EQ Journal Archive 27

By Bruce Firestone | Uncategorized

May 15

https://www.eqjournal.org/?paged=27


         Definitions        

       
   Posted on
       Tuesday 10 November 2009  
     
   
       

It is a common mistake to confuse the terms ‘mortgagee’ and ‘mortgagor’. The correct definitions are:

A mortgagee is the Lender in a mortgage agreement. They give the loan but receive  the mortgage document that is registered on title.

A mortgagor is the Borrower in a mortgage agreement. He or she receives the loan but gives  the mortgage document that is registered on title.

Most lay people assume that the mortgagee is the person, corporation
or entity that will be receiving the proceeds of the mortgage. This
misunderstanding arises because these terms were coined by lawyers who
are not tracking the direction of the funds (which to most of us is the
key in any deal). Instead, they are tracking the direction of the
mortgage document.

The Borrower (mortgagor) is giving the mortgage document to the Lender and the Lender (mortgagee) is receiving it…  So the terms only make sense if you think like a lawyer!

Prof Bruce

       
       
       
     Prof Bruce @ 9:29 am

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         Concessions are Where You Find Them        

       
   Posted on
       Sunday 8 November 2009  
     
   
       

I have a saying: “Opportunities are where you find them.”
And what I mean by that is opportunity is everywhere—all around you—you
just have to be open to those happy events to be able to see them.

A person only becomes old when they stop being open to new things and
ideas. The moment you decide you know everything, that no one can tell
you anything, you’re starting to get old. I know old 20 and 30-year
olds. I also know young 82 and 85-year olds.

Having some kind of ‘pixie dust’, concession, franchise or
differentiated value in your business model is important to having a
business that is sustainable over the long term.

Recently, a bright, personable young guy I have been tracking for a
few years told me how he turned the latest Canadian Food Inspection
Agency directive into a valuable concession (or, if you prefer,
franchise) for his firewood business. This case shows how you turn
misfortune into fortune and show adaptability—a highly prized skill for
any would-be entrepreneur.

Here is Chris’ (latest) story:

“Hi Bruce, how’s it going?  Sorry to take so long to get back to you.
Anyway, a lot has changed in the last month and a bit. I’ve had to
re-focus my business direction.  In April, the Canadian Food Inspection
Agency put a ban on moving wood from within the urban area to the rural
area of Ottawa.  And, of course, Carp Road is the boundary. So I won’t
need your wood lot anymore.

The ban was put in place because a bug called the Emerald Ash Borer
has made its way to Ottawa.  It has killed thousands of Ash trees in
Southern Ontario.  Although the bug only infects Ash trees, the ban
includes moving any wood classified as firewood from inside the city.  
80% of my firewood supply comes from local tree companies taking down
trees in the city as well as my own jobs.  So basically I either had to
give up my firewood operation or find somewhere within the quarantine
zone.  

I managed to find a good spot on Richmond Road right behind
Bridlewood.  I can now take all the wood from tree companies within the
zone. I’m one of the only firewood operations within the zone so I’ll
have no trouble getting a good supply of wood.  I’m basically using the
new regulations to my advantage.  Most tree companies will have trouble
getting rid of all their wood so it’s going to work well for me.  This
ban is a Federal ban too, the fines for breaking it could be as high as
$50 000!  

I’ve had the Canadian Food Inspection Agency in to my new lot to see
my operation, get me registered and certified on their system.  So my
original plan of only doing furnace wood is totally gone out the window,
but this new opportunity has come from it.  Like I said, I won’t need
to rent your lot anymore. Sorry about that. I’ve still got a bit of wood
up there that I probably won’t get to picking up for at least another
month.  

As well, when I was away an old friend from school turned up and gave
me a hand with running my business while I was gone.  He’s not very
experienced but is very eager to learn and has good skills at being a
foreman.  I was very impressed and decided to hire him full time.  I
don’t really need the help right now but I will next year so I wanted to
make sure I snagged him. Plus I’m getting the grass cutting going again
as well as continuing the hedge trimming. I’m going to do less tree
removals in the city and spend more time on the firewood. I’m going to
do a little bit of local snow blowing this winter too.  

