Negotiation is a critical element when purchasing a property. Most of the time, the negotiation process in asymmetric. In the current environment, this is not always the case because banks own a large portion of the properties. Therefore, they don’t have the advantage that a traditional seller would have. Great negotiation techniques will not always give you a huge advantage because the market sets the general direction of prices.For instance, if you bought a house in 2006 and successfully haggled the price down below the market, chances are you still got a rotten deal! You are just a few thousand dollars less upside down than people who bought similar properties. If you are a great negotiator, don’t brag about it. If the person you’re dealing with finds out, then they will either avoid you or tighten up. Billy Beane, the general manager of the Oakland Athletics, was featured in Moneyball, written by Michael Lewis. He eventually got a reputation for drafting the most productive players and acquiring more value through trades. Once other general managers became aware that he was so savvy, they started avoiding him. This was amplified when Moneyball was published. This is not to mention the fact that richer teams eventually copied his strategy. If you are a small investor in a big market, chances are that you’ll never have to worry about your advantage becoming known. If you are the richest investor in a small community, then people will definitely pay attention to you. As a negotiator, the best reputation is no reputation. Don’t make ridiculous, low-ball offers. Also, when someone counters with a reasonable offer, then you should also do the same. The price you’re willing to settle for should be below your asking price anyway if you’re the seller. Remember, your property is not worth more just because it’s yours. When you are the buyer, this is something you constantly experience. The market data exists for a reason. It is critical that you have done your homework prior to the negotiation. When selling, you should know exactly what price you would settle for and aim to get a higher price. If you are the buyer, you should submit an offer that is reasonable but less that what you would be willing to pay. If your opponent cannot come to an acceptable agreement, then simply move on. Do not go past your limits. Just go find a better deal. Having a plan before you make an offer or list a property for sale will save you. Auctions exist for a specific reason: to obtain the highest possible price. In an auction, there are individuals that don’t have the discipline to “stick to their guns”. They get amped over the rising prices. If a price moves past your reserve when your trying to buy a property at an auction, then resist the urge to raise your bid (even if it’s just a little bit more). As a side note, think about this the next time you are buying a car from the dealership. Ask yourself, why is the auto retail business designed the way it is? Why not just have a sticker price just like Wal-Mart and pay that price? If the dealer can’t sell cars fast enough, then adjust the price. The reason is simple: to get you to say yes and pay too much! Using this car dealership example, take special notice when they will say that the deal will only exist for right now. This is, in actuality, never the case. The same is true for real estate. If you’re not satisfied with the current negotiation, than just walk away. There is always another deal. In addition, don’t be too focused on price while you’re conceding on terms. Returning to the automobile example one last time, recall the number of times that the dealership was willing to concede on one item to make up for another. “Sure we’ll get you that price, but we can only give you $3,000 for the car you’re trading in.” These types of deals can cause you to accept something that is clearly not in your favor. Most times, this tactic involves the dealership selling the car for an X dollars a month payment. In reality, you end up paying more because they will extend the loan term for an extra year (or two) and it leaves room for a higher sticker price. Finally, you must take an honest look at yourself. How well have you controlled your emotions in the past? How well were you able to treat each transaction, tenant, purchase, and sale as a business? Knowing yourself well is probably the best negotiation tactic when investing in real estate.
Category Archives: Investing
It’s obvious that not everyone is cut out for math. However, if you go into business, there are some important metrics that you should learn and understand well. Simple items that you should know include: your cost of goods, profit margin, sales per square foot, payroll percentage, advertising percentage, inventory turnover, return on equity, and liquidity ratios. These are very basic and fundamental, especially for product-based businesses. All formulas in this post work best for an annualized period.
Every industry is different. Some industries have a high volume of sales with low profit margins while, in other industries, the opposite may be true. As a business owner, you should seek to compare your business and strive to be the best in your industry. Obviously, a mini-mart will have a lower profit margin than an upscale restaurant.
First, you must know how much your goods cost and make sure you are making a healthy profit margin. You costs of goods are calculated by:
Cost of Goods = Beginning Inventory + Purchases – Ending Inventory
Relying on intuition alone here doesn’t cut it. Many small product businesses do this. Intuition can be misleading because a lot of money can be spent on materials that remains tied up in inventory at the end of the period. This may lead you to think you’re overspending when you’re actually very profitable.
