How can a simple metric be so meaningful and helpful?
Let’s dig into the two sides of this simple equation and let it guide us with some of our property investment decision-making.
Net returns on the top, with our ‘skin in the game’ at the bottom. This simple, yet often misrepresented calculation reveals so much.
Let’s delve into how to improve our returns and reduce our cash investment, whilst keeping an eye out for those 3 pesky little irritants lurking to become our undoing: time, risk and tax.
Enjoy!
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Transcription of the show
How can a simple metric be so meaningful and helpful?
Let’s dig into the two sides of this simple equation and let it guide us with some of our property investment decision-making.
Net returns on the top, with our ‘skin in the game’ at the bottom. This simple, yet often misrepresented calculation reveals so much.
Let’s delve into how to improve our returns and reduce our cash investment, whilst keeping an eye out for those 3 pesky little irritants lurking to become our undoing: time, risk and tax.
Enjoy!
Property Chatter
Hello, and welcome to another episode of the property voice podcast. My name is Richard Brown. And as always, it's a pleasure to have you join me again on the show today. Well, it's it kind of mid morning on Tuesday, if any of you who've listened, you kind of know, I'm sure or you might recall that I've mentioned the recording deadline is Monday, Monday evening. And sorry, Shiggy. about this, hopefully, I'm not going to put you under too much pressure. It may be getting you to turn this around fairly short notice. And sorry to you, by the way, if you're listening to this, and it's a little bit late coming out this week. The reality was, I wasn't feeling that great last night. And this is one of the risks of doing things last minute, which is my want, you know, like to do this podcast last minute, because I just kind of enjoyed the, I guess the so called pressure, finding what I'm going to say, an 11th hour. But yes, I just wasn't feeling that great. I went to I've started polities or restarted pill artist classes recently. And I think my pill artist teachers like a silent a Silent Assassin or smiling and sassy nicely. She just loves to put me through it. And I just felt a little bit overstretch probably wasn't feeling 100% wasn't really up to recording anyway, less of that. What do I want to talk to you about today,
I want to talk to you about something that I think is beautiful. And that's the idea of forcing the ROI. So return on investment is a financial metric. It's one that I use, and I'm sure many of you use as well, I'll come on to the definition in a minute and how we misuse it, including me a lot of the time, but I think a lot, you know, I would consider one of my strengths to be what I would call financial engineering. So it's looking at metrics, it's looking in and be able to evaluate investments, and then determine what to do based on some of those evaluations. So the metrics alone are just a guide. But then we need to take a decision. So the financial engineering combined with say, and, you know, accurate decision making judgment, you know, what can you do about it, once you've got that data, I think those two things combined is probably one of my core competencies, or two of my core competencies, depending how you want to look at it. So and that's why I think it's a beautiful thing. Because we can do so much with this thing.
So just let's just dwell on return on investment for a minute. As I mentioned, we it's a misuse term, including by me, but essentially return on investment has two halves to an equation, a top half and a bottom half. And on the top half, we have our returns more specifically, and net returns. So an easier one to look at, perhaps on investment, if you look at stocks and shares, dividend income would be a net income return on stocks and shares investment. And that'd be the top half of the equation, if we invested in in stocks and shares, and then the bottom half of the equation might be what is the cash that we've invested in the deal. That's how we misuse it. By the way, just to dwell on that point.
If you look at the strict definition of return on investment, strict definition says it's our net returns divided by the total value of that particular asset. And that's how we misuse it and property. Because we've we've applied that Well, we've re engineered or redefined return investment to be a net returns over our personal cash investment. And they're not the same thing as the total value of the investment or then they might not be. So with the two an obvious example is if we use a mortgage, so if we use a mortgage of 100,000 property, we've got a 75% loan to value mortgage, our personal cash is only 25,000 plus any fees, etc, that have gone into it. Whereas the total value investment is arguably 100,000. And I say arguably because purchase price and value are not always the same thing, especially as time goes by. But I don't get too complex into that. But the point I'm making is we return on capital employed, return on capital, or sometimes return on equity are perhaps better terms to use. But we always default to return on investment. That's, you know, the terminology we probably understand in property. I misuse it to probably you misuse it to there be people out there going nodding going there, Richard, you know, it's about time somebody said this. But yeah, so I'm using a misusing the term return on investment. But what it means is net returns divided by our skin in the game.
So skin in the game is our personal cash that we've left there invested into the asset. Now it's stocks and shares. Typically, the personal cash is what pay for the shares. That's what we've got invested in in those stocks and shares. But we've property as I mentioned, if you've used a mortgage, which in other words is leverage, our personal cash can be somewhat reduced.
