UpwardOnward - Strategic Small Business Ramblings

January 20, 2010

NZ spearing, no wetsuit

Decided to attempt a dive in Breaker Bay without a wetsuit. Water temp was around 53ºF. I think we lasted all of 10mins before it felt like hypo was setting in. I managed to stone a fish, and we found some abalone, but needed about an hour to get our core temp back up to normal.

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January 20, 2010

NZ Scallop Diving

Vic and I dove for Scallops in the harbor. It was a little challenging with the depth at around 25ft, but the visibility at about 1m or less, but we managed to get a few for dinner.

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January 18, 2010

Lunch at Bach

Lunch at Bach. Sandwiches and Flat Whites on the coast.

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January 18, 2010

Jose's flat

Jose in front of his flat in Welly.

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January 18, 2010

Breaker Bay

View looking out to Breaker Bay.

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January 7, 2010

Lets make some apps!

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January 5, 2010

A Mortgage can be your friend

It seems as though having a mortgage is a bad thing. Most people you talk to will tell you to pay off your mortgage as soon as possible, or worse yet, to buy property without a mortgage in the first place. But in fact, the financial system is designed for people to use a mortgage to their advantage.

Disadvantages of Buying Real Estate in Cash

your money is not liquid- any money that you put into a property is no longer liquid, its hard to get it back out should you need it.
money you put into a piece of real estate is not safe from loss of principle- if the value of your real estate goes down, you lose money, possibly lots of it.
your income tax liability is higher the smaller your mortgage becomes- a mortgage helps you save on taxes (and taxes are most likely the largest expense you have nowadays- and growing).
your money generates no cash flow- you don't get payments from your money which leads to the last (at least on my list) and most important disadvantage of putting all your money into a property without a mortgage...
your money earns a Zero % rate of return- yes, money in a property does not earn any kind of return what so ever.

Advantages of Having a Mortgage

your money is liquid- by keeping cash out of your property, its very liquid, and easy to access when needed for investing or emergencies (including making payments or paying off your mortgage if you want to).
protection of principle- if you have money/equity tied up in your house, and the housing market goes down, you lose money. However, if you have your money safely out of your property, and have someone else's money in the house (i.e.- the banks money), your cash is safe, only the property value went down.
mortgage interest saves you money on taxes- mortgage interest is one of the few deductions that most employees get to take advantage of on their tax returns. Unlike businesses, we don't get the luxury of buying things before we pay tax- the government takes their cut out of our paychecks before we even get paid! Mortgage interest is preferred interest- you can deduct it on your tax return. If you have $10,000 a year in mortgage interest, you can deduct it off the top of your income. If you are in a 30% tax bracket, the real savings will be $3000. That is money that you would have paid to Uncle Sam in the form of income taxes. If you think about it, you can probably spend your own money more wisely than your Uncle Sam!
money kept out of your property can be used to generate cash flow- you are free to make money with your money (preferably in assets that protect principle and remain liquid, even better if its tax advantaged too).
as above, your money (some or all depending on what you put down) can earn a return out of your property- remember money in your property earns no return on investment, its basically dead money. Money outside your property can earn a rate of return.

Why does home equity have no rate of return?

Say you have a house that is worth $200,000, and you bought it in cash. The housing market goes up 5%. So now your house is worth $210,000. So it seems as though the money in your house, your equity, gained 5% too. Not exactly. To illustrate, lets say instead, that you bought your house (initially worth $200,000) with a 0 down, $200,000 mortgage (just for illustrative purposes). You put the money ($200,000) you would have used for a down payment (or cash payment to buy the house in full) into another asset class that gains 5% a year. The housing market goes up 5%. How much is your house worth? $210,000. Your $200,000 also gained 5% in your other asset. You just gained $20,000 total! Your cash gained a 5% return, and your house also returned 5%. What if you had the $200,000 in the house? what would the house be worth at the end of the year? just $210,000. So as you can see, whether the house is all paid off, or mortgaged to the max, the money in it (equity) has no rate of return, the house does. The money you keep outside the house however, can have a rate of return.

Arbitrage

But what about the mortgage payments? ah, this is where the risk comes in, and where you need to know your tolerance for risk, both mentally and financially. Its where good risk management comes in, but its also where Arbitrage can get interesting. Lets say you borrow the $200K at 5% interest. That's $10,000 in interest payments a year. Looking back, that cash kept outside the home, was invested in an account that gained 5% for the year, or $10,000. A wash? The trick is, its mortgage interest you were paying, and you get a deduction. So in reality, in a 30% tax bracket, you are really paying only $7000 of that in interest per year. This leaves you with a net gain of $3000, or $13,000 on the house and separated equity. Not bad for money that would have been otherwise dead. You can do whatever you want with the money, spend it, invest it, or even use it to pay down the mortgage.

You are using Arbitrage- borrowing money at a fixed rate of return, and gaining a higher rate of return on that money. Banks do this all day. They borrow money at say 2%, and loan it back out again at 5-6%. Sure they are only making 3-4% return on that money, but hey, it wasn't even their money to begin with! So you can see, banks don't want to keep their money tied up somewhere, they need it to be working for them. They want you to tie up your money with them, so they can then lend it back out again at a higher rate. So they will pay you 2% on your money sitting in a CD, and loan it back out again at 5%, netting 3%. Do this enough times, and that tiny 3% gain turns into millions. The good news is, with Arbitrage, you can also be the bank.

