By Gerald Tay (guest contributor)
I’ve received feedback, both positive as well as negative, on my previous article Property Valuation – Money Not Math. In that article I explained how many investors are playing guess work with their investments because they fail to understand how to get their yields right. I heavily criticised the current models of property valuation, which are what ‘experts’ sell as ‘wisdom’ to average investors – these models are outdated, highly controversial and inaccurate.
Putting my Net Worth on the Line
I dare put my money where my mouth is – my net worth backs my investment strategy. For 13 years, I’ve never lost money in any real estate investments and am financially wealthy because of it. Here’s the difference between Successful Investors and the “Gurus”:
Authentic Successful Investors (a.k.a The Master Investor): Investments contribute a major part of our net worth – We put our money where our mouth is and it’s what we love to do.
Self-styled Gurus/Experts/Millionaires (a.k.a The Losing Investor): Investments contribute little to his net worth – his investment activities are often hazardous to his wealth (playing guessing games in Investment Guru Land). He funds his investments and makes up for his losses using other sources such as business profits (running investment seminars), salary (real estate professionals), company bonus plans, etc.
In view of the above, it is in fact possible for you to build your financial wealth through investments – investments that are sustainable, smart and logical. I do not possess any special forecasting skills and neither do I consider myself lucky. All I did was to value my investments using science, logic and common sense, rather than play guessing games in Investment Guru Land.
If you agree with what I’m saying, read on.
What do rates of returns measure? Why are they important?
Shares, bonds and real estate are the main asset types available in the capital market. Volatility exists with all three asset types.
One difference between these asset types is that property is unique and the data on transactions is not computed on a daily basis. Shares and bonds have constantly updated prices, therefore making it easy for investors to accurately assess their performance.
In the real estate market, the situation is not so simple. Investors are never sure of the value of a certain property until the point at which they are about to sell or rent it. Property valuation methods are needed for estimating the most probable value of a property on the market.
Yields are important in a number of contexts:
- Property valuations can be made by analysing price and yields
- The returns from property should be compared with other forms of investment, and with other properties
- To evaluate whether property is overvalued and if a price bubble might be forming
Return on investment or property yield is one of the most critical components of the entire property investment process, and thankfully, working it out involves a fairly straightforward calculation.
Armed with these, your chances of success are significantly improved.
There is, however, one key principle associated with the process of investing in property that needs to be thoroughly understood, namely property yield, or return on investment (ROI) / Rate of Return.
Tip: “We don’t predict the future, but we do know that the next five years will not look like the last five years. That just doesn’t happen. Markets change. And our results over the next five will not replicate the last five. They never do.” – Gerald Tay
‘Rate of Return’ – This is the metric most used to compare different investments. It is expressed as a percentage because investment opportunities come in all sizes. Absolute dollars of profit do not allow for comparison, but a percentage is ‘relative’. The period of time measured is presumed to be one year.
The profits from an investment can come from income received during the holding period, and also capital gains from the eventual sale. Together, these are called the “Total Return”.
Always use the Total Return to compare investments. For example:
- Property buyers too often look only at the Net Rental Yield (NRY) and ignore the potential for capital loss/gain, Net Cash Flow after mortgage payments and interest, as well as the Time Value of Money.
- Total Return is based on initial cash outlay or total capital invested, not purchase price.
- A 4% Net Rental Yield (NRY) property is not equal to 4% Total Return on Investment.
What do these terms mean?
The ‘true’ Rate of Return is what most people’s understanding of it would be. People refer to it as the Compound Annual Growth rate (CAGR), Return on Investment (ROI), Return on Equity (ROE), Effective Annual rate, Internal Rate of Return (IRR), discount rate, or Annualized Compound rate. Essentially, these refer to the same concept. Different terms are used in different contexts.
Tip: ROI – Different people use different words to refer to the same thing, and use the same words to mean different things. Always clarify in your mind what is being meant, without preconceptions.
There are many different words used to describe the type of yield measurement being used in different situations.
Tip: When evaluating Property Value, Location is Mantra, and ROI is Key.
Critical Financial Ratios that Matter
It is risky to invest in stocks without having any prior knowledge of the financial health of the companies – the same applies for real estate. Knowing the financial health and profitability of your target is essential before you start on any property investment.
Financials such as profitability ratios, leverage ratios and the cash flow statements can be used to gauge the financial performance of a property. With the analysis of these ratios, you will be able to make informed and correct decisions for your investments.
Understanding how to read these ratios is the key difference between success and failure.
Tip: Remember that the ratios are not mutually exclusive.
Critical Financial Ratios to Value Property (Intrinsic Value)
By considering all of the above ratios, we derive the Intrinsic Value of the Property.
The Business of Real Estate
Tip: “Property investing is a business and should be run like a business… And if business is war, war is a business.” – Gerald Tay
All successful entrepreneurs understand the importance of managing their business by metrics. Metrics is simply a measurement of the day-to-day results of the business. The measurements are in the form of cash flow (raw numbers) and ratios. They are often used as comparisons, either to a previous period, to targets, industry averages or other investment asset classes.
Net Rental Yield (NRY) is used to compare the performance of property A versus property B versus property C.
Return on Investment (ROI) is used to compare the performance of Stock A versus Property B versus Bond B versus Gold.
Internal Rate of Return (IRR) is used to compare the Risk/Rewards of different types of investment classes versus targeted returns.
We shall cover these in greater detail in the subsequent articles.
By guest contributor Gerald Tay, who is the founder and coach at CREI Academy Group Pte Ltd, an organization dedicated to empowering retail property investors with smarter investing philosophy and strategies. He is a full-time investor with over 13 years of solid experience in building his wealth through Property Investment and is financially wealthy today.