The parable of thirty dollars

“Why do Vegas resorts always smell like a pool inside,” Mark asked as his group of friends entered the Venetian.  Kevin was going to explain how the ventilation systems add aromatic oils to the circulation.  Humans are wired for smell and the resort likes relaxed guests.  Kevin’s attention, however, was drawn to the grand hallway with its perfectly polished marble floors from which fifty foot vertical roman columns rose to the grand arched ceiling covered in Italian renaissance murals.  They had all walked the Venetian’s grand entry a couple of dozen times in the past but it never gets old.

Mark wasn’t here for the scenery though.  His room cost a fraction of the retail price so long as he played four hours of Texas Hold’em a day.  The funny thing about that is that the hotel wont make enough money off of Mark’s play to cover his discount.  Unlike every other casino game, poker is a competition between the players, not the house.  The house only gets paid a fee for dealing cards.  Because of this, most casinos have done away with poker altogether.  It’s just not that profitable.  At least the Venetian still provided it.  Maybe the resort figured that guys like Mark bring their spouses or friends who help make up the loss on the room.  Regardless, Mark’s plan was to grind at the poker table until he won enough to cover the entire cost of his trip.  The mental focus and the competition does more for his mood than the aromatic oils.

Mark sat at a table with nine other players.  The dealer pulled a deck from the shuffler and sent two cards face down to each player.  The players carefully lifted one corner from the cards a half inch off the table.  This would let them see what they were dealt without their opponents seeing.

Mark was “under the gun”.  This means that during this hand, he would have to act first in each of the four rounds.  He’d be the first to check, bet, or fold.  Being under the gun would put him at a disadvantage.  The other players will get to see what he does before they make their moves.  They’ll get clues about what his hand might be before they play.  They’ll adjust their play to what Mark does.

Normally, Mark folds whenever he’s under the gun.  It’s not worth playing with such a positional disadvantage.  He’ll just wait a few hands until it’s his turn to be “on the button”.  At that point, his position will give him the advantage.  Besides, Mark believes its good policy to always fold the first half hour of hands.  He wants to watch the other players to profile their playing style.  The more information he gathers, the stronger he competes.

This time, however, Mark was dealt two queens.  He was dealt one of the strongest hands in Texas Hold’em.  The strength of his cards could compensate for his positional weakness.

He decides to play this hand after all.  Mark considers the scenarios that would put his queens at risk.  His first concern is the number of players at the table.  Big pairs like queens aren’t great against multiple players.  The more players, the higher the likelihood that someone will get lucky and beat his otherwise dominating hand.  He wants to be heads up against one other player, two at the most.  That maximizes his chances of winning.

At this table, $10 is considered a good sized bet.  Mark wants to scare off as many other players as possible so he bets $25.  Since the other players haven’t seen Mark play yet, they don’t know if his big bet means that he has a strong hand.  He might be one of those guys who always bets too much.  Still, at this point there is more value to watching him to find out as opposed to paying him to find out.  The next five players fold.  The sixth player, however, calls his bet.  He’s on the button and must be holding something he thinks has potential to beat a monster hand.  Maybe he thinks he’ll get a chance to bluff as a contingency.  Mark’s best guess in that his opponent is holding an ace with some other high card.  The remaining two players fold.  Mark’s big bet worked.  He’s playing heads up just like he wanted.

It’s time now for “the flop” where the dealer turns over the first three community cards.  Each player’s hand is made up of his two cards plus the three community cards on the table.  The community cards this time are the ace of clubs, ten of diamonds, and two of clubs.

Ouch, the one card Mark definitely didn’t want to see on the flop was an ace.  Remember, that’s the card he thought his opponent most likely held.  A pair of aces beats a pair of queens.  At this point, Mark thinks he likely has the losing hand but there are two more cards to come.  If one of them is a queen, he’d be in a great position to elicit a big bet from his opponent and win the hand.  However, there’s only a 8% chance that one of the next two cards is a queen.

Mark doesn’t want to bet but he worries that he has to anyway.  Not betting now after his big pre-flop bet would send a strong signal that Mark doesn’t have an ace.  If his opponent figured that out, he could use it against him.  Mark decides to semi-bluff here and bet another $50.  Maybe his opponent has a pair of Kings and this will prompt him to fold.  Or maybe this will make his opponent think Mark is holding a pair of aces which will could come in handy as the hand progresses.  No such luck.  His opponent called his bet.  If Mark thought this guy had an ace before, he really believes it now.  The pot has grown to $153.