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December 30, 2009

Cap Rate - 3 Simple Uses

What is Cap Rate?

Capitalization Rate, often referred to as "Cap Rate" by investors, is the ratio of net operating income (NOI) for an asset, to the asset's cost (most often real estate is the asset in question). When looking to buy real estate, Cap Rate can be used to do quick valuations on properties, or calculate the typical return of other properties that are comparable to the one you are looking at buying. To find the cap rate you use this formula:

C (Cap Rate) = NOI (net operating income)

V (Value/Cost)

So for example, if a 2 bedroom condo you are looking at will generate about $12,000 a year in net rental income (the NOI) per year, and the sales price (sold) of the property was $300,000. We can see the cap rate would be 4%. The forumla would look something like this:

(C) 4% = (NOI) $12,000

(V) $300,000

Do this on enough properties and you can start to get a good feel for what average cap rates are in different areas around you.

Cap Rate and Finding Value

Real estate investments are valued based on all kinds of criteria. Things like location, comparable property sales prices, land value, and the replacement cost to re-build the existing structure. Using the cap rate can give a simpler valuation with less variables, this can be handy when evaluating large numbers of properties. You can use cap rate to estimate value, or purchase price in this way:

(V) $171,428 = (NOI) $12,000

(C) .07 (estimated)

So if you do your due diligence and discover the average cap rate for properties you are looking at is 7%, and the income (NOI) of a particular property is around $12,000, then you can quickly estimate the average value of a property (using your estimated cap rate) to be around $171,428.

Cap Rate to Compare Investments

If you find properties that are cash flowing around $12,000, and similar properties have sold with a cap rate around 7%, then you know that $171K is an average price for that type of property.

If you are finding lower cap rates, that can mean less market risk, since the property is in demand. Higher cap rates usually show more market risk, as the property is not in as much demand. Properties in higher demand, often have positive factors that are driving the price of the property up, lowering the cap rate. Of course there are many risk factors to evaluate in a property, but cap rate can give you a broad, albeit, simple overview.

Cap Rate and Realizing Opportunity Cost

It is wise, when finding a cap rate on a property you already own, to use the current price of the property to asses the cap rate, not the initial investment. The reason is it paints a more accurate picture of how your money is being used. For example, if I bought a property for $200,000, and it rents for $12,000/year, then the cap rate is 6%. But if the property appreciates to $400,000 5 years later, and rents increase to $18,000/year, I might be tempted to base the current cap rate on my initial investment since rents went up. The cap rate would then be 9%! Sweet! But, I would be forgetting the opportunity cost of having all my money tied up in that investment- $200K additional dollars now tied up in the property due to the price going up over time. Thats $200K "dead" dollars- money that is not working for me. If I look at the cap rate adjusted for current value it comes out to a 4% cap rate, not nearly as high as the 9% I thought I was getting. This could be a sign that I need to extract that $200K, or part of it, and put it to work in other investment vehicles or more real estate. Ideally as the property's price goes up over time, you want the NOI it generates to also increase over time, to maintain the cap rate at an acceptable level.

Filed under // Investing Real Estate

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December 30, 2009

Net Operating Income and buying Real Estate

Net Operating Income (NOI) is the net income an asset will produce. Basically, if you have a rental for example, you take the gross rent, say $15,000 a year, and minus the expenses, say, $3000 a year. You are left with $12,000, which is the NOI. It is useful to figure out when buying real estate. Often people think figuring out NOI is only used for buying rental properties, but in fact, it is also useful for buying a property you wish to live in, not only as a step for figuring out a property's value, but also to see how you can reduce risk.

Risk

Figuring out risk, and knowing your risk tolerance is important before buying a piece of real estate, or any investment for that matter. Knowing how much you can rent a property for is obviously one of the many ways in which you can mitigate risk. If you lose your job or cant make payments or some reason, being able to rent out a property is a viable option to avoid risk of foreclosure. So it helps to look at your expenses and figure out what rental income you need to cover all expenses.

Value

Figuring out NOI is also a step in figuring out the estimated Value of a property. Typically NOI is calculated by taking the gross rental income of a property and subtracting expenses like repairs, property tax, maintenance etc. You are then left with the NOI.

NOI typically does not include mortgage interest or depreciation as an expense since its more accurate to not include the amount of debt used to purchase the property. Debt amounts needed to buy a property vary, and depend on many factors. Excluding debt expenses leads to more accurate representations of value.

Basically, NOI is calculated with the simple formula:

Gross Rental Income - repairs - prop tax - maintenance - other expenses = NOI

Once you have the NOI, you can use it to calculate Value and Cap Rate, which are also very useful in the purchase process.

Filed under // Investing Real Estate

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December 17, 2009

Anyone else buy the Dollar recently?

I posted a little while back about a technical (short term at least) bottom in the USD. It recently broke its downtrend on increased volume. I have been playing the pop with Options on the $UUP. Hard to say how long this pop will last though. The Fed. is still pumping some major liquidity into everything, and the 200dma is fast approaching.

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