So net returns over our personal cash is let's fli the purpose of this conversation return on investment. And the beauty is that you can actually play with both sides of that equation. There's only two sides. And you can play with both sides of the equation to improve your overall investment performance. And so the top half really boils down into two things. So-net, you know, returns in when it comes to property usually boils down to one of two things, our gross income, and our total costs, those two, boil down to our net returns, take take our total costs away from our gross income, and you're left with your net returns.
So it's pretty obvious the drivers of the top half of the equation, we even need to increase our return our gross rental income, or we need to reduce our costs, or perhaps a combination of the two. And if we do that, on the top half of the equation, we should get all other things being equal, we should get an increase in our return on investment. And that's a beautiful thing. And then the second half the equation, the bottom half of the equation, our skin in the game. So if we're starting, you know, just starting out with a property investment, our skin in the game will be the cash, as I mentioned, just forgive me, I'm using the term return on investment to mean, the bottom half of the equation is our skin in the game, our personal cash invested.
So you know, sorry, investopedia, or you financial people out there, I'm where I'm now also misusing the term return on investment. Maybe a better phrase is return on cash in this context, but there we go. So the bottom half of the equation is our personal cash invested, let's say that. So what drives our personal cash invested? Well, in the three main drivers, in my opinion, are in my mind, that wanting to share today, our discount. So if we get a discount on the asset going in, we honestly what else happens, we can probably reduce our personal cash invested in that asset, our property asset. So if we have 100,000 pound property, and we managed to get a 10% discount, for argument's sake going in, we can buy that asset for 90,000 pounds. What if it's genuinely worth 100,000, and we paid 90 for it? Well, first of all, we're baking in equity when I'm perhaps drifting off my point. But the main point being, if we've got a 75%, loan to value mortgage, then we only need 25% of 90,000, instead of 25%, of 100,000. So by definition, it reduces our cash invested. So discount is one of the obvious ones. So that's why so many people say you make your money go into the deal. So if you can drive a good bargain, just squeeze a little bit more discount out of it every single bit will increase your return on investment, because it reduced the bottom half of the return on investment equation, which will drive up your percentage returns. So that's a beautiful thing. And the next one that I personally really enjoy, I call myself a value adding investor. So discount is one way to add some value, we forcing the discount. The second one is really to add value through undertaking some sort of project, some sort of development, conversion added value activity in the project. So we can add extension to add value to increase our rental returns, and so on. So adding value is another great way to increase the performance. And particularly if you can add value and extract some of that value, usually by refinancing.
So I like to do a project, add value refinance to pull out some, you know, we all say all of our cash, but that's a unicorn these days to pull out all of your cash, and someone's gonna write into me go and I do that all the time. But you know, it's not that common in the current climate, to pull out all of your cash unless you're adding significant value. And by significant value, you know, usually that means doing something exceptional, probably development, probably planning related to be able to recycle all of your capital from an investment, or you've got a hybrid strategy, which you could sell part of the asset and retain parts of the asset, which can't do that on a single family home. But you could do on a development project where you've got multiple units, for example. Anyway, I digress, because I kind of my mind's racing with this particular concept, how we could financially engineer an asset to improve its performance. That's what I was thinking about. It's just something I spend my time on, I suppose. So there's two elements discount and added value.
The third one is, is leverage, quite frankly. So if we increase our loan to value, we or we refinance to extract some of our original value that we've added, during the course of a project, we can increase our leverage. And by increasing our leverage, we reduce our personal cash investment. But at this point is probably appropriate to say there's a couple of things to watch helpful when you're playing this financial engineering game, so to speak, I like to call it a bit of a game. But I think on the bottom half of the equation, one thing to watch out for is over leveraging. And so over leveraging, it can help obviously with the numbers, but it can also increase risk.
So the three things to watch out for one of which is risk and over leveraging and you know, refinancing costs Constantly to over leverage and just keep our loan to value permanently high will, you know will increase our risk position, quite frankly, you have to consider that property is the property market, like most of the markets is a cyclical market. And so we get highs and lows in terms of property prices, we get sometimes a correction, sometimes even a crash. Of course, some people investing today might not remember the global financial crisis, which just over a decade ago, and they just had the, you know, relatively good times for a consistent period. But it doesn't always go that way.
Trust me, there will be highs and lows will be corrections and will be crashes. Now, one of the things that we need to watch out for is not to be highly leveraged when we've got a crash, potentially a correction, because it can leave us vulnerable or exposed in terms of our deposition that time, by the way over leveraging. And when I say of leveraging I mean constantly refinancing and pulling out cash from our assets, which some people advocate as a great strategy because you don't pay tax on debt is in flawed is fraud in my opinion. And the reason I think it's flawed is it can make you trapped or a hostage in two main ways.