Now comes “the turn” where the dealer turns up the fourth community card.  It’s the jack of clubs.  This changes things.  With that jack, it’s now possible for a player to have a straight or a flush.  If player had a king and a queen, then their hand would be ten, jack, queen, king, ace (a straight).  If a player had two club cards then their hand would be 5 club cards (a flush).  A straight or a flush would beat a pair of aces or just about anything else his opponent might have.  The turn just gave both Mark and his opponent reason to proceed with caution.

Mark double-checks his hand.  One of his cards is the queen of clubs.  He thinks that to have the winning hand, he needs the fifth and final card to be either a queen (making 3 of a kind for him), a king (making a straight for him) or any club card (making him a flush).  Mark knows there is a 28% chance that the last card will be one of those.  Based on this and the possibility that his opponent might also be able to make a straight or a flush, Mark decides he has around a 20% (1 in 5) chance of ending up with the winning hand.

With a potential straight or flush on the table, Mark decides it ok to not bet this time.  He signals that he “checks” (isn’t going to bet) and the play goes to his opponent.  Mark’s opponent isn’t sure whether mark checked because he’s nervous or because he’s laying some kind of trap.  He’s tempted to check (not bet) as well and see what the final card brings.  However, he decides that betting against Mark might help him find out where he stands.  It’s better to bet a little and lose now if he’s going to lose anyway.  So his opponent bets $30 back to Mark.

At this point, Mark has an important decision to make.  He could fold now and cut his losses.  After all, he thinks he’s 80% likely to end up with the losing hand.  He could call the $30 bet and hope for the best on the final card.  Or he could raise the bet and try to bluff his opponent off of his ace.

What should he do?

He’s most likely going to lose, right?  So take option A and fold?

It might seem counter intuitive but that would be a mistake.  It’s not because bluffing is better.  It’s not because Mark is worried that he hasn’t accounted for all of the possible outcomes.  This issue is that the pot is $183 but it only costs $30 to call the bet.

This means that by calling, Mark has a 20% chance of winning 6x his $30.  The 600% reward outweighs the 80% risk.  See why?  If he gets into this situation 100 times, then 80 times, he’ll lose $30 for a total loss of $2400.  However, 28 of the times, he’ll win $183 for a total gain of $3660.  His ends up $960 ahead after playing this scenario 100 times.  $3360 – $2400 = $960.

This is how Mark approaches poker.  Each move is an independent decision with its own cost-benefit-analysis.  It doesn’t matter what happened in the past.  He plays each bet as if he’ll run that scenario a million times keep the net.  That net gain or loss after playing the scenario a million times is called the expected value.  In any given hand, Mark’s actual gain or loss wont be the expected value.  However, over time, his aggregate gain or loss will become the expected value.  In this case, he’s most likely going to lose the hand but the expected value is positive.  In other words, over time the infrequent winners will pay for the frequent losers.  Thus, the critical question Mark asks himself is, “what move will maximize the expected value?”  Should he check, bet, fold, or raise?  It only matters which move maximizes the expected value.  It doesn’t matter how what his gut says.

Mark knew the $30 bet by his opponent was a miscalculation.  It gave Mark instant expected value.  He calls the $30 bet even though he’s most likely going to lose this hand.

The dealer turns over the final card, “the river”.  It was a seven of diamonds.  Mark didn’t get one of the cards he needed.  He knows that he has the losing hand now.  Of course, he’s not surprised.  He knew going in that this was a way more likely outcome.  After his opponent bets, Mark folds his hand.  His opponent wins.

Ok, this wasn’t the ending Mark hoped to see.  Still, he took comfort knowing that he played the hand correctly by calling that last bet.  He lost a battle but not the war.  The next time he’s in this situation where the reward outweighs the risk, he’ll do the very same thing — even if it means playing a hand most likely to lose.  Over time, as he does this, the relative few wins more than pay for the frequent losses.  Over time, he ends up ahead.  Predictably.

Isn’t that weird?