It’s taken a while but I’ve finally found my niche, my goal is to
grow a little but not to the point where all I do is price jobs and do
paperwork, I love the work and that’s what I want to keep doing!

Talk to you soon.

Chris Mulligan
613-513-6493
www.mulliganspropertymaintenance.com

       
       
       
     Prof Bruce @ 11:00 am

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        Filed under:

25 Steps to Business Success

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Business Models

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City Planning

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Entrepreneur Skill Set

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Environmentalism

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Franchise and Concession

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Value Differentiation and ‘Pixie Dust’

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         Should I Sell or Should I Hold?        

       
   Posted on
       Sunday 8 November 2009  
     
   
       

Recently, a middle aged man came to see me. Doug (not his
real name) told me that he was experiencing tough times—his wife had
divorced him years before, he had lost his job and hadn’t found work in
nearly two years, his adult children were dealing with their own
difficult issues, he was still three years away from his pension and he
had recently been forced to move out of his own home near downtown
Ottawa because he couldn’t afford to pay his mortgage, property taxes
and utility bills. He was also suffering from bouts of depression and
was uncertain about his employment prospects.

He wanted my advice—should he sell the home or continue to rent it?
He had been able to find a good tenant who was paying a modest $1,600
monthly and covering the utilities too. His conundrum—the tenants wanted
to extend for another year and Doug wasn’t sure what to do.

After paying all the costs on the house, Doug was netting about $265
monthly from the rental income on the property. He was eking out a
living in a basement apartment. He felt he could continue to do that
plus he felt an emotional attachment to the home where he had raised his
family—it was a lifeline for him.

Nevertheless, Doug remains highly rational and analytical so I
prepared a spreadsheet for him to assist him with his decision making.

What we found was that if he could sell the house for its market
value (estimated by Comparative Market Analysis, CMA to be about
$450,000), he would pocket (after real estate commission, legal fees,
disbursements and paydown of his mortgage) about $276,000.

Now that is a pile of money and my concern was that if he sold it, he
might blow it. From what I could see, it was unlikely that Doug would
be able to amass that kind of money at any time in the future again.

This is a very real fear—the vast majority of US lottery winners blow
their entire stake in under 5 years. And this would be a bit like a
lottery win for Doug—a kind of unexpected windfall.

After two more meetings with him though, I found him to be a
surprisingly canny guy with good sense when it came to money and, at
least this one concern, was allayed.

We looked at investment strategies for him—he decided that if he was
going to go ahead, he would invest the proceeds in two areas—GICs
(Guaranteed Investment Certificates, an ultra low risk form of investing
that produces current returns of around 3% p.a.) and the ROI Fund
(which has returns of about 6% p.a., invests in first mortgages and has
significant tax deferral attributes).

The difference in cashflow turns out to be around $875 per month—his
total yield on his GICs and the ROI Fund would be about $1,140 per
month.

You can download my spreadsheet in .xls format from my server at: https://www.ottawarealestatenews.com/SellOrRentYield.xls.
If you plug in different values for key variables such as: Selling
Price, Mortgage Amount, Interest Rate, Rental Income, investment
percentages, etc., the spreadsheet will automatically update the
difference in yields for you.

Now the difference from trying to live on $265 a month and $1,140 a
month is huge. That extra $875 has (in economic terms) much greater
utility for Doug than if, say, Sally was living on $5,000 a month and
considering selling her principal residence to bring her a bit extra.

So the advice I might give Doug could be very different than the advice I would give Sally.

In Sally’s case, I would be much more likely to factor in two other
real estate investing concepts—the wealth effect (basically, having her
tenant pay down her mortgage principal for her) and real estate
inflation.

