D.R. Harris & Co.

What is your San Diego Real Estate Investment Property Worth These Days?  Interview with Jeff Grant Founder and President of Sand and Sea Investments.

 

By Daniel Harris, RIA, Wednesday February 24, 2016

[I interviewed Jeff Grant about the state of San Diego real estate from an investor’s point of view.  Jeff has an outstanding reputation in town amongst real estate investors for his honesty and work ethic.  If you are or want to be a real estate investor you should definitely consider giving him a call or sending him an e-mail which can be found on his website. ]

 

The after tax, after inflation on municipal bonds is about 1.9% a year and the after tax return on publicly traded real estate investment trusts are about 4% per year.  How does our local real estate market stack up to the after tax yields on those investments?

 

Jeff said that you should expect pretax returns of around 4% per year on investment properties in San Diego and after tax returns closer to 2%.  So what we are seeing in San Diego closely mirrors what we are seeing nationally and also in the bond markets – low returns across the board for income investments.

 

I’ve heard that if you move away from condos or single family homes you can increase your investment return – is that true in San Diego?

 

Not right now.  Because condos have high HOAs your monthly overhead is high and it is difficult to create above a 2% after expense and tax return in this market.  So many people think they’ll just go out to duplexes or quads to get out from under the HOAs – but those markets are just as competitive right now so you’ll likely only get a 2% return after all taxes and expenses in the smaller multifamily market as well.

 

How to figure out what your real estate if worth – do sites like Trulia and Zillow provide an accurate view of what you can actually sell your real estate for?

 

According to Jeff these sites are often “not very accurate” and that their weaknesses “keep him employed.”  There are a number of syndicated options and he thinks the best one at the moment is Redfin because they currently provide the most accurate estimates.  Zillow, he claims, doesn’t currently account for some real primary criteria such as the height of a building in a downtown condo, or the fact the property may abut a major highway, and it doesn’t fully account for quality of schools in his experience.  According to Jeff when they take a listing they look at least 5 of these sites and amongst the five sites they will usually see a range of 40% from the lowest price estimate to the highest priced estimate.  He gave an example that a property that he thinks is worth $1 million, one of the five sites will say is worth $650k and the other will say it is worth $1.3 million. 

 

If I come to you, how quickly could I get an idea of what I could sell my condo for?

 

Within a few hours.  There is no secret to valuing real estate.  It is valued either by its replacement cost (building a new structure), the income approach or the comps.  Downtown is pretty easy because there is enough market activity that they can quickly see what they think the open market will pay. 

 

In contrast, if you own a custom home out in Point Loma, the factors that come into play are the elevation, the year built, the ceiling height, the neighborhood ect.

 

Are there things an owner can do to increase the value of their property before they list it?

 

There are two things you can do to increase the marketability or value of your property.  First, you can remodel your kitchen or bathroom which statistically creates a 1.5 times return on your investment into the remodel.  Second, you can mention in the listing that you’ll provide a credit to remodel the kitchen (such as a $3,000 credit) which actually works pretty well.

 

If I’m a private real estate investor and have cash what are currently my best options in the San Diego market?

 

Jeff said that you’ll want to look at any changes in infrastructure or neighborhoods.  It’s very hard to yield above 2% after taxes and expenses in this market, but there is potential for appreciation in neighborhoods where there is a major change in infrastructure or something of that sort.  What you don’t make on cash flow you might make back later on better than inflation price appreciation.

 

For these neighborhoods that are becoming potentially more valuable but the market hasn’t fully recognized this, the best investor returns are likely in the $250k to $450k real estate.  The $1 million and up market doesn’t have the same fundamental safety as the entry level market presumably because less people can afford to live in or rent a $1 million house.  According to Jeff, the reason why the $250k to $450k range is a better investment is because lots of people can afford to rent those types of units, so there is a deep market for renters for this type of real estate.

 

As a seller does it make sense to sell with the appreciation we’ve recently seen?

