago, I did a three-part ‘anatomy of a commercial real-estate deal’

Drew wanted to know:

You mentioned 63k income that you can spend, but I don’t see you including principle payments. Wouldn’t that cut into your cash flow?

You’ll need to go back and read the three-part article, but this question goes to the heart of whether to pay off your mortgage, and is somewhat the same argument whether you want to do this on an investment property or even your own home.

It boils down to return:

The building that I was looking at buying would have generated $255k in rents – $192k in expenses (including $130k bank interest) = $63k net ‘profit’ p.a.

Paying down principal doesn’t change that dramatically: it does lower my interest expense, which should increase my net profit, hence my return …

… in $$$ terms.

But, when you do the math, it can lower the % return  that I am getting on my money.

Aldo says:

Continuing with the comment from the previous reader, can you elaborate a bit more on why principal payments would not affect this deal? On the previous article you mentioned going for a 7yr financing or so, which will represent about 250-300k of additional capital you need to put each year. After the first year you would have invested 700 + principal (let’s say 250k) = 950k. The 63k you make then will become a 6.6% return on your own money… Then down to 5% the next year… And so on…

Aldo has forgotten to allow for the reduction in interest expense as my equity increases (and, the bank’s loan decreases), but he points to the % return on my overall investment decreasing …

… whereas, an investor should generally be looking to increase their % returns.

In simple terms: if I can buy a $100k property with 20% down (i.e. $20k), when I find (e.g. by saving) another $20k, am I financially better off:

1. Putting it into this property to pay it off quicker?

2. Putting it into my home mortgage to pay my home off quicker?

3. Putting it into another $100k property that I can buy with 20% down?

In order of decreasing return, it’s generally 3. then 2. then 1.

I know which I would rather do. How about you?

 

 

What’s a simple business to start?

Often, I’m asked about businesses to start.

Usually, the person asking has low-to-zero capital to invest; wants to start part-time; and, wants “a simple business to start”:

What is a business that I can start, so simple in nature, that virtually I (perhaps with the help of a friend) could start with less than $3000 and some hard work?

Well, there are lots of what I call ‘traditional’ businesses that you can start part-time, depending on your talents:

For example, if you are good at photography, you could do wedding photos at nights or on weekends. Same if you like baking (“cakes delivered to your door”).

But, these aren’t as easy to scale part-time, in my opinion,  as an online business …

… which is why I prefer online businesses, these days.

Even then, some online businesses are better than others:

For example, starting a blog (perhaps like this one), or selling information products (e.g. eBooks), or even starting an eBay business might be relatively easy, but they’re hard to scale into something that might one day take you full-time (so that you can quit your job and become your own boss) or even – eventually -become saleable.

So, let me share with you the little-known secret of the type of online business that I think is:

1. easiest to start, and

2. makes the most money, and

3. is still quite scaleable and saleable (the two magic words if you want to retire rich).

The secret is to create a 2-sided market place.

A two-sided market place is any kind of business that has buyers on one side and sellers on the other:

1. eBay is one example: it’s people and businesses selling to other people and businesses.

2. Amazon is NOT an example (it’s very hard to set up a warehouse and systems to become an online seller like Amazon) but the Amazon Marketplace is a example: it has buyers and sellers using Amazon’s payment platform to sell stuff to each other.

3. Etsy is another example: people make things (arts, crafts, jewellery, etc.) and list it on Etsy.com where people browse and buy things: Etsy doesn’t make anything, sell anything, or hold stock … it just makes a % of every sale for introducing both sides of the marketplace to each other.

4. The most famous recent example is Airbnb, started by 3 guys who simply came up with the idea of letting people share their couches for backpackers to stay (they weren’t even the first: couchsurfing.com got there first); it has since evolved into a real competitor to the Expedias and Pricelines of this world and is on track to become a $1bill.+ company.

That’s why, when people ask me what business to start, this type of business is usually where I then point them.

But, how to start?!

To start Airbnb (I suggest you don’t, this is just an example):

1. One of the startup’s founding team goes around their home city photographing and signing up a whole bunch of ‘bed and breakfast’-style accommodation (I know that Airbnb didn’t start with this; remember, this is just an example)

2. The other founder gets to kick back with a tiny budget to drive traffic to a ‘sign up to be notified when … ‘ landing page (LaunchRock is ideal for this).

[HINT: try $50 worth of Facebook ads and another $50 of Google Adwords and see if that drives any traffic. Spend $10 on each ad platform on 5 different keywords rather than $50 on one. Remember to target your ads specifically to your city (I know FB allows this; I’m not sure if Google does). Submit your landing page to sites like betali.st and startupli.st. Wait for a more significant story before you spam Techcrunch and Mashable]

3. Once you have 20 to 50 BnB’s signed up, and perhaps 200 – 600 names on the landing page, you put the two sides together and see if magic happens!

4. If so, you rinse and repeat in another city, and another (until you raise sufficient investment to allow you to hire ‘city managers’ to do the photographic/doorknocking for you).

5. If not, this marketplace idea sucks. Try another.

Now, stop asking and go do it … 🙂

LATEST NEWS

Catch my latest interview herehttp://www.creditcardassist.com/blog/7-million-7-years-best-of-the-best-blogger-series-22702/ – thanks Bill (founder of Credit Card Assist).

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Poor little rich doctor …

A couple of weeks ago, I responded to a reader request from a young doctor who is on what can only be described as an OMG level of income:

I am a young physician (early 30s) making approximately 800k per year. After expenses and taxes, I am left with ~300k to save/invest.

Never mind the fact that he is losing approximately $500k a year in “expenses and taxes”, a $300k take home is still pretty good in anybody’s language!