I calculated these in an approximate manner (at the bottom of the
spreadsheet). The wealth effect averages $3,273 per year over the first
five years. That is, over the first five years, her mortgage principal
owing to her bank will drop by more than $16,000. Now this (ultimately)
goes into Sally’s pocket (when she sells the property) but the problem
is that it isn’t “IGA money” (as my wife would call it)—it isn’t money
you can touch, feel or spend and for Doug, waiting five years to get it
isn’t really an option if he can’t survive long enough to actually see
the money.

The other real estate return is, of course, inflation. In this model I
am assuming a 2.5% p.a. increase in property values which averages just
under $2,500 on this property per year for the first five years. Again,
this isn’t money that Doug can use until he sells the property but he
is sophisticated enough to understand that neither the ROI Fund nor his
GICs give him any inflation protection at all.

So he is rightly nervous about selling and missing out on these other types of returns.

But even after factoring these other returns in, we found his
adjusted cashflow was still higher under the sell option than the rent
option (by nearly $5,000 per year).

So while my bias is to build and hold (see for example: https://www.eqjournalblog.com/?p=218), this case, due to the human factors invloved, seemed to me to be an exception.

Prof Bruce

Postscript: We got Doug’s house sold for him and because of its
proximity to downtown Ottawa, we got a full price offer. He has since
moved out of that basement apartment, he has a bit of walking around
money and he surprised me—he diversified his investment strategy. He
decided to invest some of the proceeds in GICs and the ROI Fund but he
is actively looking for a rundown place he can buy, live in and fix up
so he can do it again. I wouldn’t bet against him—it turns out he has a
good eye for real estate and he is holding his head high these days.

(Please note that I have changed some of the facts of the case study to protect the identity of our client.)

Postscript: Here is a comment by Mark Sherboneau, a business owner in the field of investment management.

“Hi Bruce,

That is a really good case study. I liked how you incorporated the spreadsheet to help validate the case.

With respect to the questions that you had yesterday on inflation
protection, ROI markets the fund as having inflation protected qualities
in that the yield that is offered will adjust up or down over time with
the prevailing interest rate condition.  So, assuming that we are in an
inflationary period and interest rates are going up to curb
inflationary pressures, the yield returned by ROI will also go up as
principle and interest are reinvested at higher  (then prevailing)
rates.

But ROI does not offer the same inflationary protection that real
estate does, in that real estate appreciates more or less with inflation
essentially locking in inflationary growth.  

There are however fixed income instruments in Canada that do operate
like that called real return bonds.  Real return bonds are typically
issued by the federal government and a few provinces and the par value
of the bond is adjusted upward (or potentially downward) by the rate of
inflation as measured by core CPI.  The US has a similar instrument
called Treasury Inflation Protected bods (TIPS) which operate in the
same manner and are typically offered by the US government.

In summary, ROI has some measure of inflation protection through the
adjusted yield on the new loans placed; however, ROI does not offer the
same 1:1 relationship that real estate and real return bonds offer.

Regards,

Mark Sherboneau, mark@foundationpwm.com”

       
       
       
     Prof Bruce @ 10:33 am

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         Why Scotiabank Place Is Where It Is (Part 2)        

       
   Posted on
       Sunday 8 November 2009  
     
   
       

I was asked recently on a local radio show about why
Scotiabank Place (SBP) is where it is and why it isn’t at Lansdowne
Park. My comments on the show were part of a 20-year record of mine
explaining the rationale behind the location of the arena where the Sens
play. I also summarized it for a local newspaper and put it on this
blog at: https://www.eqjournalblog.com/?p=261.

The main reason SBP isn’t downtown at Lansdowne is that in 1989/90
when we were making that decision, we just didn’t feel we could put
another 2 million visits per year into an established community,
especially one without a subway or light rail connection.

Having said this, the case for a CFL team might be different since a
CFL team has played at Lansdowne for the last Century and so it is an
existing (or pre-existing) condition.