It’s hard for us to assess risk and to know how to trade reward for risk.  We’re so wired for self-preservation that fear tends to drive our behavior.  We tend to emotionally feel the same way about a 25% risk as we do about a 99% risk.  That’s why it feels wrong to play a hand that we know is most likely to lose.  We don’t emotionally connect with the fact that the greater reward makes playing that hand the most likely thing to bring a positive outcome over time.

Venture capitalists get this.  Their whole plan is to invest in lots of startups that are most likely going to fail.  Yet VC’s nonetheless increase their funds’ value over time.  How can this be?  Their few big winners cover their frequent losers.

Life is full of situations where short term risks, even ones unlikely to win, can pay off in the long term with a little persistence and a willingness to fail.  In 2016, the Oakland Raiders made 95% of their one point conversions but they made 71% of their two point conversions.  If those rates held, they could have scored around 8% more points in their season by just going for the two point conversion every time.  No team does that. Of course, there are other factors but maybe it’s worth reexamining the conventional wisdom for a team like that.

Maybe we’re missing opportunities because the risk motivates us more than the reward.  We don’t put ourselves out there.   We turn down a chance to grow because it’s uncomfortable.  We stay in our comfort zones.  We avoid change because we think of all the ways the change could be worse than the status quo.  Our emotions discount the ways it could be better.

Not only that, maybe we punish ourselves too much when we fail.  If you think about it, if we put ourselves in a position where failure was possible, it means we judged the reward to be worth the risk.  You can feel bad if you misjudged the risk or the reward.  You can feel bad about a mistake in your cost benefit analysis.  You can feel bad if you bet the farm on a losing hand instead of betting something you could afford.  You can feel back if you didn’t try to prevent the failure along the way.  But if you knew the risk, you knew the reward, and you did your best, then does it really make sense to feel bad when the failure occurs?  The failure was always on the table.  Why not feel proud for going for it?  If the reward really outweighs the risk and you consistently take the risk, you’ll eventually end up ahead.   This isn’t a self-help, positive thinking pep talk.  It’s cold, rational math.

Mark could have regretted calling that $30 bet but it was the right thing to do.  He took pride in making a good play without taking shame in the loss.  Sure, he lost that hand but when he eventually wins, it’s worth it.  Mark hasn’t paid for a Vegas vacation in the last decade.

 

 

 

 

Choice Humanitarian

Savings Box

The overcast sky cooled what would have otherwise been a hot and muggy day in the La Concha village in Guanajuato, Mexico.  Twenty women gathered on the dirt road as they did every week.  The Treasurer they elected to safeguard the key opened the plastic toolbox and removed twenty beautifully hand-knit pouches, laying them to the side.  The Secretary, also elected, then opened the village’s green ledger.  One by one, the Secretary read the names of the women who volunteered to participate in the village’s savings box program.  As her name was called, each woman took her pouch and deposited at least 100 pesos, the minimum amount they all agreed would be required to save each week.  The Secretary recorded the amount deposited and called the next name.  When everything was done, the President reported the grand totals to the participants.  The Treasurer then returned the pouches to the savings box and locked it.

This savings box program is a fundamental building block in Choice Humanitarian’s approach to rural village development.  First, it creates a reason for the villagers to gather every week to focus on developing their village.  This recommits them to work together to increase their standard of living .  Second, it creates a governance council for village development that the villagers themselves, not the humanitarian agency, operate.  The villagers elect their leaders and vote on the decisions.  Third, it creates access to capital.  A village will typically run a weekly savings box program for a year or two before using the savings to make small businesses loans in the village.   At that point, a villager can request a loan from the council that is funded from the pouches in the savings box.  Using the loan, the villager might start a small strawberry farm, purchase chicks to raise to chickens, or any other number of income producing ventures.  The savings box is self-sustaining from the interest on the loans.

La Concha has been with Choice for three and a half years.  They have diligently run the weekly savings box program that entire time.  Now, they have advanced to the point that they can finance small businesses.  Juanita, pictured below, runs the village grocery store out of a small cinderblock building.  She used a loan from the savings box program to cover the costs required by the government program that enabled her to buy a tortilla machine.  Her family grows the corn, cooks it in a wood burning stove, presses it, and uses the meal to create hundreds of tortillas a day which she sells to surrounding villages.  Prior to the machine, she would make tens of tortillas a day, only enough for her own village.

