by Emily Chan
Many people save whatever they have left after their expenses. But looking at cash as your employees, this would be like “first sacrifice the ones you need to kill and then try to put the leftover ones to work.” It should be the other way round. You should always save to invest before you spend on expenses. In The Richest Man in Babylon, George S. Clayson highlighted one of the key success secrets of the ancients: “A part of all you earn is yours to keep.”5 But many people only save what is “left over.” Prosperous people often save first and then live on what is left over. This makes a big difference. It not only makes sure you have cash to invest, it also forces you to plan your expenses and be more resourceful If you find that your cash after savings is not enough to cover your expenses.
POSSIBLE SOURCES OF INVESTMENT INCOME (I): REAL ESTATE
So if dollars are your employees, where should they be put to work? If each dollar is a seed, then how to grow the seeds into trees? In other words, where to invest?
Before discussing where to invest, it is important to first emphasize the difference between speculation and investment and to understand risk. Speculation is when you hope to get a return. Results are subject to chance and are out of your control. Gambling or buying lottery tickets is speculation. Buying real estate on the assumption that whatever you pick will increase in value over time is speculation (which is indeed one of the key root causes of the 2008 U.S. housing market and financial crisis). Investment is when you earn a return. You have a strategy and a plan. You do your research and analysis. You manage your investment accordingly to increase your chance of a return. HBS focuses on investing, not on speculating.
It is also important to understand risk. No one has a crystal ball. Even with all the research, analysis, and planning you can do, when you invest, you always risk losing money. As the saying goes, “no risk, no return.” HBS does not teach you to minimize risk. This is because risk is often proportional to potential return. The key is not to minimize risk but to manage risk. Managing risk means you understand the risk involved and have determined that you can afford it, and the potential reward is worth the risk you are taking.
There are many possible sources of investment income. Three of my favorites are real estate, the public stock market, and private companies. Most HBS graduates I know invest in at least two and many in all three. Investing in multiple sources helps manage risk because of the safety of diversification and wider exposure to opportunities. To manage risks, most people start with simple, small investments and step by step move to more complex and larger deals as they become more experienced. I discuss real estate and the public stock market in this book, but not investing in private companies, which requires sophistication in deal sourcing, industry evaluation, company assessment, valuation, monitoring, and exit. It would take a whole book in itself to explain. Also, it is much riskier and often requires much bigger investments than real estate and the public stock market, though its returns can be substantially bigger.
First, consider real estate as a source of investment income. There is a famous story called “Acres of Diamonds” by Russell H. Conwell6 about a man who dreamed of owning a diamond mine. He sold his farm, took the money, and wasted his life in a futile search. Ironically, the man who bought his farm was looking in the stream behind the farmhouse and noticed a brilliant, shiny stone glittering in the water. Yes, it was a diamond. Thus was discovered the famous diamond mine from which came many of the crown jewels in Europe. The farm was sitting atop acres of diamonds.
Many people are like the man going in search of diamonds. They waste time, money, and energy in endless moneymaking schemes while the greatest source of wealth is under their feet—real estate. If you look at people who are filthy rich, real estate is close to being a common denominator. People such as Donald Trump, Li Ka Shing, and many other billionaires around the world made their fortunes in real estate. Of course, many of them started off with a lot of money and they invested millions of dollars. However the beauty of real estate is that you do not really have to be a major developer. You can start with a small amount of money on small properties and gradually expand.
The attractiveness of real estate comes from a number of key factors:
Leverage
Multiple sources of cash flow
Bargains
Leverage
Archimedes said, “Give me a lever and I’ll move to earth.” As investors, we do not want to use the lever to move the world; we just want to use it to buy as much as we can. In the finance world, lever, or leverage, means borrowing. Because you have to pay interest to borrow, many people wrongly believe you borrow only when you cannot afford to pay all cash. HBS teaches you to use leverage even when you can easily afford to pay all in your own cash. Leverage allows you to increase the amount you earn for each dollar you invest (percentage return). In a way, if cash is your employee, leverage is like borrowing employees from someone else to work for you. You pay for the use of these temporary employees, but they help you achieve more with less of your own workforce.
An example to illustrate of how leverage can improve profitability: say you buy an apartment that is worth US$200,000. The apartment is expected to appreciate 10 percent in one year. You can obtain a loan at 5 percent interest a year. Assuming you can afford to pay US$200,000 in your own cash, would you pay all with your own cash or would you borrow?
Here is the math. Assuming no fees and taxes, if you pay all cash, you make 10 percent on your money invested after one year. But if you take a loan of 80 percent and pay only 20 percent in cash, you would make 30 percent on your money invested:
Selling price (10 percent appreciation) 220,000
Minus interest paid 8,000
Minus mortgage repayment 160,000
Minus 20 percent deposit paid 40,000
Net profit 12,000
Percent returns 30 percent
(12,000/40,000)
Of course, while leverage is powerful, overleveraging is extremely dangerous, as evidenced by the 2008 sub-prime mortgage crisis; I’ll return to this point shortly.
