Altus Insight - February, 2013
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Instead of the my normal articles discussing economic and socio-political events and their possible effects on investment returns, this article is effectively a glossary of terms and a explanation of how the terms are inter-related and used within our daily activities at Altus Equity. The article is broken out into two different sections: 1. Investment terms, definitions, and interconnectivity, and 2. Valuations.
Before jumping into the meat of the article, I am excited to announce that I have joined the board for the local Habitat for Humanity organization. For those of you not familiar with Habitat for Humanity, it is a non-profit organization that provides housing for people who can’t otherwise afford it. A key differentiator with Habitat for Humanity, and a reason it works well with our operating principles at Altus Equity, is Habitat’s focus is helping those that are already striving to do the best they can. Habitat helps those that are trying against the odds to improve their own life situations and are not receiving government assistance. Additionally, the home recipient has to provide sweat equity to the home they are to receive. Sweat donations are also made by a wide range of volunteers, which has a powerful effect of building community. Altus, and I, look forward to helping Habitat for Humanity where we can.
Investment and Returns
Return OF Investment: The understanding and application is something far too many investors overlook or don’t take into consideration in their investment decisions. All too often investment decisions are made only with the expected returns in mind and without consideration to the risk of investment associated with each investment. Which is the better investment: A 12% expected annual return with a 20% chance of losing 10% of the invested capital, or an 8% expected return with a 5% chance of losing 10% of the invested capital? It has been claimed that the first three investing rules of Warren Buffet are 1. Don’t lose capital, 2. Don’t lose capital, and 3. Don’t lose capital. This is for good reason, as losses on invested capital require much higher returns on the remaining capital to achieve the same result as what the original capital would have returned even at much lower returns. Consider the following simplified example of two investors capturing different annual returns over a 5 year period:
Investor #1: Year 1 – 10% gain, Yr 2 - 9% gain, Yr 3 – 8% gain, Yr 4 – 8% gain, Yr 5 – 8% gain
Investor #2: Year 1 – 12% gain, Yr 2 – 18% gain, Yr 3 – 25% gain, Yr 4 – 25% loss, Yr 5 – 15% gain
Which of the above investors has a total better return? Investor #2 obviously can out-brag Investor #1 in 4 of the 5 years, and not by an insignificant amount. Unfortunately, many investors are more caught up in extolling the virtue of their returns in their good years than understanding their true investment returns. In the example above, Investor #1 had a 51% total gain while Investor #2 had a 49% total gain. The 25% loss Investor #2 experienced in year 4 had a devastating effect on their returns, in affect wiping out nearly the full 2 previous years of great returns. Can you as an investor match Investor #2 returns for the good 4 years and manage to avoid the 5th year (year #4)? Very few investors can.
This isn’t to say that investments that have the chance of losing invested capital are bad investments. Take, for example, angel investors in early stage companies (usually tech related and long term in nature). An unwritten rule of thumb is that a good angel investor can expect to make a fantastic return on 33% of their investment, recapture their original investment but not much more on 33% of their investments, and experience a complete loss of investment on the remaining 33% of their investments. The hope is that the returns on the successful 1/3rd of investments greatly outweigh the losses on the catastrophic 1/3rd of their investments. These are expert investors and their strategy of accepting loss of investment works for them, but they go into these investments knowing (and accepting) the risk of investment loss. The key is to understand the risk of loss and take that into account when comparing various investment opportunities.
Return ON Investment (ROI): This easy definition for this term is the total profit on an investment divided by the total investment amount. For example, $25,000 of gain on a $100,000 investment is a 25% ROI. The problem with this equation is it doesn’t take into account the time the investment is working prior to obtaining its return. It is also difficult to calculate when the investment amount changes over time or returns are paid over time as opposed to a lump sum simultaneous with the invested capital. A term that may be used as more descriptive is Annualized ROI, which, as it sounds, calculates the return on investment for a year period as Profit/Investment/Time Period of Investment*Time Periods in a Year. There are also limitations with this term/equation in that it becomes less and less accurate the longer the investment period (it doesn’t factor compounding) and like ROI, is difficult to calculate when there are multiple instances of investment or profit/gain. Annualized ROI is often used for short term investments or trades (like flipping a house) which creates another limitation to its use that is often overlooked by investors when comparing a short term investment (like flipping a house) to a longer term investment (like owning a note). Let’s again use an example: 1. An investment of $100,000 returns $10,000 of gain in 6 months, but the investor is unable to find a satisfactory replacement investment for an additional 6 months. The annualized return on the 6 months investment is 20% (and certainly worth bragging about). 2. An investment in a deed of trust creates a cash flow of 1% per month and isn’t paid off for 24 months. In this example, the annualized return is 12%, which is equal to the total return for a full year. In the first example, because of the downtime between investments, the return for the full year is only 10%. Thus, while the 1st investment may have seemed more profitable on the surface, the second investment achieved a better total return because of the continuity of the investment.