 

If you bought in 2008 and want out now might be a good time.  According to Jeff’s studies the real estate cycle in San Diego lasts about 15 years but we’ve seen such strong appreciation he’s not sure if there is much upside left in this current cycle. 

 

Jeff says one way to do this for the long term investor, if they sell, is to stay outside the real estate market for 1-3 years and wait for another dip to hit and then try to take advantage of it.

 

How long does it usually take to sell an investment property in San Diego from when we first get in touch with you until when we get the money out of the deal?

 

We’ll list within a week and a half of the seller first getting in touch with us and once sold the buyer will have their money in 45 days.  The average property spends 28 days on the market.  Anything fairly priced is getting a lot of buyer attention right now.

 

What if you want to do a 1031 exchange – any advice for people in that position?

 

Those are tough right now.  The best part of the market from an investment point of view is at the $250k-$450k level, but for a 1031 exchange to work, you have to buy a more expensive property than you sold.  Most sellers with a 1031 exchange therefore need to buy a property that is worth $500k or more and that just isn’t a good part of the market for investment returns right now.

 

To generate an attractive cash flow currently you’ll need to improve the property and increase the rent.  The deals that will generate a return and work for a 1031 exchange aren’t the ones that you just buy the nicer investment property – you’ll have to put some effort into it.

 

What are typical financing terms for nonowner occupied investment property in San Diego

 

You’ll usually have to put 25% down and pay an interest rate of 4.50% on a 30 year fixed for the investment property.  Most deals are all cash right now – but if you finance, it usually won’t be through a big bank.  There are adjustable rate options too but for the investor a fixed rate loan is better because it makes your expenses more predictable.

 

 

 

 

Business Valuation and Succession for the $1 million EBITDA and up company -- interview with Todd Poling, Founder and President of Vantage Point Advisors. 

 

by: Daniel Harris RIA, Monday February 22, 2016

 

In our view, Vantage Point Advisors is the first firm you should be talking to if you own a business that pretax profits in excess of $1 million per year and you are thinking of selling in the next decade. 

 

You can get Todd’s e-mail from his profile page at Vantage Point

 

Todd is a CPA and is a member of the American Society of Appraisers.  He has experience at a Big 8 accounting firm, he served as a managing director of CBIZ Valuation Group (a national firm), and he has also worked as a general manager for a private company – so he’s seen all sides of business valuation.  Todd started Vantage Point Advisors in 2005, and this local firm has since expanded nationally to have offices in Los Angeles and Philadelphia. 

 

What jumped off the page to us, when we interviewed Todd was how well he actually knew the financial industry and the way public companies see the world.  He also impressed us with how creative he was in proposing ways the make a private business more valuable to a public or large company buyer (who make up the majority of buyers for companies with revenues of $15 million and EBITDA above $1 million).  We believe that if you work with Todd – you will probably earn a several fold return on the consulting fee you pay his firm.  His fees are reasonable and in line with the industry as well.

 

Vantage point provides a range of valuation services to companies with between $1 million and $500 million in annual revenue.  They have clusters of clients in the $1-$10 million range, the $50-$100 million range and then a few clients closer to the $500 million range.  So they are in a position to see the industry from a very broad perspective – which is exactly what you need in a valuation firm.

 

We think if you are your family have a business with greater than $1 million per year in EBITDA – you absolutely need to talk to him as your first step in considering selling your business.  As a valuation expert, he can tell you, without bias, how you will be perceived by a public or large company buyer and what your options are.  More importantly, he can show you how a few small changes might significantly change the buyer’s perception of you – allowing you to potentially get a much better deal in an exit from the company.

 

 

Now, I don’t normally give such a long introduction (or provide a transcript of the interview mostly in its full form) – but I think he deserves it.  On 2/19/16 Todd and I had a talk about what a company with $1 million + in EBITDA (pre-tax profit) can do to make themselves attractive to a large or public company buyer. 

 

Can you tell us a little bit about the client’s you serve?