Now, you may argue that if you invest without borrowing and make 10 percent, you make $20,000, which is higher than $12,000. This is true but then you run the risk of “too many eggs in one basket.” HBS teaches that while many analytical tools can help you understand the markets, no one really has a crystal ball. One HBS graduate I know works for a famous investment bank. He works as a research analyst, writing reports widely read by fund managers around the world. Each report analyzes a particular company and makes recommendation on whether to buy, hold, or sell the stock of the company. I still remember this classic quote: he said, “I am doing well in the firm. I am right about one-third of the time, wrong about one-third, and the rest is neither right nor wrong because the unexpected happens.” Well, so much for predicting the market.
So if no one really knows for sure what is going to happen in the market, what do you do? HBS teaches you to diversify. If you invest your $200,000 cash in five different apartments of about the same price range, putting down 20 percent of your cash as deposit for each and borrowing 80 percent for each, you would generate 30 percent return on your $200,000 instead of 10 percent. You will also be diversifying your risk. Even if you lose on one apartment, you may still be able to make up by success in your other apartments. Instead of investing only in real estate, you can also diversify by investing in other areas like bonds, public stocks, or even collectibles or private businesses.
Multiple Sources of Cash Flow Over Time
The second reason why real estate is attractive is the multiple streams of investment income it can generate:
Rent
Loan reduction
Value appreciation
Tax deductions
Cash Flow from Rent
To calculate this cash flow, use the following formula:
Income from rent
Minus Operating expenses (rates, tax, maintenance, management fees, and so on)
; Minus Loan repayment
Net cash flow
As can be seen in the formula, cash flow is a direct function of the loan repayment. The bigger the loan you take and the shorter the repayment period, the smaller the net cash flow until the loan is paid off. So how much loan should one take to maximize returns? To calculate, use the following formula:
The final decision on how much debt to take on should be based on both percent cash-on-cash returns and the risk involved in the loans. Negative cash flow will happen if the related expenses and loan payments are greater than the rental income, especially since the property would inevitably have no income from time to time as a result of tenant turnover. You must be able to cover that negative cash flow through your net cash flow generated in the past, your salary, or your other investment income. Many people in Hong Kong were forced into bankruptcy after 1997 because they did not plan their cash flow well. They accepted negative net cash flow (rental income that did not cover mortgage payments and expenses) because they believed they could profit when the property appreciated. But property prices continued to fall for a few years after 1997. When some of these people lost their jobs in the 2001/2002 recession, they could no longer make their monthly payments to the banks. Neither could they get cash by selling the property, because property prices had declined so much that the price they could get by selling would be less than what they owed the bank (this is called negative equity). As a result, these people were forced into mortgage defaults or even personal bankruptcy. Overleveraging and negative equity are also key contributors to the 2008 global financial crisis. Hence, while leverage is powerful in increasing profits, you must look at your own financial situation to determine how much you should borrow.
Cash Flow from Loan Reduction
Over time, as you pay down the principal of your mortgage, your equity (your ownership of the property net of debt) will grow.
You can get cash from this increase in equity in two ways: sell or refinance. Selling is straightforward but may not be the best thing to do unless you have a better investment than the property in hand. Refinancing is another option. For example, say you purchased an apartment with 20 percent deposit. Your equity was 20 percent then. Over time, you paid down your loan and your equity increased. Say your equity has grown to 65 percent after 10 years, and assume the value of the property has not changed, and you can refinance and get a new loan for 80 percent of the value of your property. You repay the 35 percent (100 percent minus 65 percent) you owe on your earlier loan. You can use the remaining 45 percent (80 percent minus 35 percent) to make other investments or to indulge yourself by spending on expenses.
Figure 1.1 North American Home Prices
Source: U.S. government statistics.
Cash Flow from Value Appreciation
Among all the lessons history teaches, none is more certain than the fact that real estate will appreciate in the long-term. Figure 1.1 shows what happened to the median price of homes in North America between 1940 and 2000.
