October 30th 2010
Return On Investment (ROI)
This is a large subject. I shall try and cover most of the elements as
they relate to real estate.
First, there seem to be more fools in the real estate business than
usual. For example, look at this idiot writing on one of the bulletin
boards:
"I'm having difficulty getting started
in below-market-value purchases. I have no trouble finding properties
around 20% BMV, but I've had to walk away from them due to them not
meeting the rental coverage required for an 85% remortgage. It's
getting really frustrating now as I've walked away from properties with
substantial discounts just because the deal doesn't stack up. Any ideas
on what I can do?"
I'm quoting from page 16 of the January 2010 HPA magazine, which is
quoting a question from a property related bulletin board.
This is about the equivalent of someone saying "I dont seem to have the
qualifications to be a brain surgeon, how can I get started cutting
people up?"
This guy should not be in business at all as he doesn't understand
simple maths. If you cant work out the maths of a particular deal then
dont get into business on your own as you will go broke. After all, he
says it himself: "the deal doesn't stack up." Okay, so what do you do
with deals that dont stack up? You walk away.
Let's start at the top. There is no such thing as BMV. It is ad-speak
for "I need to sell this thing, it's going at a discount, so please buy
it."
First question: Discount to what? The number the seller first thought
of?
Market value is of no importance to anyone. It could go up next week or
down. So what?
Second question: What about real value, intrinsic value? If you cant
value a deal then leave it alone.
What? You dont know how to value a deal? Then you are in the wrong
business.
A house has a value irrespective of what you or anyone else pretends
that value is. Let's use ROI to work it out.
I just bought some shares. I dont care if they go up or down in value.
I bought for the dividends. I paid £10 a share which gives me a
dividend payout of 17%. That is the return on my investment. If the
price of the shares goes up it wont make any difference to my dividend
payout. The important issue is the price I pay to get into the deal.
That determines the percentage return I get on the money I invested.
It's the ROI.
If the shares become more expensive then I have to pay more to buy
them. That wont alter the actual payout, but it will mean that my ROI
will go down. At £10 a share I am earning £1.70 a share. If
the shares go up to £20 that is a great capital gain, but the
dividend is still £1.70 a share, so if I bought at this level I
would be paying twice as much to get that dividend. That cuts the ROI
in half.
Conversely if the shares drop to £5 I will now be able to get
twice as many shares for my money and thus get twice as much ROI.
From the above example it is obvious that the best deal is the one
where I can get in for the smallest amount of money. The higher the
cost of the item, the less the ROI is going to be. Incidentally, it
also means that the more upside potential there is if you get into the
deal at a very low price. This means you buy low. It doesn't mean you
buy BMV, it means you buy low. BMV may well still be high. You need to
find out.
This means the first thing you need to do is find the proper value of
whatever it is you want to buy. That is your starting point. Without
knowing that you cant proceed to do any meaningful calculations at all.
If you are attempting to do business in real estate you wont get very
far if you dont know how to value a house. I am not talking about
market value, but about intrinsic value.
Let's go back to the example of the shares.
The market value of a share is what it can be bought/sold for at the
moment. You get a quote from a market maker, and that is market value.
It is not the same at what the share is worth. The price includes a
large amount of sentiment value. The economy may be in a mess. People
may be broke. The market sector may be out of favour. The company may
have just gone through a rough patch. All that affects the price.
The intrinsic value can be worked out using all kinds of very simple
calculations. What's the book value? What's the PER? Does the company
have an amazing invention which will make next year's profits go
through the roof?
With a house it's very easy. Once again, you can work out the PER, or
price/earnings ratio. That's easy to do. What does it cost to buy?
Let's call that A. If you turned the house into a business and rented
it out, what level of rent would you get over the course of a year?
Let's call that B. A staid business would normally sell for ten times
earnings. Have a look at B. Multiply it by ten. Is the sale price more
than the result? If so, then the house is expensive. In good times when
house prices are rising the figure would probably be above ten times B.
In hard times it would be more likely to be below.
We are now going through hard times so the price of the house should
ideally be less than ten times B. If it isn't, then it's too expensive.
You dont buy it, as prices are likely to fall, or stagnate for some
years. You will not get a capital gain. You will also get a smaller
than normal ROI. In short, the deal is not good, so you dont buy.
Let's go back to the question from the bulletin board.
Heck, the return (rent) on this guy's deal doesn't even cover the
mortgage payments. If that is the case then the price of the property
is too high. "Any ideas on what I can do?" asks this particular idiot.
The answer is simple: dont buy as the price is too high. Wait for
prices to come down. If they are too high, then they will have to fall.