Internal Rate of Return (IRR): This is a far superior way to measure total investment returns than the ROI measures above as it measures the true return on investment regardless of when investments were made, over how many periods the investment position is held, or when return on or of investment are paid and calculates the annual return on an investment taking all those factors into account. The limitation to this term and formula is that it is very difficult to calculate without the use of a spreadsheet program or financial calculator. This makes it difficult to use for ‘back of the envelope’ calculations and opportunity comparisons. For time periods of approximately 1 year, annualized ROI and IRR calculations will be very similar.
Yield: Also commonly called “Cash on Cash Return”, yield measures the percentage return of money paid out from an investment during a particular investment period. Examples of this are dividend payments, bond coupons, and net rent. Yield is different than IRR in that it doesn’t measure the change in value of the underlying asset, only the amount of distributable return that asset is returning each period. The equation is straightforward, total income for a period/total investment = yield for that period. Yield is most commonly an annual measure. In understanding yield, it is also important that the markets consider yield as more valuable than non distributed investment returns (capital appreciation for instance). Generally speaking, investments with a particular yield will be priced higher than the same investment with deferred returns. Realized returns reduce the risk of loss of investment (see above discussion regarding Return OF Investment). If leverage is used on an investment, yield is calculated on the returns AFTER the interest costs (and loan amortization if present) are included.
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)/Operating Income: Technically this is not a definition that has anything directly to do with investment or returns, but I am including it here as it is important to understand in that EBIT is more commonly used for valuations than is yield. EBIT is the annual income of a particular investment or business. Assuming 100% collection of receivables EBIT will equal cash flow before inclusion of debt payments or taxes.
It is entirely possible that I am biased, but I believe having a strong understanding of valuations and how they are calculated is more important in the alternative asset world than it is in investments, like stocks and bonds that are traded on exchanges with a clearly discernable market price. This is simply because the exchanges dictate the price of an asset, determined by the instantaneous supply and demand for that asset, regardless of the underlying fundamentals of that asset. Alternative assets aren’t immune to effects of human emotion, but because the markets move slower and transactions take longer, it is only in extreme circumstances that human emotion can have a drastic short term effect on an entire marketplace. At Altus, every investment we make, with a few rare exceptions, starts with our best guess of the value after we are done with our improvements and then works backward. It is only in understanding the finished value (or our best guess of finished value – often internally referred to as After Repair Value or Stabilization Value) that we can calculate the expected returns of an investment. Alternative assets are valued in a variety of manners, all of which will use the above definitions in their explanation. The following definitions are made in full understanding that each alternative asset transaction (either the asset or the transaction itself) is unlike any other alternative asset transaction which causes variability in pricing. As such, these definitions are generalities only.
Valuations normally fall into one of three categories: Comparables, Replacement Cost/Asset Value and Investment. However, alternative assets valuation always comes down to what a seller and buyer can agree on for price and terms.
Comparables: While most often and directly used in real estate, and especially single family real estate, this method of valuation is used in some degree across all alternative asset classes. A Comparable method of valuation determines the value of an asset by finding similar recently sold assets to which compare it and adjusts for differences between the subject asset and previously sold assets. In single family real estate appraisers try to find sold comparables (called comps) that are model matches to the house being sold. If that is unavailable, they then look to the most similar sold houses in a surrounding area. In commercial real estate, less emphasis is placed on similar floor plans with more emphasis being placed on location (busy street vs. office park, etc) and quality of the building/desirability of the location. With businesses, notes, and other kinds of alternative assets a ‘comparable’ method of valuation is going to be less prominent, but any smart investor/buyer is still going to look around and make sure they aren’t paying more than a similar opportunity, otherwise, why not invest/buy the other opportunity?
Replacement Cost/Asset Value: Replacement Cost applies more to real estate while Asset Value applies more to businesses. In both cases Replacement Cost/Asset Value is the true intrinsic value of a piece of real estate or business assuming there is demand for the asset(s) in question. Generally speaking, if an asset that has a market demand can be purchased for less than it would be to recreate that exact same asset, that asset is going to be a good buy. It may not be tomorrow, and it may not be next month, but so long as the demand for that asset continues, the price will at some point increase back to (although in reality usually above) the replacement cost of the asset you own. If such an asset can be purchased that also produces income while waiting for the market correction? all the better. This is more difficult when valuing business assets if those business assets contain a large equipment component (as opposed to accounts receivable, intellectual property, etc) because the very use of those assets to create the income is also creating a decline in value in those same assets. This is generally not the case with real estate, although buildings do have to be updated on occasion.