Some experts may disagree. Throughout history, there have been many self-proclaimed experts who predicted that “real estate prices have peaked.” Take a look what experts have been saying in the United States during these 60 years (as collected by Gary W. Eldred in The 106 Common Mistakes Homebuyers Make):7
The prices of houses seem to have reached a plateau, and there is reasonable expectancy that prices will decline. (Time, December 1947)
Home cost is too much for the mass market. Today’s average price is around $8,000, out of reach for two-thirds of all buyers. (Science Digest, April 1948)
If you have bought your house since the War . . . you have made your deal at the top of the market. . . . The days when you couldn’t lose on a house purchase are no longer with us. (House Beautiful, November 1948)
The goal of owning a home seems to be getting beyond the reach of more and more Americans. The typical new house today is about $28,000. (BusinessWeek, September 1969)
The median price of a home today is approaching $50,000. Housing experts predict price rises in the future won’t be that great. (Nation’s Business, June 1977)
The era of easy profits in real estate may be drawing to a close. (Money, January 1981)
In California . . . for example, it is not unusual to find families of average means buying $100,000 houses. . . . I’m confident prices have passed their peak. (John Wesley English and Gray Emerson Cardiff, The Coming Real Estate Crash, 1980)
The golden-age of risk-free run-ups in home prices is gone. (Money, March 1985)
If you’re looking to buy, be careful. Rising home values are not a sure thing anymore. (Miami Herald, October 1985)
Most economists agree . . . (a home) will become little more than a roof and a tax deduction, certainly not the lucrative investment it was through much of the 1980s. (Money, April 1986)
Financial planners agree that houses will continue to be a poor investment. (Kiplinger’s Personal Financial Magazine, November 1993)
A home is where a bad investment is. (San Francisco Examiner, November 1996)
However, history has proven these experts (and many others) wrong. Data indicate that over the long-term, real estate generally increases in value. I emphasize long-term (10 or 20 years or even more) because there will be short-to medium-term ups and downs due to economic cycles and turmoil, but real estate prices tend to go up over the long-term. Of course, it will be years before we can see how the 2008 U.S. housing market crash will play out. But data on median prices so far still seem to indicate that while median price in the United States has declined roughly 20 percent from the peak (around 2005 and 2006), it is still higher in 2008 than it was 10 or 20 years ago.
I also emphasize generally because this does not mean every property will appreciate. Appreciation of an individual property depends on its location, condition, management, purchase price, and other factors. As with any investment (not speculation), you must be prepared to put in time to research and understand the market.
Property generally appreciates for two main reasons: inflation and supply versus demand. While economic growth is cyclical and deflation sometimes occurs, prices generally inflate over the long-term. When there is inflation, prices go up, including those of property.
While it is definitely true that modest inflation over the long-term increases home prices, some people mistakenly believe that the higher the inflation, the greater the increase in price. The logic of high inflation goes like this: with inflation and hence rapidly rising prices for labor and materials, developers cut back on new construction and raise prices. With higher prices for new development, many property buyers switch to the resale market and buy existing homes. With more buyers bidding for existing property, the prices go up.
However, this high inflation, high property appreciation is not so true anymore. The key reason is the way central banks in many countries are now using interest rates to control inflation. Interest rates are often raised when inflation becomes too high. As interest rates go up, home affordability goes down. People who might like to buy are blocked from the market. On the other hand, low rates of inflation mean low interest rates. With low mortgage interest, more people can afford to buy. More demand means higher prices. Therefore, real estate prices may continue to go up even in a low-inflation environment.
Cash Flow from Tax Deductions
In many countries, the government encourages home ownership through various tax deductions. Different countries have different tax deduction allowances. Here are some of the items qualified for tax deductions in various countries:
Purchase costs such as prepaid interest on the loan, fire and liability insurance, escrow fees, or miscellaneous fees from lender.
Ongoing operating expenses such as interest on loans, insurance, utilities, gardening and cleaning expenses, repairs such as roofing or plumbing, or management fees.
Depreciation. In some countries such as the United States, property owners are given an annual depreciation all
owance on the structure (that is, the building but not the land) to deduct against other income. The theory is that this deduction will be saved up and will be used to replace the structure at the end of its useful life. This is similar to depreciation of equipment for businesses.
Tax deductions increase property owners’ cash flows by reducing the amount of taxes they have to pay on their income. This is especially significant in countries where income tax is extremely high.
Bargains
One key concept about investing I took away from HBS: “Often, you do not make money when you sell. You make money when you buy.” Warren Buffett preaches the same phenomenon: buy at bargain price so you have a margin of safety. Then, even if the market does not appreciate as forecast, you will have built in a buffer because you buy below market price. You may still be able to make a profit (or at least not lose as much money) when you sell. Many people made millions speculating in the Hong Kong property market prior to 1997, but many have gone bankrupt since then. Prices were rising so rapidly prior to 1997 that many people were buying at market prices without bothering to look for bargains, so they had no leeway when the market paused.
One of the key attractions of real estate is the possibility of finding bargains. Bargains are available for three reasons. First, relative to the stock market, where sellers can find buyers at market price with relatively little effort (just call the stockbroker), the property market is relatively illiquid. “Willing” or desperate property sellers may not easily find buyers. They may consent to drop prices just to close a deal quickly (of course, at the same time, such illiquidity might affect you If you need to sell quickly). Second, property is not a commodity like stock. Each property is different (location, floor level, view, condition, number of bedrooms). Hence there is room for negotiation depending on the property seller’s level of desperation, knowledge of the market, and negotiation skills relative to those of the buyer. Third, some property owners do not manage their property well. They do not maintain and configure according to market needs. As a result, there is opportunity to buy such property and then quickly increase the value by renovation (new paint, new pipes, new carpet or floor tiles, an additional bedroom, and the like).