The first way is if you over leverage, particularly getting above the original price or investment, you've put into cash investment you put into the into that particular property, it could mean that if you were ever to sell, and by the way, you say, I'm never going to sell I'm never going to sell but you might be forced to sell, you might need to sell for some reason. And that's a risk position you don't really want to be in is that you could your capital gains tax bill could actually exceed your equity in some some circumstances. To be fair, that's probably where you've had extreme, repeat refinancings. But it could leave you in a position where you don't have enough equity to cover your tax bill, you don't want to be there.
The second thing that over leveraging can do is it can make you mortgage hostage as well or mortgage prisoner. And what I mean by that is, if you keep over leveraging and maintaining a high loan to value every say, two to five years for argument's sake, pulling out equity, and just going again, and when that inevitable property price correction or property price crash comes along, and you've got a high loan to value, you know, there's a couple of scenarios that you know, you might be faced with, you might need to top up your debt or pay down your debts, actually, to top up your equity at the request of a lender, and you might not be able to re mortgage out because you know, the market by definition might be squeezed, it might be a credit crunch. Lenders might not be lending, they may have reduced their loan to value requirements.
And you might be in a bit of a pickle. So don't really want to be in that place either. So big watch word on the the temptation as it were to manipulate the return on investment by over leveraging, and then constantly refinancing to do the same. So if you're going to do anything at the bottom end of the equation, that would suggest you stick with discount, adding value, extract some of that value to begin with, but then probably let the loan to value slide over time, which will put you in a better position if and probably when property prices will take a correction. So probably dwelt on that quite a while. Hopefully, you've that's something. But The other thing, watchwords, if you like in terms of the bottom half of the equation, our skin in the game part of the equation, what is tax taxation? And well, it's actually not just related to the bottom half of the equation, actually. It's it's the whole return on investment, attacking face. How should the top Richard, Get your facts? Right, it's more about the top end of the equation. So taxation will affect our returns. I personally don't measure my return on investment on an after-tax basis. But I should, I certainly have a watch worth a watch on it. And I just know that in general terms, I've managed my tax affairs pretty well. So kind of know what they look like, if there's a change in my tax position, it could quite significantly affect my after tax returns. So something that's worth, you know, keeping and keeping an eye on. And then the third one is time.
So very often, which is tempted to look at Well, I can make loads of money on this particular deal. My ROI is, you know, stellar, you know, it's it's double digit. It's, you know, data, and actually forgetting the fact that we're spending an inordinate amount of time to achieve that return. Of course, if we're spending an inordinate amount of time on investment is no longer an investment. It's actually a job or a business. And so we just need to watch out for the time that we're putting into it. And by you know, by words, we need actually to get better returns, if we've got to give ourselves another job. But by definition, most investments are not completely passive anyway. So there'll be some time that we need to spend, whether it's due diligence going in, whether it's monitoring and checking up and talking to whoever's handling our money if we're giving it to someone else, to you know, to manage for us. Or it's actually in terms of the transactions that we need to process, you know, before, during, and after the investment period. So time is a really important factor as well to take into into consideration.
And a bit of a watchword also, which is just a bit of a sidebar. So I'm kind of focused a little bit on going into a new property transaction, or a new property project here in most parts. And most of what I've been talking about is in that context, but perhaps just a brief, you know, call out that if you've got an existing portfolio, I have a portfolio, you many of you will have an existing portfolio, portfolio, it could be two or three properties, it's worth looking at the return on investment in, you know, throughout the ownership of our property, portfolios, and individual properties, obviously. And so in this context, I might replace the bottom half of the equation, our skin in the game, cash input with our equity instead. So I probably look at both. So I'll give you an example. A few years ago, I bought a property in rural Cornwall, small town. And, you know, it's not the Cornwall hasn't got many major cities anyway, but this has got, you know, fairly small town. And therefore, it was a bit sticky from a rental demand point of view. So if it did, okay, but inevitably, the tenants would rotate round about the summer and round about Christmas. And I just have an extended void period. It wasn't too dramatic, but it was just annoying was a bit of a niggle. And so, of course, voids is another area, which can affect our net rental returns, which has a bearing on our return on investment. So I was kind of looking at this and thinking, well, it's not ideal, really. And, and I couldn't really there wasn't massive rental demand, which would drive prices up, which would fill that unit, you know, particularly quickly. But one thing I noticed is that house prices are starting to shoot up pretty, you know, stable, or, you know, just a gradual increase for the first couple of years of ownership. And then there was a spike in growth over the last couple of years.