Juanita

This gives you a feel for how Choice works with a villages to fight extreme poverty.  Choice has evolved its programs over 30 years.   Today, Choice operates in a thousand villages across seven countries.  You can visit villages in Nepal that operate savings boxes in similar ways to Mexico, Ecuador, Kenya, Guatemala, Bolivia, and Peru.

It’s a grind.  Villages like La Concha are typically underserved by local governments and non-profit organizations.  Governments focus on urban development because it’s more cost effective monetarily and often in terms of electoral votes too.  Non-profits, for similar economic and access reasons, are likewise more likely to be found in small municipalities than in the rural villages where Choice operates.  These villages are typically sustained by small farms.  Village life is defined by coping with poverty.  There is little access to running water, medicine, sanitation, and often, a balanced diet.  One of the early exercises Choice does a village council is to ask the villagers to describe what success would look like if the village came out of poverty.  One village woman wrote, “I just want a dignified  bathroom”.

Choice sees itself as a sponsor for village development.  They design the programs and train the villagers to execute them in a way that is tailored for their specific needs.  The donations I’ve made to Choice over the years have largely gone to pay the salaries of full time in-country staff, often hired out of Universities in the state.  Choice staff members, hired at a ratio of one staff per village served, work full time in teams with the villages for five years.  When a village “graduates”, the Choice staff steps away from the council and the staff moves to the next village.  Successful villages then provide support and training to the new villages.

In Mexico, there is around a 70% graduation rate of the villages.  This means that 70% of the villages arrive after five years at a point where they would no longer be considered to exist in extreme poverty.  The have access to clean water, balanced diet, sanitation and other basics.  There are villages in Mexico who graduated fifteen years ago who remain transformed today.  In fact, Choice in Mexico has a waiting list for villages who have requested their help.  They no longer recruit.

Here is a picture of the staff at Choice headquarters in Mexico.  In addition to working with villages in their region, they oversee the work of the other several regions where additional staff work with villages.  Juan, the handsome man in the middle, is Choice’s director in Mexico.  What an amazing person.  With his doctorate in economics, he taught in a few Universities in Mexico before joining Choice to build the program there.  He has had such an impact in the country.  The villagers and the staff absolutely adore him.

Choice staff

One parting thought before I wrap up this post.  A couple of weeks after I returned from Mexico with Choice, I listened to this podcast episode that interviewed Joe Studwell about his book, How Asia Works.  Allegedly, Bill Gates named this one of his top 5 books of 2017 and required the agricultural division at the Gates Foundation to read it.  I’m adding this book to my list.

What struck me from the Studwell interview was his description of how land reform was successfully implemented by governments in East Asia to grow their economies faster than the West.  As I understood it, governments in East Asia financed small farm ventures in an attempt to leverage the available labor to produce higher yields than big agribusiness.  It worked and it made a significant impact on the GDP in these countries.  Studwell’s description of land reform reminded me of Choice’s savings box program.  The savings box creates a pool of capital for villages to finance small agribusinesses that put to work the underutilized available labor in the villages.  This in turn enables the village to produce income and escape extreme poverty.  What I heard described in Studwell’s book seemed like a variation on that theme, performed at scale by central governments.

 

 

 

 

 

First investing post

“I found an investment that might work.  It’s a single family home near Fashion Place mall.  A new investor had it under contract for $200k.  He found meth when he inspected it, got cold feet, and backed out.  Now the owner will sell it for $180k.  What do you think?”

call from a realtor friend two days ago

In my intro post, I said I’d first post about my trip to Mexico with Choice Humanitarian.  I actually wrote a draft for my first Choice post but I didn’t like it.  I need to start over.  In the meantime, here’s a post on one of my passions, investing.  These days, I get calls like this weekly.  Sometimes, the stories can be interesting.

My day job is in high tech but around three years ago, I got interested in real estate investing as a hobby.  My interest was more academic than anything else.  I just liked figuring out how it worked.  Probably too much HGTV.

Regardless, I came across and added this book by Gary Elred to my Audible library to help pass the time on my commute.  Listening to this book inspired me to do something we all fantasize about from time to time — making spreadsheets.  Amirite?

Over time, I read several more books, evolved my spreadsheets, and even did a small coding project to download and analyze real estate deals off the Internet.  I was probably spending ten hours a week on this new hobby if you include my commute time.  It was like playing a virtual investing game, like Age of Empires.  I’m enough of a geek to find this kind of stuff fun.  Sad, I know.  After a year of doing real estate thought experiments in my head and on Excel, I decided to leave the virtual investing world and enter the real one, no pun intended.