We are also talking about a different scale—CFL teams play 9 home
games plus 1 exhibition game per year. They also may have one playoff
home date. A major new arena had to have at least 150 events per year to
justify its existence. We are looking at an order of magnitude
difference.

I was also asked about the viability of the CFL team. As I understand
the current proposal by Lansdowne Live, they plan to have the CFL team
run by the owner of the Ottawa 67s, Jeff Hunt. Many observers felt that
Junior Hockey was doomed in Ottawa with the return of the Ottawa
Senators but Jeff Hunt has led a remarkable renaissance of the junior
team with unsurpassed marketing smarts*. If anyone can make CFL football
work in Ottawa, it is Jeff Hunt.

(* How about enjoying a 67s game at 10:30 am with 9,000 screaming
kids from local schools in attendance? Who would have thought that a
major junior game starting at that time of the day would be a huge
success not only in terms of attendance but also in terms of creating
the next generation of 67s fans?)

Still, if the City is going to go ahead with the re-development of
Lansdowne Park by endorsing the Lansdowne Live proposal as well as go
forward with its $6.5 billion light rail plan, it would make sense to
hook up all of our MCF’s, Major Community Facilities—everything
including the new convention centre, any relocated trade show space,
SBP, the airport and, of course, Lansdowne Park.

I can’t imagine any other city would plan to spend this kind of money
on rapid transit and not hook up its major outdoor stadium. Perhaps it
might be possible to run light rail along surface streets like they do
elsewhere. Calgary’s light rail system seems to be able to do that
satisfactorily.

I think light rail is the right way to go—can you think of a major
city anywhere that does not have a subway or light rail system or is not
planning to get one? The question one has to ask though is the one that
Andy Haydon raised—is this the right time to do it?

After the failure to get light rail off the ground (so to speak) with
the cancellation of the plan to put it into the fast growing southern
part of this City, maybe Ottawa should have turned its collective mind
to completing the bus transitway. We have a terrific bus system but,
like so many other Ottawa initiatives, we never finished the system.

The idea was that you could get on a bus in Kanata, Orleans or
Barrhaven and get downtown on the Transitway without your bus ever
mixing with automobile traffic.

Perhaps Ottawa would be wiser to make the investment needed to complete the Transitway before we go after light rail?

That doesn’t solve the problem of better public transit access for
Lansdowne Park but there is nothing in the current plan to connect light
rail to the Park anyway.

Prof Bruce

       
       
       
     Prof Bruce @ 9:18 am

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Livable Cities and Neo-Urbanism

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         Measuring the Value of Design and Creativity        

       
   Posted on
       Saturday 7 November 2009  
     
   
       

Value of a City’s Treescape

This is an analysis I did in 2003; I was trying to show that the
worth of art and creativity is significantly under valued by society.
The context was a debate we were having at the time about whether the
profession of architecture was doing enough to explain its value
proposition. This is a debate that extends to all creative pursuits: for
many artists, their works become more valuable after their passing.

So I asked the question: “Can we change the equation for creative
persons so that: a) death is not a career move for them and b) put
another way, can we teach creative persons to more clearly define and
value their contributions so that they can get rich while they’re still alive?”

Introduction

We can usually quite easily measure the cost of a ‘thing’ and, as a
result, we find it easier to establish a budget for the cost of a new
project than to determine, with any degree of confidence, the revenues
or stream of benefits that flow from that project.

At Carleton University’s (CU’s) School of Architecture, we are trying
to change the School’s paradigm from a preponderant reliance on
justifying Architectural Design and related Fees for Service based on
the cost of a design to a new paradigm, where the benefits created by
excellence in design services are also taken into account.

Gosh, even McDonald’s Restaurants are converting from the Dark Side
and spending more on the design of their franchises (at least in France
they are). McDonald’s is doing this for a reason—better designed stores
are attracting more customers, who are staying longer and spending more
per capita.