There was plenty of well-considered reader debate and advice for the young doctor, including this highly-reasoned argument from traineeinvestor:

I’d suggest he continue to focus most of his energy on maintaining or growing his professional income. Time spent on side ventures and investments should be limited so that it does not interfere with the $800K professional income.

In terms of investments, given his time constraints, I’d go with a Boglehead approach, possibly supplemented with some geared cash flow positive real estate (especially if he lives in the US and can take advantage of depressed prices and long term fixed borrowing costs).

I agree on both counts:

a) When you are earning a super-high level of salary, your primary goal should be to protect that source of income. It’s a river of money: you should do everything in your power to keep it flowing!

b) However, you shouldn’t just let the money flow into the taxman’s pocket, then into yours, and then out again by increasing your spending. Instead (and in keeping with our ‘river’ analogy) you should also build a downstream dam.

And, you should only open the sluice-gates to let off a much smaller amount than is going into the dam …

Why?

Because that’s the only way that the dam gets to fill up!

This way, when the river stops flowing (ideally, at a time of your choosing i.e. early retirement, but it could be forced upon you even earlier for a variety of reasons), you can keep the sluice gates open, knowing that there’s still enough water in the dam to keep the flow running for the rest of your life.

In other words: you don’t want the dam to run dry before you do 😉

But, this is much harder to achieve than you may think, so here’s where I differ – but, only slightly – starting by reversing the order of traineeinvestor’s otherwise excellent investment strategy:

I’d go with a geared cash flow positive real estate approach (especially if he lives in the US and can take advantage of depressed prices and long term fixed borrowing costs), possibly supplemented with some Boglehead-type investments.

The reasons are two-fold:

Firstly, I’m not accepting that 62.5% (i.e. $500k) of our doctor’s $800k earning capacity can simply be wiped off in “expenses and taxes” …

… professionals are just sitting ducks when it comes to taxes.

But, by implementing a nicely geared (and, maybe even cashflow negative after depreciation allowances) real-estate strategy, there may be deductions that can legitimately increase his super-high professional’s take-home income, without falling afoul of the tax man.

This is a clear-cut case of where a professional’s advice can add huge value [AJC: not in asking “is real-estate a good investment for me” but in asking “is real-estate a good tax-advantaged but highly legitimate investment vehicle for me?”], and our doctor should not take another step without seeking such professional advice.

Secondly, he should go through every single expense with his accountant and see what he can reduce or better manage. Nobody can afford to burn $500k worth of dollar bills …

… not even a super-high-income doctor.

Secondly, real-estate (especially when prices are depressed) is just a great long-term investment.

With his $300k (and, hopefully much more once he implements some of his accountant’s tax and cost-management advice) cashflow plus any income that he receives from his tenants, the doctor can afford to leverage quite a large portfolio of such high-quality, long-term, income-producing investments.

And, it is this large portfolio that becomes his growing ‘dam’ of cash, trickling out at perhaps a $100k – $150k sustainable annual spending rate … one that he should be able to index with inflation and maintain for his whole life, whether he (one day, perhaps quite soon) chooses to work full-time, part-time, or not at all.

And, isn’t that the whole (financial) point of it all?

Why are professional athletes so horrible with money?

In 2009, Sports Illustrated observed:

78% of NFL players and 60% of NBA players are bankrupt within two years of leaving the game.

From this Get Rich Slowly concluded:

Many professional athletes are horrible with money.

Why does this occur?

Investopedia in a recent article stated the obvious:

Athletes have a unique problem that many other professions don’t: the earnings window is small. While the more traditional careers may allow a person to work 30 to 50 years, a professional athlete will work only a fraction of that time. This leaves the retired athlete with the job of managing what they have to last for the rest of their life with only a fraction of their old salary being earned.

Whilst I agree with GRS that many sports players are horrible with money, this is simply an undistributed middle fallacy of the type:

  1. All students carry backpacks.
  2. My grandfather carries a backpack.
  3. Therefore, my grandfather is a student.

In other words, this problem is not isolated to athletes … they are just one class of people who have highly skewed earnings.

Others include anybody with what I call “Found Money”, which is my term for any one-off (or otherwise time-limited) sudden influx of cash. For example:

– Anybody who signs a major contract (athletes, musicians, actors, celebrities, even sales people or small business owners who “land that once in a lifetime deal”)

– Anybody who wins a substantial sum

– Anybody who inherits a substantial sum

… and, so on.

The Horrible Money Management Syndrome, that Get Rich Slowly incorrectly attributes to athletes, actually comes with the sudden influx of money i.e. it’s a problem with the source, not the recipient.

For example, there are lottery winners from all walks of life, yet the operators of the UK Lottery found that, on average, lottery winners had spent 44% of their winnings after just 2.5 years, which supports the anecdotal evidence that 80% will be entirely broke in just 5 years after winning a major lottery!

Whilst some sharp wits may observe that this is “because the qualifications for playing the lottery are being ignorant of the principles of mathematics” [AJC: for example, as one blogger recently observed, you are more likely to die from melting underwear than winning the lottery], my theory is that …

you need to learn the lessons slowly on the way up, in order to stop yourself learning them the hard way on the way down.

In case any of you are planning to make a lot of money quite suddenly [AJC: even faster than $7 million in 7 years ‘suddenly’], you would be wise to heed the lessons that I taught my children when they were still very young (and, follow to this day):

When they get money [AJC: Any money: an allowance, a gift, find it on the street, etc.] half goes into Spending and the other half into Savings.

So, too, does it go for you: anytime that you get any additional money [insert ‘found money’ methods of choice: you’re a professional athlete; you win the lottery; you get a pay increase; a second job; loose change that you save out of your pockets; a gift; a manufacturer’s cash rebate; tax refund check; etc.; etc.] you Spend half and you Save half.

At least, this is advice that will tide you over until I share my Found Money System with you …

… next time 😉