 

“Our client list looks like San Diego with lots of venture backed development stage companies where we value the stock options up to companies with $150-$200 million in EBITDA”

 

[EBITDA is your pretax profit or stated differently, earnings before interest, taxes, depreciation and amortization]

 

What kind of clients do you do valuation work for?

 

“We probably [do] 2/3rds of our work with traditional businesses – you know, closely held family businesses that are close to sale or in a sale or private companies where they have a specific valuation need whether they need to value their debt, or some warrants, or a purchase price allocation or something like that.  I would say probably 1/3rd are venture backed type technology or biotech companies.”

 

Do you guys work for your clients more on a transactional basis, when there is a sale pending or are you always involved in some capacity for their valuation work?

 

“The best way to think about it is that we’re just purely just a financial valuation firm.  And that is important because we’re not an accounting firm and we’re not an investment bank or business broker that is actually selling companies and representing companies for sale.  We purely come in on a consulting role to value a business or a business interest. 

 

Why we do that varies depending on the company’s need and generally the type of business or stage of development of the company will dictate what their needs are.  For example, for venture backed companies like we talked about it is almost always a stock option or some type of financial reporting need…they’re not coming to us and saying ‘gosh we’re thinking of exiting in five years what might the valuation be.’  Of course the venture backed firms are thinking about exiting – they’re VC backed – they’re going to go public, they’re going to get bought or they’re going to fail.”

 

How does a traditional family held businesses end up using valuation services?

 

“You get into your traditional closely held [often family] business which might be as little as half a million or so in EBITDA up to tens of millions or more in EBITDA and the issues they have around valuation are completely different. 

 

They may have a buy-sell issue where a shareholder is leaving.  They may have a family succession planning problem or opportunity where dad is trying to transfer 20% interest each year for five years to his son or elements of the family or maybe some internal family and some external not related management team.

 

ESOP’s, of course, are their own animal. 

 

[They also do valuations for] shareholder disputes, ‘I think I want to leave the company and I think the value of my shares are worth 10 and you want to stay [at the company] and you think they are worth 5’.  The buy-sell agreement says that you need to have an appraisal of the shares done – so we’ll come in and value the shares.”

 

Finally there is “real estate appraisal and fixed asset appraisal which we do not do.  Sometimes it is a subset of the business valuation where there may be a real estate appraiser involved as well where we just partner with them”

 

What about a public or large company exit for these closely held businesses?

 

“The company says – we’d like to think about an exit in the next 5-7 years and we’d like to sell for $50 million and were interested in

a) what is the valuation today and whether we are in shouting distance of that type of exit and

b) more importantly, what the company needs to look like 5 years hence in order to command that $50 million valuation.”

 

Do you do these valuations in a one off way – or do you stay with the process all the way until the sale of a closely held family business?

 

“It depends on when the client comes to us.…every week I’ll get a call from someone in a family owned or closely held business – nice companies, good companies, companies that are on buyers radars or it’s a competitor or a high net worth individual that wants to buy a business or PE [private equity] firm – these are good companies that are names people know.

 

And they say to me – ‘someone is calling me and is interested in buying our business and they are offering me 4 times cash flow which is $4 million – I need you to do a valuation for us’

 

…and I’ll say ‘we’re happy to do it – the best we can do is provide you an analysis that will give you a reference point to evaluate the reasonableness of that $4 million offer’

 

…but you’re dead in the water as a seller because your only negotiating leverage [the owner has] is to say no because you haven’t been proactive and the buyer is in control in that context. 

 

In that case we may do the valuation, we may help them along a little bit in the negotiation although that is typically when I introduce them to a business attorney because now it is more about deal points – you set the price and we’ll set the terms.  They may get their $4 million but what if it is 75% in an earn out – they may lose control of everything. 

 

Is there a way for the family to be proactive about the process and give the seller actual leverage in the negotiation?