Next, business owners need to know their gross profit margins. The profit margin on your products accounts for all operating expenses including labor, rent, utilities, materials, etc. It is calculated as follows:
Profit Margin = 1 – (Cost of Goods / Sales of Goods)
Keep in mind that a small percentage can make a world of difference for many businesses.
Next, how well are you utilizing the space in which you rent? Sales per Square Foot is a good metric to analyzing this. Are there competitors that are able to carry as much product and make as many sales with less space? Here is the calculation:
Sales per Square Foot = Total Sales / Square Feet
How much of your total sales is paid for labor? How do you compare to other businesses in your industry?
Payroll Percentage = Total Payroll / Total Revenues
Advertising is an expense in which you can easily overspend in comparison with how much business the advertising generates. General advertising through traditional media is generally expensive and it’s usually impossible to pinpoint how much you are getting in return. Direct advertising, such as direct mail and pay per click online, is easier to quantify and understand its effectiveness. Similar to the payroll calculation, advertising cost is viewed as a percentage of your total sales:
Advertising percentage = Total Advertising Costs / Total Sales
How fast is your inventory turning into sales? Inventory turnover is a key metric in determining how fast your inventory cycle is. The faster you turn your inventory, the less time your cash is tied up. The calculation is as follows:
Inventory Turnover = (Beginning Inventory + Purchases – Ending Inventory) / (Ending Inventory * Number of Periods)
Many business calculate this based on 4 periods per year. That is, each period is one quarter. In general, the higher the inventory turnover, the better your cash flow is. You can usually improve inventory turnover through redesigning business processes and software.
Return on Equity tells you what your return is on the net worth of your company. This is a function of your profits and the difference between your assets and what you owe on them.
Return on Equity = Net Income / (Total Assets – Total Liabilities)
For return on equity, you should aim for a percentage that is at least in the high teens, higher if you’re in a fast growing industry. Be careful with this metric, however. A high number could be an indication that you are too far in debt. On the other hand, I feel that this is one of the most important metrics of a business.
Liquidity ratios are important in determining how well you are managing your short term cash. I tend to lean towards the conservitive side here. There are two ratios I want to introduce. The first is the Current Ratio. This is simply:
Current Ratio = Current Assets / Current Liabilities
I typically prefer to maintain a 2 to 1 ratio here. Some businesses, such as Wal-Mart, have consistent enough cash flows in which they can operate on a lower ratio. This is because the income they have coming in is very steady and is turned into cash quickly. There is nothing tied up in accounts receivable for long periods of time.
There are many business that build up inventory and accounts receivable too fast and the ratio between accounts receivable to sales increases. As a side note, before investing in a company (or buying a stock), always look at how fast inventories and accounts receivable is increasing in relation to sales. If inventory and accounts receivable are rising faster than sales, it should be a red flag.
The amount that you have in accounts receivable is important in two ways: 1) the actual balance and 2) how fast you typically collect on these. High balances with long collection periods may lead to disaster because the business still has yet to collect the money from the sale and it must buy new inventory and operate in the mean time. It can also be misleading because accrual accounting allows a business to book the sales as income prior to collecting the money. The important concept here is that a company’s management can decieve investors buy showing rapidly increasing sales when they are recklessly financing their customers.
The Acid-test Ratio is similar to the Current Ratio but it strips out inventory. This ratio should, for most businesses, be greater than 1 to 1.
Acid-Test Ratio = (Cash + Accounts Receivable + Short-term Investments) / Current Liabilities
When you use these ratios, you should compare them to other businesses within your industry. Some industries are more capital intensive than others and some have steadier cash flows than others. The more capital intensive and the more erratic your cash flows are, the more conservative you should be when financing your company.
In order to build wealth, you must first understand how money works. Most people do not. They prefer a good story and chase whatever is popular. Real estate was popular a few years ago. Now that prices have fallen to the point where you can actually make money once again, it is become very unpopular.
