Dartboard investing only works when you stand inches away

December 27, 2010
Dartboard Investing

Those ancient Mayans had one messed-up clock

 

Every day, people miss out on great investments because they don’t know how to quantify risk vs. return. You need written investment criteria.  Here’s a sample.

If you don’t have the energy to click the link, it’s mostly a series of questions that read something like this:

What type of investment is it?
Real estate.

This is a straightforward question with a clear answer. Knowing what classification the investment falls into tells you how liquid it is and how much its value might fluctuate. If the investment were a stock it’d be easy to sell, though not necessarily for a premium. A plot of dirt, improved or raw, has tangible value. But selling it, even in a seller’s market, can burn a lot of hours.

If I bite, how will this affect my allocation?
Negligible.

You don’t necessarily want your eggs in a million baskets, nor in one, but you do need to know how many they’re in. And if the breakdown among the baskets gets out of proportion, you want to know that, too. Say your portfolio starts out with 33% in growth stocks, 33% in long-term notes and 33% in real estate. Six months later, if the percentages have changed to 5, 34 and 61, you’ll want to rearrange to keep things in balance (or ride the 61% component if so inclined.)

But what if this transaction did affect allocation? What would you do to balance the imbalance? You could sell an asset, buy other assets, or decide you’re going to live with a different breakdown.

What do you estimate the return will be?
4½–8%, plus however much the property appreciates, which we estimate will be nothing for the next 3-5 years.

We keep score when building wealth. Amazingly, some people haven’t figured this out yet or refuse to acknowledge it. If you think investing has an emotional component, and that either being a nice person or playing hunches is part of the game, please stop reading Control Your Cash and find something less demanding. Seriously. See, we said “please”. Didn’t hurt your feelings or anything. You should be happy.

What exactly is the investment?
A 2nd floor, 1-bedroom/1-bath 770 ft2 condo in an above-average part of town. The condo’s listed at $50,000 and approved for a short sale*.

Meanwhile, nearby condos rent for $650-750 a month.  Estimated annual expenses read like this. (This is something called an annual property operating data worksheet. Download it at your leisure.)

The above question is self-explanatory, right? And its relevance should be self-evident. If it isn’t, return to kindergarten and start over. We’ll be waiting.

———-

Anyhow, this investment allows for multiple variables that affect ROI (that’s return on investment, in case you forgot.) Variables include things like rents, and whether you can buy the property as owner-occupied, which means you should be able to get a cheaper loan with lower closing costs. Here’s what we mean:

There are two primary ways to buy this condo as an investment if you have neither the cash up front nor excellent credit. Find a partner, or incorporate.

1. Find a partner (a joint venture.)

An investor lends you $50,000 interest-free to complete the sale. You buy the house and live in it.

Nothing’s free, of course. Under this form of owner occupancy, you pay the investor 70% of the house’s net operating income (i.e., the rent.) Another 10% of the rent goes into a reserve maintenance account – out of which you pay for things like appliance repair. Which you shouldn’t need to if you have a home warranty. But there’ll always be some unexpected expense that a warranty won’t cover: stucco repair, interior paint, etc.

What about the remaining 20% of the rent? That’s yours to keep. Yes, under this arrangement you pay only 80% of fair-market rent. On the other hand, doing it this way you can’t write off your expenses on your tax return.

Who would work out a scheme like this? Lots of people. It’s a perfect vehicle for a father who wants to help his kid buy a home and still earn a return.

Or

2. Form a limited liability company (details here, here, here, and here.)

You and the person who’s lending you money are partners in the LLC, which becomes the official and legal owner of the property. Once you create the LLC and it takes ownership of the property, it’s the sole owner: nobody and nothing else. It’s not as if you own x% of the property and your partner owns 100-x%. The LLC owns it all. You own a particular share of the LLC, but that’s a different issue.

Each LLC has an operating agreement that lays out the details of the deal: such as who gets to write expenses off, how you’ll split profits when you sell the property, and specific duties for each partner. The LLC also protects you from unlimited liability in case a tenant or a visitor decides to sue. They can sue for $1 trillion if they want, and even have a case, but they can’t get more than your investment in the LLC.

With this example, the investor again lends you $50,000 interest-free. You find a tenant, charge her the going rate and again keep 10% in a maintenance account.

This scheme works for partners with disparate skills – e.g. one partner with the time and expertise to find the property (in this example, you) and the other with most of the money.

What’s the downside?

Property values could drop even further, meaning you might need years just to break even. If the property doesn’t rent immediately, your return will decline.

The renter might damage the property. This is why you qualify prospective tenants and collect a security deposit. If you really want to avoid headaches, spend 10% of the rent on a property manager. If you value your time at all, hiring a property manager will pay for itself quickly.