 

“So any [business valuation after an offer] is a little less useful than if somebody comes and says we’re finally getting serious about this thing called an exit and we want to

 

[1] plan ahead

[2] want to time the market the best we can

[3] we want to build our business to sell

[4] we want to really clean it up and tighten up our management team

[5] diversify our customers geographical mix or concentration if we have that problem

[6] start to identify who some of the proper buyers might be

 

In that case – we’ll do a two phased analysis where we do a current valuation but also a pro forma, sort of reverse engineered exit date evaluation.  We’d probably spend 2/3 of our time on the exit date valuation as opposed to the current date valuation because they’re not selling the business today.

 

…It’s no different from modeling someone’s portfolio who says I want $10,000 a month in income 20 years from now – you have to have that number of what they want before you can show them what they need to be doing now”

 

So basically the seller comes to you and says I want to sell my business for x amount and you walk them through the steps of what they have to do so they could actually sell it for that amount?

 

“Yeah – that’s right.  We say in order for you to get $50 million five years from now, to keep it simple, you’ll need $10 million in EBITDA if it is a 5 times EBITDA type business.  And if you’re at 25% EBITDA margins and then it’s just doing the math and then you can build a trajectory around the business to get there then it gets interesting because you start to identify things like – wow – that’s a growth rate that we can’t even think about achieving with our current scale and team so we have to think about acquisitions or really bringing on capital to augment what we are doing or doing different things.

 

And then there is risk, you are now talking about a different business.  [After seeing what it would take to get the exit you want] you might ask yourself would I rather have a $30 million exit with modest risk than the potential for a $50 million exit with a lot of risk that may tip me over and I might not get anything. 

 

That’s the best case scenario – someone comes in early and we might work with them on an annual or even quarterly basis – we won’t be the only one on the advisory team…there is probably an operational consultant…if you don’t have a board or an advisory board you probably need a third party keeping the management team honest and probably revisiting or at least making sure your tax planning is in order because it is cash in your pocket after taxes that matters most so you are building a business that will have a preferential tax strategy after the exit.  Then a financial advisor, a guy like you who is there at the end as well.  It all has to get married together.  Those are great projects because we can have influence little by little and update the analysis as we go.

 

A year later when we are doing the first annual update, we look at their projection and they have a five year projection and a discounted cash flow analysis and we realize they are three months behind plan on revenue and the reasons are all the things you always hear: ‘well this customer did this and that customer did that and Sheldon left and blah blah blah.’ 

 

Well didn’t we sort of know that?  Don’t we all lose customers?  Doesn’t every project cost more and take longer than you thought it was going to – so if that is the case why aren’t you modeling that in? 

 

And then they realize that they have to stretch it out and with their modified plan [and now] it’s taking them three years what they hoped to do in two.  Well, that has a huge impact on value.  

 

But most of the time companies wait too long until someone has called them and that’s natural – you’re busy, you’re working hard, you’re growing your company – you’re not spending as much time on housekeeping and strategic things as you should be.”

 

Who is the optimal client for this proactive accountability to get a family business ready for sale?

 

“It doesn’t really matter how big the company or how long they have been around or anything.  They need to be a real company…one that is at or reasonably close to $1 million in EBITDA – and that’s not because of us – it’s because the cost of buying a business with diligence and research and from a brain damage standpoint is significant.  It’s probably not much harder to review a company with $2 million in EBITDA than one with $500,000 in EBITDA.  In fact, you can make the argument that it is probably easier because the data is better, you’ve got a smart controller and assistant controller in a $2 million EBITDA company, the owner is less important, you probably have a compiled or reviewed financial statement as opposed to quickbooks.”

 

[After that] it’s on a case by case basis – the ideal client is someone who will give themselves time to model and mold their business into something that is really appealing to a buyer. 

 

….As an owner or leader any time you get your status quo challenged it is probably an effective exercise.  Going through that process will help the owner identify, and I say that carefully, we’re not the ones who say you need to upgrade your management team – we’re the ones who come in and recognize in the course of the valuation…and we help the owner recognize that they’re going to need a different team to get to the point that they want to get to. 