Investing in property is a long term scheme. You need to be patient. If
prices are too high they will eventually fall. They may take four of
five years, or longer to reach a bottom. You'll have to wait.
Now let's do the full maths on a deal I saw the other day to see how
things work out, or not as the case may be.
There's a three bedroomed flat in London. It is on the market for
£225,000. It will rent out for £1,500 a month. I can get a
75% mortgage at 4.5%. Is this a deal worth getting into?
Let's do two calculations. The first is a simple ROI calculation. The
second is a full-scale profit and loss calculation.
First the ROI: The income from the deal is £1,500 x 12 =
£18,000. That is our B. Multiply it by 10 and you get
£180,000. The property is over-valued. It's as simple as that.
However, because of the wonders of mortgage funding we can do a more
sophisticated appraisal of the situation. The secret lies in the
difference between the interest rate charged for the mortgage and the
notional interest implied by the ROI calculation. In this instance the
difference is 5.5%, which is quite a useful margin. Let's see how the
more sophisticated maths work out.
You can bung all this into a spreadsheet. You have the following values
to input. Purchase price; rental amount (this should be reduced by 10%
to cover repairs and renewals, and by a further 5% to cover voids);
deposit; opportunity cost; interest rate. You can now work out what the
ROI is.
The purchase price is £200,000. The rent is £18,000 less
15% for repairs and voids, which leaves us only £15,300. The
deposit is 25% of the purchase price, which equals £50,000. Your
opportunity cost is the amount lost by taking the deposit out of
whatever income earning opportunity it was previously invested. Let's
say you had it invested in bonds bringing in 5%. 5% of £50,000 is
£2,500. The interest rate being charged on your loan is 4.5%.
That amounts to £6,750. (All these figures are per annum.)
Let's do the sum, and see whether this is a good deal or not.
What we are going to work out now is the ROI on the money we actually
put into the deal, which is only £50,000. The mortgage company
stumped up the rest.
The cost of the loan is £6,750, which needs to be subtracted from
the income minus repairs and voids, which gives us £8,530 in our
pocket. That is the return on our investment of £50,000, which is
a little above 17%.
We now need to decide whether that is what we want. Since we were
getting 5% on the money before, we are doing much better. It's suddenly
looking good. Go for it. If the return was less than 5%, obviously we
would have been better leaving our money where it was.
But we would have lost the opportunity of a capital gain, I hear you
say. Not so. If the ROI was less than 5% that would have meant the
price of the house was too expensive, and its price would have to drop
or stagnate rather than increase, so there would be no capital gain for
some time. You would have bought in at too expensive a level.
There is one other final point that needs to be remembered. Your ROI in
the second calculation we did was based on an interest rate
differential of 5.5%. This is very very important.
If you do the standard ROI valuation as we did in the first
calculation, that is based on a 10% return. The closer interest rates
get to 10% the less margin there is for any real profit in a mortgaged
deal. If mortgage interest rates are at 8%, then your return is
negligible. That is why it is dangerous to do your maths on a deal that
has low interest rates. Let me remind you that a 2% rise in interest
rates translates into a 30% rise in your borrowing costs, which is why
professionals buy when interest rates are coming down, not when they
are low and likely to rise.
I would remind you that in October 2010, which is when I am writing
this, interest rates in the UK are down at the lowest level they have
ever been. They have to rise at some point in the near future. Will you
be able to cope?
There is an alternative way to do this kind of valuation.
The average ROI on investment deals can be pretty well anywhere these
days. At the bank or building society you will get shafted with a
return of between 1% and 3.5%. That's hopeless.
Bonds wont give you much in these times of low interest rates. Stock
dividends can be anywhere from 1% to about 17%. Many of the investments
I use myself vary from 8% to 96%.
The only way to look at the problem is to work out what your minimum
desired return should be. I would generally look for a return of 10%
over the current inflation rate. In the UK inflation is running at
about 3.5% I'd therefore want a return of more than 13.5%.
If we are looking at the real estate market in general, you would
reckon in today's market to get between 7% and 8% ROI. Less than 7% is
poor.
Okay, now we know where we should be, let's work out what is called the
Capitalization Rate, or CAP.
First you need to obtain the Net Operating Income. This is the gross
income from the rental minus expenses. This is similar to the equation
listed above. Once again we will call this figure A. You then
take the Purchase Price, which we will call B. CAP = A/B.
Taking the figures from the example given above we get 15,300/200,000.
This comes to 7.65%, which is within our range. The ROI is average for
the current market. If you are happy with that, then there is a deal
there. It's not good enough for me. I can do better elsewhere.
And there you have it. Easy peasy. Just do the maths. Work out the ROI
and you wont go far wrong with your business deals.
john
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