Real estate investing, when done the right way, is not such a fun and exciting process. It involves crunching numbers to see if a potential property makes any investment sense. When real estate was more popular, people bought houses and had to ‘feed’ that property each and every month. That makes no financial sense and should have been a red flag that there was something wrong with the market. Today, you can find properties that will give you over 20% positive cash flow on your investment.
In one of my favorite books, The Art of Contrary Thinking, Humphrey Neill says that when everybody thinks the same thing, everybody is likely to be wrong. This has long been a truth that has plagued people with investing. Psychologically, we are hardwired to be copycats and follow the trends. This is how we survived in the days before civilization. In the modern world, we have to be mindful of our heuristics; especially when to avoid using them. Those who don’t think ahead will continue to buy at the top of the market and sell at the bottom.
Now, I will get back to my point that real estate is a numbers game. Where does one start? I have a Cash Flow Analysis calculator that will get you started. You simply enter in the expected income, expenses, and loan terms. The mortgage payments are calculated for you and items that often get overlooked get factored in. One of these includes deducting a percentage of the rent to factor in vacancy time. Obviously, a property is not rented 100% of the time. Therefore, a 5% vacancy rate is included as a default value. If the average rate is higher in your area, you can change it to a higher amount.
Obviously, what you pay for an investment is crucial. If you don’t buy correctly, you will not have a good return on your investment. Using Cash Flow Analysis will determine what the investment potential is. This tool will calculate return on investment for you. If capital appreciation and tax savings are part of your strategy, our tool can factor that in also.
Building wealth involves saving and investing the right way. Warren Buffet has a strategy that involves getting a business for less than its intrinsic value. Using our Cash Flow Analysis calculator, you have one tool to apply to real estate that’s similar to what Buffet uses at Berkshire Hathaway. By entering the numbers, you will know if the property you’re interested in is undervalued or not.
There are value traps, however. You may find that a property seems to look good from a numbers standpoint. When you go physically inspect the property, it may be run down or it’s in a bad neighborhood. Therefore, this tool is by no means perfect. But, it can save you from overpaying and help sort out the financial data associated with a potential investment.
The Financial Philosopher blog had an interesting post in reference to the two different types of freedom.
“Freedom from” is described as a “negative freedom and it is based in fear because it is sought as relief from uncertainty or from restrictions placed on the individual by society (other people) and/or institutions (e.g. government, financial creditors). The pursuit of freedom from can paradoxically reduce or remove one’s freedom.”
“Freedom to” is “the healthy form of freedom because it is the form where the individual obtains the capacity to be creative, to act as the authentic self. When one obtains the means to be authentic, they are enabled to reach the highest form of productivity because their actions are purposeful and meaningful; thus the actions are self-feeding and self-radiating; therefore, the individual is happy by virtue of doing — they are free because they are acting as the authentic self, not because of a certain or pre-defined amount of financial capacity.”
The author believes that you can’t accomplish “freedom to” until you have accomplished “freedom from.” You can read the full post here:
Last week featured plenty of negative news but the financial markets still went higher. Rising oil prices, problems in the Middle East, Japan, falling home prices, and sovereign debt problems couldn’t stop the financial markets from going up. Walmart’s CEO has said that consumers should expect higher prices because of the surge in commodity prices.
The Federal Government faces a shutdown if no new budget is passed. The entire debate is over a drop in the bucket; about $30 Billion when our budget deficit is over a trillion dollars. David Walker referred to as “arguing about the bar tab on the Titanic.”
According to the Case-Shiller Home Price Index, home prices have returned to their 2003 levels. Home prices fell 3.06 % (year over year) in January. With high unemployment, high inventories, and the coming foreclosures, prices will remain depressed for some time and likely to drop even further.
In other finance news this week, real wages continue to fall and have not improved in over a decade. Wages have generally been falling since the recession began in 2007 and remains the current trend. This, combined with commodity inflation, is a big problem and will negatively impact consumer spending.
Josh Brown of the Reformed Broker believes there will be no QE3 and that the economy should be able to pick up the slack when QE2 ends. In an interview on CNBC, it was noted that banks are still not lending to the most important part of our economy – small business. Brown sees commodities prices going lower which should help consumers.