You and your partner might disagree on how to manage the place and, when it comes time, how to sell it. You solve this with an operating agreement, one that looks something like this:

That’s pretty much it. Just make sure that every conceivable subject of potential dispute finds its way into the operating agreement, and that you register your LLC in a state that’s business-friendly. That usually means Delaware or Nevada. Or failing that, your home state. (You can live and operate in, say, North Dakota but register in Maine if you want. It’s totally legal.) Just don’t register in California, and never New York: their LLCs don’t protect you enough.

The old pessimistic saw says you have to have money to make money. That’s not true if you leverage someone else’s.

*Selling a house short means begging the lender’s representatives to take less than they originally agreed to, on the theory that a wounded bird in the hand is worth more than a potentially rabid pair in the bush. Details here.

**This post is featured in the 1/4/11 edition of the real estate investing carnival**

**This post is also featured in the Carnival of the Road to Financial Independence**

Filed Under: Investments, Making Smart Choices, Math, Net Worth, Personal Finance Tagged With: , , , ,

He’s not overpaid. You probably aren’t either

August 2, 2010

The labor market's biggest bargain

 

This post is written in response to a fellow financial blogger who argues that

“(Pro athletes) are all overpaid in my view… they should be paid for performance… $100K base salary… if you play well, you make more. Play bad, and we take money from you.”

She (I’m assuming it’s a lady. I hope it’s a lady) isn’t the first person to take this position, nor the first to put standard English usage through a cheese grater, just the most recent.

Jim Irsay, who owns the Indianapolis Colts, pays Peyton Manning $14 million annually. For that, Irsay gets about as indestructible a force as there is in pro football, the linchpin of an offense that’s a threat to go to the Super Bowl every year. Before Manning got to town, the Colts were the laughingstock of the league and the franchise value nowhere near what it is now.

Irsay didn’t remain rich enough to own a football team by overpaying people. If having Manning around is worth $14 million to Manning, you can be sure it’s worth more than that to Irsay.

Here at Control Your Cash, we neither idolize Manning nor disdain him (same goes for any pro athlete.)  But what good would result from paying him a base salary of <1% of what he commands on the market? Would the author have the remaining 31 NFL owners collude and refuse to pay any more than that to an athlete who could enrich their teams by tens of millions of dollars?

Begrudging athletes their salaries is nothing more than jealousy – the same activities we grew up doing for fun, these people worked so hard to get proficient at that they can command lots of money. Meanwhile, I’m punching a clock, getting yelled at by the boss and trying to figure out how to pay the mortgage. It’s so unfair.

Even years after high school is over, the star quarterback still receives a mixture of adulation and envy. Besides, how do you “pay for performance”, anyway? Say you tie LeBron James’ salary to his scoring and rebounding averages. In other words, you’d encourage him to shoot every time he touches the ball, even when the game situation calls for him to pass: or you’re giving him incentive to always play close to the basket, rather than ever defend someone on the perimeter. And yes, let’s put a coach in a position where he can draw up plays that have a direct negative financial impact on certain players. That won’t cause any resentment.

So, you argue, pay athletes for winning. Then how do you determine how much of each victory each player is responsible for? Should a player who works so hard in a game that he injures himself risk further injury by coming back earlier than he should, just so he can get paid more? Maybe you could just trust that the majority of pro sports owners know what they’re doing. And the few stupid ones (like the guy in Minnesota who just signed Darko Milicic for $20 million) are engaging in an exchange that doesn’t affect you or me in any direct way.

Instead, take this as a lesson: for the most part, how much an employee gets paid correlates to how much he’s helping his boss get paid. The salesman is the standard example, because sales is so easily quantified: bring $x to the company, keep $yx for yourself where y is a number between 0 and 1 (a lot closer to 0.)

Do you want more money? Let’s do a flowchart:

If you’re salaried, it’s a little more convoluted. Sometimes it’s a case of determining how much it would cost the company to not have you around. Even a receptionist or a custodian provides some value, in that respect. (If either of those happen to be what you do for a living, don’t let anyone tell you that it’s a “non-revenue” position. Ask how much revenue your company would be amassing if the grounds were filthy and the phones unanswered.)

If you’re a cubicle toad, it can be harder still. Your humble blogger used to work as a $45,000/year advertising copywriter. For this, the ad agency got:

-550 collateral pieces (or as normal people call them, “junk mail and flyers”)
-887 headlines
-223 radio commercials
-34 television commercials
-11 long-form presentation pieces

In other words, the agency was getting the biggest deal since the guy who bought Manhattan from Peter Minuit*. That work output was what about 2.2 ordinary writers could have done in the same period. An ordinary writer got paid around $40,000 (if you want to find out these things, it helps to make friends with the girls in the accounting department.) So in return for the $5,000 “surplus”, said writer was leaving an additional $43,000 on the table.

The agency billed its clients over $25 million that year. $45,000 was hardly a fair representation of a prodigious writer’s value. It was more fair than paying Peyton Manning “$100,000 base salary” would be, but not by much.