Investment: Unlike the ‘Comparable’ method, an Investment valuation focuses more on the fundamentals of an investment, generally the cash flow produced by a particular investment. There are several different methods/equations used to determine an investment value, with many of them being specific to an asset type but related to similar methods/valuations in other asset types.
Times Gross: This is commonly used for business valuations and indicates that a business’s value is some multiple of the gross revenue of the business. Generally speaking this is used for high growth companies, often companies that are not even yet profitable. The calculation is simply Revenue * Market determined Multiple = Company Value.
Rent Multiplier: This is real estates’ equivalent to ‘Times Gross’ and is the purchase price divided by the yearly rents. Or conversely, some people may pull up past sales and look at the rent multiplier and then multiply their yearly rent by the common multiplier to determine the value of the subject property.
I personally think using ‘Times Gross’ and ‘Rent Multiplier’ as a method of valuation is ridiculous. Investors don’t put Gross Revenue or Gross Rents into their pocket. It is net income that determines an investor’s returns. Some geographies tend to use the Rent Multiplier more than other methods, but I always try to stick to my personal rules of investing, and they don’t include making purchases based on a calculation from gross revenue. However, I am happy to sell a property based on a multiplier if that is what the market wants. As a seller, the market determines how my asset is valued more than I do.
Times Earnings: A far better method (in my opinion) of valuing businesses is to use a multiplier based on the net operating income, or EBITDA, of a business since it is income we are all after. Note that this doesn’t take into account debt because the levels of debt of a business are determinant on the individual buyer or investor into a business and don’t directly affect the operating profitability of a business. Like the ‘Times Gross’ calculation, the Times Earnings multiplier is determined by other market transactions. Note that the multiplier indicates how many years it will take for an investor/business buyer to receive their full investment back as earnings. A business with $100,000 in operating income, with an industry standard multiplier of 5x would have a market value of $500,000. Thus, if a person paid $500,000 for that business, they are doing so expecting to earn $100,000 per year in investment income and $500,000, equivalent to their initial investment, back in 5 years.
Our stock investor readers are familiar with a term Price to Earnings ratio. This is essentially the same formula as Times Earnings and is calculated as the purchase price divided by the annual earnings, thus calculating the multiplier.
Capitalization Rate (Cap Rate): This is my preferred method of valuation for investment real estate. The Cap Rate is the annual operating income of a property (remember, not including debt, depreciation, or amortization, but including property taxes since that is an operating expense) divided by the market value of the property. Used another, and more common way, the value of the property is determined by dividing the annual operating income of a property by the cap rate to calculate the market value of the property. Currently cap rates range from 5% to 10% depending on the type of property, the location, the quality of the construction (factoring in deferred maintenance), etc. Higher cap rates may be found in some locals but would indicate that the property is in a severely distressed state. As an example, a 5% cap rate on an apartment building producing $100,000 in net income would indicate the value of the property is $2 million ($100,000/.05).
Note that the ‘Times Earnings’ calculation mentioned above is the inverse equation to the cap rate, meaning a 5% cap rate is equal to a 20x multiplier. This is calculated by 100/5=20 and 100/20=5. Likewise a 4% cap rate is equal to a 25x multiplier by 100/4 = 25 and 100/25 = 4. As an aside, if an investment is being contemplated into a property producing only a 4% capitalization rate (meaning a 4% return on a full cash purchase) there better be some serious non income factors for making that investment.
Yield: As mentioned above, yield is the measure of the cash produced by an investment. Certain types of alternative assets, such as notes, private bonds, or life insurance policies create a yield without the operations associated with businesses or real estate. Note that a cap rate measures the yield of a real estate investment assuming there is no debt involved with the ownership. If there is debt, the yield is calculated after the cost of the debt is taken into account. Yields are used to price items such as debt in that a buyer will want to obtain a certain yield for the risk associated with a particular debt purchase. If the outstanding debt is $100,000 and the note calls for $10,000 in payments, the note is written to produce a 10% yield. However, the value of the note may go up or down over the lifetime of the note. An increase in value of the note would result in a decline in yield while a decrease in value of the note would result in an increase in yield on the note. For instance, if the note increased in value (although in reality it is the stream of payments that is increasing in value), someone might pay $125,000 to obtain an 8% yield (10,000/.08 = $125,000). In the value of the stream of income loses value, then the yield may increase to 12% (as an example) which would then put the face value of the note at $83,333. Determining a market value for individual, or even small packages of, note(s) is even more difficult than determining value for real estate or businesses, and as such a determined price is even more so the common point where a seller will sell and a buyer will buy.
We use the above definitions and equations (and many, many more) every day and in relationship to every asset that we review. Experience obviously is a large part of any investor’s success but even simply understanding investing vernacular and how valuation occurs will put an investor far ahead of most their peers. Still have questions about any of the above (or other such topics)? Give me a call or drop me an email. I will be glad to discuss further.