Stimulus vs. Austerity
The never-ending debate over stimulus vs. austerity wages on. This week, Paul Krugman fired back at those who often refer to the depression in 1921 as validation that austerity and a “hands off” approach by the government is always best. Although I generally disagree with Krugman’s magnitude of stimulus (he continues to claim that government stimulus and spending is too small), he brings up a great point that the depression in 1921 is far different from the Great Depression and the situation we are in right now. The depression in 1921 did not take place because of a credit bubble and was rather ordinary. Like a typical recession, this one was a function of the normal business cycle and had a v-shaped recovery. A recession/depression brought on by a credit crisis is different because the deleveraging phase usually takes years to get through. Instead of spending money, people will save and pay down debt instead. This is why historians are wrong in assuming that governments doing nothing will lead to a fast and painless recovery similar to 1921.
In the current environment, consumers are paying down debt while the government is adding debt. This trend cannot continue without serious consequences, but that is a discussion for a different day. We will eventually have to get our fiscal house in order, preferably before the bond market forces it.
Individual investors typically perform poorly when managing their own investment portfolios. This is evident in numerous studies in which individual investors collectively perform far worse than market index benchmarks such as the S & P 500. Prospect theory plays a huge role in investor psychology and behavioral finance.
The prospect theory value function shows that people are generally risk adverse and that losses hurt far more than gains (generally twice as much). An example of this from an investment standpoint is that investors hold onto their losses for too long and sell their winners too quickly. They lock in their gains for a winning stock while hoping for a losing stock to recover. To make matters worse, individual investors will often buy more of a losing stock by rationalizing that buying more is an even better deal. These tendencies that individual investors have has been described by Peter Lynch as “cutting the flowers and watering the weeds.”
Investors’ rationale for holding onto losers is that by selling, they will actually become losers. This implies that investors feel that ‘the game is not over’ until they sell the underlying security. This makes little logical sense because financial markets are liquid and the current prices reflect what another investor would pay. This means that if the market price is less than the purchase price, the position is already a loss.
The price that one pays as an investor should be considered a sunk cost and the price paid should never be used as a reference point. Instead, you should re-evaluate and judge the security in terms of its value and potential based on the current price. In most situations, individual investors would be better off if they sell their losses and let the winners run.
The 21st century has given us one bubble after another: dot.com stocks, real estate, and commodities.
Bubbles are driven by excessive speculation. In a recent article by John Hussman, he states, “we can think of a bubble as an advance in an asset’s price to levels that are “detached from fundamentals” – essentially, the primary motive for investing ceases to be the expectation of future cash flows or consumption, and instead centers on the expectation of further increases in price.”
When an asset has reached bubble status, the investment makes no sense because its high price cannot justify the return on investment from future cash flows. For example, during the real estate bubble, investors had to “feed” their properties. That is, they had to take money out of their own pockets to pay the expenses since their cash flows were negative.
Valuation is the Most Important Metric
Valuation when you enter an investment is the biggest determinant of your success. Buying an asset for less than its intrinsic value, as Warren Buffet describes it, is the basic formula for success. In the S&P 500 (or any other index), long-term bull markets begin at low valuations (usually with an average P/E less than 12) and long-term bear markets start with high valuations (usually with an average P/E of over 20).
The last bull market in the US started in 1982 and ended in 2000. Over that period, people started assuming that the stock market was an easy and guaranteed way to make a return of 10-15% per year. Currently, we are in a secular bear market that began in 2000. Valuations were at all-time highs and the trend was unsustainable.
Where do we stand now?
Currently, valuations are still high with the Case-Shiller adjusted P/E at over 24. They were reasonable at the bottom of the market crash in 2009 but the rebound has risen to the point in which the next 5-10 year outlook looks to be below average. The rally that started in April 2009, John Hussman, believes is basically a mild speculative bubble. A lot of what may be driving the speculation is the anchoring of the stock price peaks we saw in 2000 and 2007. This anchoring gives the illusion that prices are not all that high.
The Case-Shiller adjusted P/E ratio is based on average inflation-adjusted earnings from the previous 10 years. The chart below from multpl.com shows the Case-Shiller index since 1880. As you can see, the adjusted P/E was around 7 in 1982 and rose to nearly 45 in 2000. In 2011, we still stand above the long-term trend. The chart also illustrates how P/E ratios are mean reverting over long periods of time.