The point of all this? Know your worth. 99.something% of salaried employees don’t. Your employer knows exactly how expendable (or valuable) you are. If it’s the former, you’re about to get fired. If it’s the latter, he’s in no rush to share the details of that information with you.

And if you’re in business for yourself, you get to transcend this entire stupid charade.

*Minuit got the island for $24, we all know that. But his heirs don’t own it today, right? He must have unloaded it at some point.

Filed Under: Capitalism, Economics Tagged With: , , , , , ,

Stick a Pin in it, It’s Done

July 18, 2010

I can't make change, all I have are quadrillions

Control Hoard Your Cash

Cash is a bad investment, right? Not as bad as penny stocks, perhaps, or California muni bonds, but certainly not much better.

Besides, can you even call holding cash “investing”? Does it fit the definition of using money to generate potential profitable returns?

It can, when deflation happens.

Simply spend enough time on this planet, and you’ll be conditioned to believe that prices and wages inevitably rise- and that what a dollar bought a year ago, it’ll buy slightly less of today.

2010 is an outlying economic year for many reasons, not the least of which is the possibility/certainty of deflation.

Well, that and the gargantuan government spending. Our apologies if we used the word “gargantuan” in a recent post: we’re running out of adjectives that denote bigness. According to the economists at the Bureau of Labor Statistics (which spends an average of $2 per taxpayer per year), the consumer price index fell .1% last month, .2% in May, and .1% in April. Those numbers look miniscule, don’t they? Harmless, even. But keeping in mind that the numbers are several, and that they determine a trend, it might be time to start worrying. It’s hard to draw too many conclusions when the BLS only ratiocinates to one decimal place, but cumulatively, the above numbers tell us that prices have fallen somewhere between 2.5% and 5.4% in a mere 3 months.

Great news for spenders. Rotten news for savers. If that 3-month average were to maintain itself for a year, we’d be looking at a 20% decline in prices.

So what’s the downside to this? You’re complaining about lower prices? God, you really are a killjoy. You probably complain about how sweaty things get during sex, too.

It’s not that simple. Prices and wages usually move in lockstep.

So things are neither better nor worse than usual, then.

Not quite. Say you have a long-term obligation, like a 30-year fixed mortgage. One of the features people like about mortgages that last so long is that by the time you get to the end of the term, the payments will be tiny. They’ll be as large in nominal terms as they are today – fixed rate means if you pay $1000 a month in Year 1, you’ll pay $1000 in Year 30.

Go back to 2005, when annual inflation was close to 4.0%. That’s pretty close to the historical average, maybe a little higher. Say your monthly payment was $1000. If prices rose at 4% throughout the term of your loan, the final payment would be the equivalent of only $321 in constant dollars.

When deflation happens, those payments get progressively harder to make, not easier. During deflation, it’s great to be owed money, less great to owe it. Extended deflation makes banking less viable as an industry. If prices are dropping 20% annually, bank rates have to lower accordingly. That 1-year CD that pays barely 1% in nominal terms thus pays 21% in real terms. Banks aren’t in the habit of throwing money away, which means they’ll stop offering anything other than super-risky loans. If you can keep money in an ammo box buried in your backyard, and enjoy a real rate of return of 20%, banks outlive their usefulness.

A little inflation isn’t all that bad. You could almost argue that it’s crucial for a healthy economy, in that it gives people an incentive to lend and borrow (the latter in hopes of larger returns, the former with the comfort of guaranteed returns.) Deflation isn’t exactly a sign of a robust economy. Again, it usually means wages are decreasing on average, which upon further examination often means that wages are staying the same, just the number of people employed is decreasing, thus lowering the mean. The latest sustained period of deflation in this country’s history was from 1930 to 1933. Go ask your great-grandparents how much fun it was to escape the Great Plains while John Steinbeck wrote books about them and Woody Guthrie sang songs about their plight.

Thanks for the history lesson. How does this help me now?

Get out of that dying industry that you work in, where your shaky paycheck is sustained at the whim of your employer.
If you’re at the point where you’re looking at passive income to supplement or outperform your active income, a) nice going and b) don’t get locked into modest rates. Instead of a conservative money-market account, see what your bank is offering in terms of certificates of deposit. Don’t be shy about shopping around, either: there’s no rule that says you have to keep all your accounts at the same bank. In fact, almost no rich people do. Use the CD ladder technique, which manages to get your entire investment to pay long-term returns even though you’re only in it for the short term.

You want more details on that? You can wait for it to find its way into the rotation as our weekly free book excerpt, but by then the economy could be riding a hyperinflationary thermal for all we know. Or you can one-click your way here.

**This post was featured in Canajun Finances’ Best of Money Carnival #61.**

**This post is featured in the Carnival of Personal Finance #267**

Filed Under: Economy Tagged With: , , , , , ,
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