Talk referring back now to a couple of years ago, I actually took the decision to sell that property. And the reason I decided to sell that property was I looked at my return on equity. So not just my cash, I'd only left about 10 or 12,000 of my personal cash invested in that property. But meanwhile, my equity was substantially above 100,000 pounds, it grown in value over the time. And so my return on equity, as opposed to my return on cash was was not looking so compelling. And so I that is the moment about taking a decision. So crude only then see that usually what you find is your return on investment levels off over time as a bit of a seesaw effect, if prices go up, your return on investment can go down. If rents go up, your return on investment can go up. And so you get the sea soaring effect, as house prices move at a different rate of growth to rents. So don't be too hasty to cash in your chips or freak out about an investment if you've got to find a finding that just look at it over a period of time. But this particular property of mine in Cornwall, at the Cecil was a bit too, you know, lopsided if you like the capital side have gone, you know, great guns, but the income net ring rental returns on the income side of the equation weren't really getting that great.
So I took a decision to cash in my capital, and to reinvest it elsewhere in what I felt would give me a better income return, but also, you know, decent capital growth prospects to and they made that judgment call on the fact that rental demand in that local area in Cornwall was likely to increase anytime soon, I'm probably not going to get the income side or the net return side of the equation, you know, climbing anytime soon, it probably seen its greatest capital growth over the last couple of years. And whilst you know, there probably would be more over time, I wanted to rebalance that seesaw. So that's the decision I took and decided to, to cash in my chips. But also, and here's the thing, it does bring me on to so I've been focusing on income returns net, with net rental returns being on the top half of this equation on my return on investment. But we shouldn't avoid looking at Capital returns as well. And so the house price growth that I'd seen on that property in Cornwall had also given a massive return on capital as well. And so my personal cash input is a 10 to 12,000. I'd certainly got this capital growth. So my return on capital based on my own personal cash investment was just you know, it was probably four digit growth. So you know, double digit triple digit probably approaching if not four digit growth, and so that was absolutely stunning as well, but you probably couldn't maintain that rate of growth over the long term. So I looked at that too.
So you can look at your income But don't forget the capital returns. And if you reduce your bottom half of the equation, your cash investment your skin in the game, personal skin in the game, the capital returns can be quite significant as well. And of course, if you stick in property, for any period of time, you'll probably know that you're going to get, you know, your returns are going to be magnified from not just income returns, but also capital returns, many of us look at our capital growth over time has actually been the secret, the hidden gem sticking around, stick around long enough, and you'll see that, but sometimes you can force that capital, you can take it out, and you can put it into a better performing asset. And oh, some people say they're gonna hold assets forever, properties forever, excuse me, and never sell them after pay tax perhaps on returns.
But paying tax sometimes is such a bad thing, you know, so you can take it out. But the optimal period of time to sort of minimize your tax take, if I can say that, without getting too complicated, put it into another asset and go again, of course, it'll be transaction costs, there will be taxation, to take into consideration. So keep that in mind. Anyway, so, um, hopefully is coming over that I think, you know, return on investment, this financial engineering, and then deciding what to do with individual properties and properties within our portfolio. You know, looking at both sides of the return on investment equation, taken into consideration those, those Watch out thing points of taxation, time and risk. And, of course, taken account of our capital returns, as well as our income returns, put it all together, and it really is a beautiful thing. So that's what I wanted to talk to you about today. That's on my mind, that's my heart. I hope it's been interesting. So obviously conceptual, you know, the, the financial metrics usually involve a calculator or a spreadsheet. So you need to translate the concept into practical, then, of course, it just gives you information from which you can take decisions and hopefully make good decisions of how to go forward. But that's that that was on my mind. That's what I wanted to share with you. Hopefully, it's been interesting. Then, if you want to know a little bit more about it, just drop me a message. And I'll perhaps give you a few pointers about how I look at things or some tools that you could potentially use so which also is a cue for drop the headline podcast at the propertyvoice.net. If you want to talk about anything from today's episode, or indeed more generally about property investing, be delighted to hear from you. Meanwhile, the show notes are going to be over at the website, propertyvoice.net so make sure you check that out. Before I go, just a quick point. I'm probably just going to do two more episodes before I'm going to just take a bit of a break over the Christmas new year period. So just mark it in your diary is just going to take a bit of a break there. But in the meantime, I just like to say thanks very much for listening once again this week. And until next time on the property voice podcast.
That's all from me this week, remember if you want to talk about anything from today’s show, or just talk property investing more generally, email me at podcast@thepropertyvoice.net, I would be happy to hear from you! The show notes can be found at our website www.thepropertyvoice.net
Thanks very much for listening again this week, so all that left to say is ciao ciao!