In other words, better design is a paying proposition. What we want
to see is that more of the value created by designers is captured by
them through higher fees. Higher fees can be justified to the client by
higher Return on Investment (ROI) for clients. Today, everyone should
want to be able to measure benefits as well as costs; as they said in
Jerry McGuire: “Show me the money.” And get higher fees too.

So here are the three questions we are going to ask in this essay:

Q1. Can we measure ROI from dollars spent on design?

Q2. How much of the ROI can be attributed to greater net benefits
derived from design and creativity versus, say, lower costs or higher
revenues derived from other sources?

Q3. How can creative persons obtain more value from what they do?

For example, what if we could show by a cross-sectional analysis
(i.e. a comparison with other existing museums) that an extra, say, $35m
invested in the design and construction of a National Museum would
result in an increase in annual visitor count of 2 million at $10 each
for admission? Well, obviously, we don’t need to go through the
rigmarole of a spreadsheet analysis to know that a $35m additional
investment that produces an extra $20m per year in revenues is worth
doing.

Folks like former Canadian Prime Minister Pierre Trudeau and
Architect Douglas Cardinal understand this at the ‘nano’ scale—they just
have a gut feeling about this stuff; they get it intuitively. Mr.
Cardinal often describes Monsieur Trudeau as his ‘patron’ with respect
to the design and construction of the fabulous Canadian Museum of
Civilization. Douglas uses the term in its purest form; he understands
that creative people need the support of powerful people and he respects
utterly the fact that creative people are entrusted with great
responsibility to protect the interests of their patrons and their
audience too.

Canadian Museum of Civilization: Sinuous Curves, Extraordinary Design, Greater Value from Creativity

An unbelievable design like this has got to be worth more than just
another square box, so higher fees should be justified on the basis of
more hours worked on the part of the Architect (clients don’t really
care about this) and a better product (many clients don’t care about
this either). No, what most clients want is to be shown a higher ROI for
their money before they will pay you more.

At CU, we teach our entrepreneurs and entrepreneur designers (it
warms my heart to see how many Architects are now taking an interest in
these matters) to measure ROI using an Internal Rate of Return (IRR)
methodology. The IRR (https://www.old.dramatispersonae.org/IRR/IRRPowerOfLeverageGoalSetting.htm)
seems to be the most useful and accurate way to measure and to weigh
the relative costs and benefits of a new project, design or program.
Knowledge of these techniques puts designers on a more level playing
field with their patrons so they can negotiate better deals (read higher
fees) for themselves.

Value is measured not just on the basis of costs and benefits. Value
in a free market is whatever a willing buyer and willing seller agree
to. It can be much higher than costs, about equal to costs, or much
lower. Obviously, creative persons would prefer not to sell their
services or products (art, for example) below cost but this isn’t
unheard of.

Vincent Van Gogh, Poor until the End—Don’t Let This Happen to You

So we may determine that the IRR from investment A is much greater
than from investment B but that has nothing to do with the price one
might get for A or B. As we will see later on, the price for a thing
(your fees as a designer, the price paid for the art you create,
whatever) is what you negotiate for it. By knowing a thing or two about
ROI and IRR, maybe you can negotiate higher prices because now you have
more leverage from having more knowledge about the stream of benefits
relative to its costs that will flow from your work.

What we are going to learn from the model I created for the following
example of planting ordered street trees in my community surprised
me—we are going to see that almost all the increase in value from an
improved treescape is derived from the act of creation and design and
not from, say, decreases in air conditioning costs. And also, we are
going to conclude (unfortunately) that you don’t necessarily get what
you deserve in this life. Read on, Dear Reader.

Johnny Knew a Thing or Two about the Value of Creation

Constraints

My wife, Dawn, and I were chatting around the dinner table one
evening last week and she asked me: “What is the value of a better
streetscape, umm, treescape here on Zokol Crescent (where we live)?”
Well, she didn’t actually put in quite this way but the message was—if
we got all our neighbors together and planted trees along our road, that
would be … nice.