 

And they’ve all probably known that at some level but they are loyal and they’re busy and its hard to change and they kept a person too long or they really need a $250k CFO not a $175k hot shot controller.  They’re trying to save 75 grand, but they are never going to get to the other side of the bay without that CFO.  So, I think we help them understand and identify some of the issues that are going to be impediments to getting to the exit that they want.”

 

What are the things that you see holding certain businesses at lower valuations?

 

“The usual suspects are team, competitive position in the marketplace whether it is customer concentration, geographic concentration, and things like that.  You’re [usually] going to need to grow beyond your current range of fullness in order to get to the valuation that you want to get to.

 

That always then changes the discussion around capital.  You realize your bank is probably not the right bank and they may find out that they have a bunch of SBA loans, just as an aside, wrapped around owner occupied real estate – it’s going to cost them an arm and a leg to get out of just in order to upgrade their banking relationship.  And they are like “oh man” right?  So it’s a lack of flexibility in their banking relationship.  Maybe they need to bring on outside capital in the form of real equity.  Those things always come up and then challenge the management team to think or rethink what they are doing along those lines so they can position the business to get to where they want to get.

 

The last layer of the onion is that risk.  I mentioned that a few minutes ago.  They may go ‘gosh, you know what, on second thought, I don’t really want to sign up for that’. 

 

It’s kind of like some of these athletes that are great in high school and they go to Kentucky to play basketball or Texas to play football and realize they should have stayed closer to home.  It just doesn’t work for their personality.  So then you have to say, well, you’re going to need to scale back your expectations and that’s ok.  The beautiful thing about owning a company is that you can do what you want.  Nobody is going to fire you because you don’t want to grow the business at 20% per year

 

….Maybe you want to bring in a team and say ‘you know what – I’ve reached my limitations and I need to bring in a team in order to get to that next level and I’m ready to do that now.’  Those are the kind of conversations that invariably come from a [business] valuation and they have nothing to do with valuation – none of those things have anything to do with valuation.  They’re byproducts of going through the process and recognizing where you need to be in order to get to that next step, and the following step, so that you can get to the exit you want. 

 

Is the exit typically a public company buyer in the same industry, is it a financial buyer or is it usually a private company buyer?

 

“That’s an interesting question.  It is almost always not an IPO.   Very few companies go public for fairly obvious reasons.

 

…There are basically more or less four different paths [an owner can take when considering an exit]”

 

“One is sell to a strategic [a buyer from your own industry], two is sell to a financial buyer [like a private equity firm], three is an ESOP or some kind of a management buyout thing, which is an internal transaction, and four which a lot of times owners don’t ever think about is maybe the best transaction is not selling”

 

“We spend a lot of time helping the [management or ownership] team understand what they have so they can evaluate what they might get and I think that’s lost a lot of time on people where they think about ‘man if I’ve got a $2 million EBIDTA I might think I might get 6 times [EBITDA] from a strategic buyer, I’ll get 5 times from a financial buyer.’  Okay great – are you going to get cash in both of those deals?  Or are you going to get an earn out?  Is the strategic buyer going to give you stock?  Are they going to fire your entire team – is it worth $2 million to ruin 30 years worth of relationships?  Those are rhetorical questions that no one can answer other than the seller.  But they need to be asked. 

 

…Then you get into things like ESOP and go ‘maybe I’m only going to get 4.5 times [EBITDA] with an ESOP – [but] if I’m an S Corp ESOP – I’m not going to be paying any taxes – it’s on a pass through basis.  In California that’s a big deal - if you are clipping along at $2, $3, $4 million in EBITDA – what are you paying – 60%?  So [the corporate taxes] goes away [with the use an S Corp ESOP structure] so your 4.5x is effectively a 7 or 8.  It not cash in the bank today – you’re going to take a note back and all these other things but it is something to seriously consider. 