First, I attended a few real estate investor meetups in the area.  I remember these as mostly really awkward.  Half of the people there were new (like me) and looking to ditch their day jobs (not like me).  The other half were real estate professionals or experienced investors there to network.  We were supposed to introduce ourselves and network to make deals.   I’ve always been in engineering, not sales, so this was a bit out of the comfort zone.  I wasn’t even ready to jump into any deals yet.  I also remember noticing a common assumption that I thought was odd.  Meetings would start by someone telling the room that real estate is the only safe way to invest.  “Did anyone see the market today?”  If it was going down, it was proof of the central banks or wall street insiders preying on the little guys.  If it was going up, the bigger players were laying their careful traps.

As a guy who loves his day job, feels comfortable in the stock market, and was new to real estate, it was hard to identify with most of the folks I met.  My default position going in was that real estate was interesting but risky.  It was unfamiliar outside my virtual gameplay and wasn’t diversified.  Plus, it seemed surrounded by an industry of thousand dollar self-help seminars which always trigger the skeptic in me.  Even more, I’ve never been a fan of the bandit signs advertising that you can make $10k a month as someone’s intern (yes, they are bs).  It always seemed a questionable marketing choice to use a ‘ransom note’ as the aesthetic for your ads.

Bandit

In spite of my initial apprehension, I was able to meet a few interesting folks.  My first real estate deal was the purchase of two condos with an investor friend I met at an open house.  He’s a smart guy and has a track record of successfully flipping houses in the area.  For our partnership, he brought a seller financed deal, did the rehab, and managed the condos.  I contributed the down payment.  We split all the gains 50/50.

This deal turned out ‘meh’.  My spreadsheet said it would deliver 13% ROI comprised of cash flow, appreciation, and tax benefit.  However, I made a rookie mistake and neglected to account for the HoA fees.  That made the actual performance after 9 months closer to a 2% loss before tax.  The tax write offs paid for the 2% loss and even made me a little money by the time I sold my half of the partnership for the price of my original contribution.   To me, it was a good experiment and good learning.

My second deal turned out better.  I decided to try the BRRRR strategy which is to buy a distressed property, fix it up, and rent it out before financing it.  In theory, this gets you a higher ROI because the value you create through the rehab may be applied as part of the down payment on the mortgage.  Your amount invested is less for the same return.  In my case, this really worked.

As I completed couple of deals, I started getting introduced to more real estate professionals which in turn exposed me to more potential deals.  Now I could play my Age of Empires game on actual real world deals that my friends were making or that I might even have the option to make.  I probably analyze 3 deals a week, still not that many by the standards of my professional friends but pretty good for a hobby, I think.  It usually takes ten minutes for me to get a pretty good analysis.  Sometimes, there are interesting stories in the deals.  Fast forward to today and I’m getting regular calls/texts like the one that opened up this post.

Speaking of the meth house call this week, what is the right answer?

I had never purchased a meth house before but I know folks who have done it more than once.  It costs around $5k to hire a disaster recovery company to remediate the meth.  Once they are done, the house gets a clean bill of health.  Apparently, the house is also free of all mold, bacteria and many other contaminants.  Maybe that’s good enough for you and maybe it’s not.  A decision to never buy a meth house is a fine answer, IMO.  I feel like I’d try it for a really exceptional deal.  For this post, let’s assume we’re comfortable that the house can be adequately remediated.  Now the cost is $185k.

When I got the call, I happened to be on the freeway very close to the house.  I took the 10 minute detour to stop by.

house

The house was ordinary for the neighborhood which was mostly pretty well kept.  Comparing it to similar properties, it should sell for $260k and rent for $1.3k, data my realtor friend compiled.  At a purchase of $180k plus $5k in meth remediation and $25k of other rehab, the total acquisition is $210k.

Proforma

I’ve set up my spreadsheet to have assumptions entered in the blue cells.  In this case, I really only needed to enter the acquisition cost, after repair value (ARV), the expense ratio, and the rent.  The rest is pretty standard for the area.  To calculate the expense ratio, I had to look up the taxes for the property on the county assessor website.  I guessed at the insurance cost and figured $200 in reserves for repairs seems reasonable.  I also assumed that a future tenant would pay all utilities.