So I left the room and booted up my PC and created a spreadsheet
right away to see if we could measure the value of a creatively designed
treescape for Zokol, which you’ll see shortly.

The constraints I put on this exercise included:

1. that the treescape would be professionally designed;
2. that the trees would be at least 1.5 inch caliper specimens so that
we didn’t have to wait 20 years for the effects to be seen—visual impact
would be felt after five;
3. that we would use a design that brought uniformity to the tree planting and to the street;
4. that ultimately we would have a canopy of trees form over our street;
5. that the trees would be long, lived native hardwood species;
6. that the trees would be disease resistant;
7. that we would look at two scenarios—one where the trees would be
planted by professionals and one do-it-yourself case but the design and
planting would be supervised by a design professional;
8. that we would not accept a ‘no’ from the City who might raise
objections (like, say, that the trees require maintenance, that they
might interfere with underground services (blatantly wrong if you pick
the right species), they mess up city streets when their leaves fall
(hmm), that the first six metres of our front yards should be clear of
everything except grass (ugh), etc.);
9. that we would need at least 50% of the home owners on our street to
agree to participate in the program so that we didn’t end up with a
Hodge Podge effect and that the ‘free rider’ problem (the mooches
amongst us) would be manageable;
10. that the budget would not exceed $200 per tree for purchase of the
trees and another $200 per tree for professional planting services;
11. that there would be at least one tree per lot and preferably two each;
12. that this investment in design and development must have a ROI that
exceeds most home owners’ investment portfolio rates of return.

Gee, Maybe Street Trees do add Some Value, After All

Valuation

So how do we go about measuring the value of an improved treescape?
Well, first of all, let’s not reinvent the wheel. Let’s look at what a
Google search turned up (https://www.arborday.org):

“Trees can boost the market value of your home by an average of 6 or 7 percent.” -Dr. Lowell Ponte

“Landscaping, especially with trees, can increase property values as much as 20 percent.” -Management Information Services/ICMA

“Healthy, mature trees add an average of 10 percent to a property’s value.” -USDA Forest Service

Ordered Street Trees Forming a Canopy

So, OK, let’s use the low end of the range for value increase—a
mature treescape adds, say, 6% to property values with emphasis on the
word ‘mature’. Let’s further assume that the streetscape is mature at 20
years using, say, maples and oaks, which happen to grow very well in
the clay soils around where I live.

So we can hypothesize that we will see value increases something like:

Year 0 $400 per home (i.e., the cost of two self planted trees per home in the do-it-yourself program)
Year 5 10% of the ultimate value
Year 10 33% of the ultimate value
Year 20 100% of the ultimate increase in value of 6% per home

We could make other assumptions than these but this seemed reasonable
to me. As it happens, the ROI is not too vulnerable to these
assumptions and if you don’t like mine, change the model
(https://saragassocity.com/Images/TreescapeValuation.xls) for yourself
and you’ll see the ROI is not very sensitive to this time profile of
benefits.

Of course, there are other benefits of planting trees in city spaces like, for example:

“One acre of forest absorbs six tons of carbon dioxide and puts out
four tons of oxygen. This is enough to meet the annual needs of 18
people.” -U.S. Department of Agriculture,

or

“Trees can be a stimulus to economic development, attracting new
business and tourism. Commercial retail areas are more attractive to
shoppers, apartments rent more quickly, tenants stay longer, and space
in a wooded setting is more valuable to sell or rent.” -The National
Arbor Day Foundation,

or

“Trees properly placed around buildings can reduce air conditioning
needs by 30 percent and can save 20 – 50 percent in energy used for
heating.” -USDA Forest Service

and

“Shade from trees could save up to $175 per year (per structure) in air conditioning costs.” -Dr. Lowell Ponte.

(Unfortunately, as so often is the case in research, the data used here are US based.)