 

…Then there is the option to do nothing for now.  If you are getting 5x EBITDA in a sale and lets say it’s a cash deal so you get $7.5 million, but there are some transaction costs so now you got $7 million and there are some management people you want to take care of – but you gave up a business that was growing and you were happy and you had a whole bunch of tax benefits because you were running a whole bunch of garbage through the company and, and, and, the list goes on. 

 

So you go ‘gosh, you know if I just keep my company I’ll get that $7 million if I do $2 million of EBITDA this year and $2.5 million next year and $3 [million] after that – I’m going to get my $7 million after tax back in four years and still own my company.

 

What about a market timing element – are certain businesses in demand at a certain time?  Does that impact this process at all?  For example – using a public company example – what is an oil company worth in 2006 versus an oil company today?  Does that come into the private company valuations in your modeling estimates?

 

“Yes!  And that is a thing that I think is really understated and under appreciated.

 

…Assuming you have liquidity and estate planning set up so time is on your side, you can time the market [as a business owner] in just about any industry. 

 

You’ll see over the course of a business cycle a 2x or maybe even a 3x differential in multiples [a multiple is the number times your amount of pre-tax profit that equals company’s market value or worth].  If you are in the restaurant supply equipment market you might be in a cycle [where you are worth] 2 times [EBITDA] and you might see a [multiple] of 5 or 6 times in the cycle.  If you know that is coming, why would you ever sell at 2?  Why wouldn’t you say let’s build my plan so I can get as big and fast and strong as I can, as soon as I possibly can, then recognize when I’m getting close to that peak and the multiples are getting close to the 4s and 5s that’s probably when I want to press the eject button.”

 

[Todd is basically saying you should wait for good general market conditions to sell.  This is exactly what investment bankers and private equity sellers do when clustering IPO’s in mid to late bull markets when there is strong buyer demand and holding back IPO’s when market conditions are negative for a given industry]

 

As an almost final question, I see your firm does some work valuing assets in family limited partnerships – can you talk about that a little bit?

 

“On family limited partnerships and discount studies… [they value discounts] on portfolios of business interests or business real estate. 

 

For example, someone may own 10 apartment buildings all in separate LLCs.  Let’s just say each one of those is worth $10 million in asset value or $100 million in total.  If they gift a 2% limited partnership interest in the Master LP, it’s not going to worth $2 million.  It is going to be worth $2 million less discounts for lack of control and lack of marketability.  So we’ll do that valuation analysis that provides the discount study to the $2 million, pro rata interest, which might be 40% in total.  So it might get discounted down to $1.2 million.”

 

What about Grantor Retained Annuity Trusts – where you zero them out after a couple of years – do you do that as well?

 

“We do that.  There are usually three people at the table when that happens.  There is usually a trust attorney or estate attorney, there is usually a tax CPA, and a valuation firm.  And we do the appraisal element which is the discount study, the estate attorney does the estate planning work, and the tax accountant is just sort of their in the middle.  We’re not qualified to do the legal or the accounting.”

 

Thank you for sharing your insights with us

 

“Your welcome.”

 

 

 

 

“Does it make sense to index treasuries?”

By Daniel Harris RIA, Saturday February 20, 2016

 

Index funds have made a big push into the bond markets in order to save costs for investors.  What most investors don’t know is that the index fund is often dramatically more expensive than going direct and buying the bonds directly from the government through an online brokerage firm.  You can usually buy your government bonds for free from an online brokerage firm and have no costs of maintaining an automated bond buying program often called an “automatic roll” where when one bond matures, your online broker buys the exact same bond the next week at the next auction.

 

By contrast, the latest trend in this is the tremendous growth in the assets under management of the very short-term US Treasury bond ETFs.  These funds generally hold treasuries that mature in less than a year and most the bonds in the funds mature in the next 3-6 months.  These funds pay an after expense yield of only 0.10% and cost 0.15% per year to operate (to buy a security that the government will sell to you without any transaction costs). 