Expenses

So after driving to the property and doing some excel work, I’m about 20 minutes into this analysis.  We now have some performance metrics.

Metrics

You can google the terms if you’re curious or leave me a comment and I’ll explain.

You’ll see that the investor would have to put down $58.8k.  After all expenses are paid, this property is expected to yield $14 a month which equates to an annual cash on cash return of 0.3%.  That’s not awesome which is why my spreadsheet tags it as red.  I really want to see 5% cash on cash return or better.  However, keep in mind that the ROI is made up of more than just return on cash.  Believe it or not, this property would actually yield almost 20% a year for the first 5 years in spite of the low cash return.  More on that later.

The other thing to call out here is that the DSCR (debt service coverage ratio) is marked red at 1.02.  You really want that to be 1.25 or higher.  The DCSR is a number that gets higher when you have more income left over to pay your mortgage after you pay your expenses.  If you wanted to get a commercial loan on a property (which you couldn’t on this residential property) then the bank would require the DSCR to be greater than 1.25 because the banks have done research that suggests that properties above 1.25 DSCR are unlikely to default.  Even though we’re not commercially financing this property, I like to know what a commercial lender would think about its financial performance.  If a commercial lender would be concerned about default, I figure we should too.

Now that we have all of these metrics calculated, we can forecast the performance of this investment.  We’re still only 20 minutes into the analysis.

Forecast

Here’s where we see that there are some positive aspects of this investment in spite of the initial low cash on cash return.  The cash return does not account for the appreciation of the property nor the equity captured by buying the property at a discount up front.  To find the total return of a real estate investment in a given year, I add up all of the cash flow it generated in the past (accrued cash flow) and then I add that to the proceeds after selling the property and paying the selling costs.  In this investment, we’d get $95k if we sold the property after a year.  Our $58k grew to $95k which is a 63% return.  That’s mostly because we had 50k of equity by buying at a discount up front but had to give up some of that in selling costs.

Consider, however, how the 3.0% appreciation factors into the return.  On this $260k property, that’s $7.8k of added value in the first year.  That $7.8k adds 13.4% return to the $58k originally invested.  Do you see why?  The 3% appreciation is on the $260k value of the property, not the $58k down payment.

This is the magic of debt as applied to a real estate investment.  Some people say that debt is what makes real estate investing work.  Others say, pejoratively, that you can write your own ROI on real estate because of debt.  The implication is that the debt is a two edged sword.  While it does boost the ROI, it also adds risk.

Now let’s talk about the RRI.  Once we know the Total Return each year, we can calculate the RRI.  The RRI tells us what interest rate we got.  So in this example, we start with $58k investment and end with $145.9k after five years.  That $145.9k is what you would end up with if you put $58k into a savings account and got 19.9% interest each year for 5 years.  Hence, I consider 19.9% to be the annual yield for the first 5 years on this investment.  The icing on the cake is that the return can be achieved with minimal tax consequence.  This post is already too long to cover tax efficiency though.

One thing to notice is that the RRI goes down each year.  That’s again the magic of debt, this time working against us.  We can chose to minimize debt or maximize return.  As the debt is paid down, the return goes down as well.  The initial equity gain is also being amortized over a larger number of years.

After a few years, many investors will exchange their properties into more valuable properties.  This resets the RRI curve.  Alternatively, they may refinance their properties to pull cash out that can be invested elsewhere.  This also resets the RRI curve, increasing the debt, the ROI, and the risk.  I am oversimplifying a little because there are other factors but you get the idea.

You might say, “In the table above, we’d get 63% return by selling in year 1.  Why not sell immediately”?

This is where you get into an interesting debate between flipping a property or holding it.  It’s tempting in this example to just flip the property and take the $50k minus $20k selling costs = $30k of free equity on day 0.  There’s a catch though.  If you sell within a year, the proceeds are considered ordinary income to the IRS.  Depending on your tax bracket, another 20k of that 50k could be paid in taxes, leaving you with as little as $10k.  By holding, you eliminate most of the tax.

But for fun, let’s suppose taxes are the same.  Holding still wins for a reason that wasn’t originally obvious to me.  By holding, we end up with an asset that is appreciating and kicking off cash flow each year.  How do you compare the future appreciation and cash flow against a cash payout ($30k) today?