 

Additionally, if you buy through an index fund you’ll also have to pay a standard brokerage commission ($7 or so) when you buy and sell these ETF’s.  These funds have seen tremendous inflows – having drawn in roughly $2 billion in client money in the last month or so which is an up to 80% increase in their asset base.

 

Index funds aren’t free – it’s just as expensive to send out a prospectus for a very short-term bond fund as it is for a stock fund.  You still need a major accounting firm to do the fund’s tax calculations and audit your books.  You still have legal requirements to comply with – as a result even in very short-term treasury bonds you have to pay 0.15% in fees in many cases even though you can generally buy their underlying assets without paying any transaction or maintenance costs.

 

For example, every Monday or Tuesday, the U.S. government sells a ton of short-term treasury bills at auction.  This past week the government sold $30 billion in 6 month Treasury Bills directly to the public.  Everyone gets the same price.  The most recent batch of Treasury Bills that mature in August of 2016, were just sold for with a 6-month yield of 0.21%.  In August when these bills mature – you can buy another set of 6-month bonds that will also likely pay 0.21% in interest.  So every year you are getting 0.42% in interest on your bonds – which is at least 4 times what you’ll earn on your money market account or a comparable maturity short-term treasury bond etf.

 

At online brokerage firms, there is generally no charge to buy treasury bonds so long as you buy them directly from the government at the auction and not from some other bond investor on the secondary market.  Usually you only need to keep $3,000 in the treasury bonds to get this service for free. 

 

Alternatively, people like me can always reinvest your maturing bond portfolios very easily at virtually no cost to you.  It’s so easy for me to buy at the auction that it takes virtually no work but it often more quadruples your yield compared to if you bought treasuries through an etf.  By using a person to buy at the auction you can make a conscious decision of whether to but the one-month, three-month or six month treasury bill based on the expected yield at that auction.  Or, by using a brokerage “automatic roll” program you select one of these maturity dates and the broker will automatically purchase the same maturity bond over and over again regardless of changes in yield until you tell it to stop.

 

How can your brokerage firm and I underprice the major index fund companies on your bonds?  Easy – every index fund has its own legal structure, which the investor is forced to pay for.  We don’t have these expenses – so we’re much cheaper or sometimes even free.

 

Now, the same fund company that charges you 0.15% for low yielding bonds, will probably charge you 0.07% for a large cap US stock index fund.  So you get stuck with higher costs on a less productive asset.  They aren’t being dishonest; their firm has higher costs in auditing treasury holdings because they are turned over more frequently so the audit takes more work.  So the legal procedures are expensive and not really justified when you can buy the assets directly through your brokerage firm and have $0 in transaction or maintenance costs.

 

Doing it yourself or through an inexpensive advisor for convenience will likely quadruple your annual interest received from 0.10% to 0.42%. The market is full of these little anomalies where you can save money by something slightly differently.

 

For some investors, particularly those who invest in private real estate, or need their money soon, maintaining a bond buying program is a good idea as we can precisely match maturity dates with when you need your money to make down payments or commitments to your real estate projects.  A very efficient bond buying program, using highly liquid and very safe investments will almost always boost the yield of your money while you aren’t using it, while taking extremely little risk.  It also saves you the time of having to find the bonds that fit your needs and putting in all the orders yourself.  If you’d like to learn more about our bond buying programs and what it costs (it’s super cheap) simply e-mail us and let us know of your interest.

 

 

“Why economic game changes are common but stock market game changers are rare”

By: Daniel Harris RIA, Thursday 2/18/16

 

One of the things that I find with a lot of clients who come to me is that they don’t really know the odds of the game they are playing.  To help you out, I’m going to lay out the odds of an investment loss if you invest in large U.S. company stocks.  These odds are derived from historical experience.  I’m going to talk about how severe the losses have been in the past and how common it is to lose money in U.S. stocks.

 

What are your odds that you make money in a given year investing in the S&P 500 (data is from 1926-2015)

 

Odd of making money in a given year: 74%

Odds of losing money in a given year: 26%

 

So, as you can see historically, you’ve had a nearly 3 in 4 chance of making money in any given year when buying the S&P 500.

 

If I lose money how likely am I to lose money in a given year and how much am I likely to lose (data is from 1926-2015)

 

Remember the odds are you make money almost ¾ of the time.  But what are your odds of a big loss?

 

In any given year, you have only about a 6% chance of having a loss of greater than 20% and a 94% chance of losing less than 20% or making a profit. 

 

Stated another way, in all years in which you lose money your odds are about 2 in 3 that you’ll lose less than 10% and 3 in 4 that you’ll lose less than 15%.  Even when you lose money – it’s uncommon to take a loss of more than 15% and its more likely than not that your loss will be less than 10% in any given year.

 

Odds of a loss this severe impacting you in any given year (out of 90 years of data 1926-2015)

 

0-5% loss in portfolio value in a given year: 6% chance

5.1%-10% loss in value in a given year: 11% chance

10.1-15% loss in value in a given year: 3% chance

15.1%-20% loss in value in a given year: never happened before

20.1%-25% loss in value in a given year: 2% chance (happened in 1930 and 2002)

25.1%-30% loss in value in a given year: 1% chance (happened in 1974)

30.1%-35% loss in value in a given year: 1% chance (happened in 1937)

30.1%-40% loss in value in a given year: 1% chance (happened in 2008)

40.1%-45% loss in value in a given year: 1% chance (happened in 1933)

 

Now you might be wondering – isn’t this an overly simplistic way to look at investing?  Are past returns predictive of future outcomes? 

 

While they aren’t a guarantee of course, they give you a pretty good idea of how prices have swung around in the U.S. stock market in the past and it’s historically been a pretty good predictor of future returns.  You’ll notice the really bad years are not randomly distributed – rather they come after periods of asset price inflation (1930 and 1933 happened after the roaring 20’s stock bubble; 1974 happened after the 1960’s stock market bubble and the craze for conglomerates; 2002 and 2008 happened in the aftermath of the tech stock equity bubble).  This is why we try to warn out clients to not overpay for stocks (or any other asset class) – because that is how you get majorly burned in investing.

 

You can get a string of bad years together – which similarly happens a lot after asset price run ups.  While a lot of investors are very focused on fees – we find that very few investors naturally focus on what actually matters – how likely they are to take a 30-45% loss in a given year.  Those losses really hurt, and while you recover from them, we really think that you should try to do what you can to avoid them where possible.

 

So what about those economic game changers…

 

While the odds are 74% that you’ll make money in any given year, and 22% that if you lose money, you’ll lose less than 15% of your portfolio value in a given year – the odds are actually high that you will experience a rare event in the real economy.

 

Here are some examples

 

• The covered period has seen 3 separate equity bubbles and collapses

• The covered period saw 30 Year US Treasury Bond rates range from  15.21% and as low as 1.58% (which recently happened in January 2015)

• The covered period has seen a period of rationing, has seen us temporarily losing in a major World War and fighting to a stalemate in two other wars

• The covered period has seen a nuclear arms scare

• During the covered period, the economy experienced deflation 11% of the time in five separate periods (1926-28, 1930-32, 1938-39, 1949, 1954) and we nearly experienced deflation in 2008

• The economy experienced hyperinflation (10% or more growth in the interest rates) 5% of the time and in three separate periods (1946, 1974 and 1978-79).

 

So what is the take away?

 

  I want to you understand that weird economic events like hyperinflation or deflation, low or high interest rates, rationing, wars, and other seeming unique events happen with a much higher frequency than we think they would. 

 

Alternatively, big stock market losses are actually much less common than we think. The historic odds are 91% that you will either make money in stocks in a given year or suffer a single digit decline in your portfolio value.  It’s for this reason that smart investors know that stocks are usually a good deal and the actual risk has been much lower than what we usually perceive. 

 

If you want to get our analysis on whether your odds of loss are higher or lower than these historical odds feel free to get in touch with us.