You need a way to quantify how much the future appreciation and cash flow are worth today.  This is called the Present Value of that future cash flow and appreciation.

The present value is the amount you’d have to put into a bank account (or otherwise invest) in order to draw the same amount you’d get from the appreciation and cash flow.  The present value tells you how much your future payouts are worth today.  That’s because if you had that amount today, you could invest it and get the same future payouts.  Make sense?

It’s like the lottery.  Lottery winners can take a lump sum payment today or they can opt to take payments over time.  In theory, the lump sum should equate to the amount they’d have to put in the bank in order to get similar interest payments over the same time period.  The lotto can pay you a million dollars today or $40k per year for the rest of your life.  Assuming some interest rates, the lump sum would have an equal value to the present value of the future payments.

All of this means that if we can calculate the present value of our future payouts then we should be able to compare that to the lump sum today.  That will tell us whether it’s better to take the lump sum or take the future payments.  That’s really the critical question to ask if you have a choice to flip a property or hold it.  Flipping is a lump sum today.  Holding is a set of future payments.  Use present value to make an apples to apples comparison.

In the meth house investment, the total return for the first five years is around $18k per year: (145-58)/5.  How much money would we have to put into a bank account (or invest in the market) in order to get $18k per year for 5 years?  To some extent, it depends on how much interest the bank will pay us.  If the bank paid 0% interest, then to get 5 payments of 18k, we’d need $90k (18 x 5).  If the bank paid 1%, we’d need $97k.

For this example, let’s be super conservative.  Let’s say we put the money in a bank account and got 0% interest.  The present value of those 5 future 18k payments is then $90k.  The value of taking the lump sum from flipping is $30k (minus taxes).  Holding wins.

So in summary, this investment makes more sense to hold than to flip and is expected to yield 20% in the first 5 years barring any 2008-style market correction.  However, it’s financial performance is still not good enough for a bank.  I take that as a good indicator that the investment is too sensitive to the economy softening or us miscalculating something.  I’ve analyzed other deals that can yield a 20% sustained return that a bank would underwrite.

In the end, I told my realtor friend that my opinion was to pass on this investment based on the numbers.  There are investments out there that mitigate the future financial risks better.  If you’re going to deal with meth remediation, you should get paid better for it.  To eliminate the red cells in my spreadsheet, you’d have to acquire the property for 170k including rehab and remediation.  Or you’d have to find a way to get $1550 rent.  Or you’d have to put more money down and take a lower return.  Or some combination.  If a good scenario existed to eliminate my spreadsheet warnings, I’d say go for it.

Introduction

I’m a pretty introverted person.

Some folks are surprised when I tell them this.  It’s because I have learned to turn on my “outgoing mode” when the situation calls for it.  However, deep inside, I’m a pretty private guy.  I mention this because starting a blog and writing this intro feel completely weird to me.

Why am I doing it?  This summer, I hit my 20 year anniversary at a high tech company.  It’s has been a fantastic place to work but I can’t believe it has been that long.  In tech time, that’s like 1000 years.

The day after my anniversary, I took an extended vacation.  Before leaving on vacation, a couple of friends at work challenged me to start a blog.  I can only assume this is because they know that I can be quite the blowhard and they would love to see me embarrass myself.

During the vacation, I had an amazing opportunity to spend a few days in rural Mexico with Choice Humanitarian.  The trip was truly inspiring.  I wanted to share what I learned there with my friends and family.  That seemed like a pretty good excuse to start a blog.  So the combination of being challenged by my friends, having a great starting topic, enjoying writing, and wanting to do something different have brought me to start this blog.

My first few posts will cover what I learned on the trip to Mexico with Choice.  After that, if writing the blog becomes engaging for me, I’ll delve into other topics that I find interesting: macro-economics, stock market investing, real estate investing, politics, computer coding, network security, STEM education, poker, parenting, or whatever else crosses my path.

At this point, I’m not sure how this blog will turn out.  Maybe it will be an interesting experiment that dies an early death.  Maybe it will become part of me and take me to unexpected places.  Either outcome, or anywhere in between, is fine with me.

If you find the content useful or have any feedback, please feel free to drop me a note.  While I’m doing this primarily for myself, I’d be really happy if others can benefit too.