I have based the increase in property values from an improved
treescape on a biological growth curve—values tend to increase slowly
from Time 0 (where the increase in property values is presumably just
equal to the cost of planting them) to about Year 10 when a faster
annual increase in value sets in culminating in a maximum increase in
value at Year 20.

Bigger is Better

I wanted to try one more case—I wanted to see if savings in, say,
annual AC (Air Conditioning) costs might have a significant impact on
the IRR (I use Internal Rate of Return and ROI as interchangeable terms
in this essay but I am actually calculating the IRR here).

I was a bit lazy and used straight line approximations to calculate
the annual savings in AC costs rather than generating a true biological
growth curve. So I assumed constant increases from 0 to 5, from 5 to 10
and from 10 to 20 years. Given the number of assumptions used here, it
doesn’t really matter. Also, because Ottawa is such a northern shelf
city (it is a sunny -27 degrees Celsius as I write this and the sun is
heating up my home office nicely, btw), I reduced the savings in AC
costs from Dr. Ponte’s $175 USD number to, an arbitrary, $75 CAD in Year
20.

Well, you can see from the spreadsheet included in the Appendix
below, the impact of a reduction in AC costs (Case 4) on the ROI. It
changes the IRR from 20% p.a. to 21% p.a.—a pretty minimal change.
Clearly, the most powerful impact of street tree planting is the
increase in property values that arises from the perception that this
street is a more desirable place to live, a more aesthetically pleasing
place to come home to.

I also tried the model with a much higher cost base—I included a
figure of $800 per home, which specifies professional tree planting. The
IRR dropped from 20% p.a. to a still respectable 16% p.a. (17% if you
include annual AC savings). However, convincing our neighbors to get on
side with a program that calls for spending $800 each doesn’t seem too
realistic, so we are likely stuck with a do-it-yourself planting
solution that starts at $200 per household.

Conclusion

These kinds of techniques are being applied everywhere today. It
seems to me that folks are quite risk averse these days—reluctant to
invest in anything without being shown that it will pay off for them.
Whether we are talking about a tech investment or an investment in
better design or a more innovative and diverse functional program for a
new construction program or whatever, people want you to be able to
prove that it is worthwhile for them and you can’t do that without doing
this type of analysis.

I believe that at the end of the day, everything creative people
do—building cities, for example— require faith, or if you prefer,
belief. City-building or enterprise-building are optimistic kinds of
endeavors and, no matter what the numbers may say, before anyone commits
to anything, they also need to feel in their ‘gut’ that it’ll work out
somehow, more or less as planned.

There is an important lesson in this for all manner of creative
people to learn—that much or even most of the value in a ‘thing’ is in
the eye of the beholder. Creative people involved in design and
invention tend to undervalue their contribution to the economic well
being of their society. In this example, 95.2% of the increase in the
ROI (i.e., 20%/21%) can be attributed to the act of creation and just
4.8% can be attributed to the actual measurable change in benefits (that
is, the annual savings in our neighbors’ AC bills).

I have to admit that what CU’s Dean of Engineering and Design, Samy
Mahmoud, said to me a few years ago seems to be true: “You don’t get
what you deserve (in our society); you get what you negotiate.” So
architects, landscape architects, industrial designers, interior
designers, artists, musicians, actors, writers (hmm), directors,
decorators, set designers, photographers, videographers, graphic
artists, even engineers (hmm) and scientists take note, you need to say:
‘More please, Sir.’

Of course, there are many other benefits derived from tree planting
than we have included above. However, we have enough of a justification,
at least for the residents of my street, to consider implementing this
program, just from the economic benefits included here. Very few people
tend to be ‘other directed’ (i.e., motivated by something other than
money and self interest). But that’s OK, because if they follow their
own personal interests in this case, they neatly coincide with the
greater social good too.

Nature’s Free Air Conditioning

Copyright. Dr. Bruce M. Firestone, Ottawa, Canada. 2003

www.DramatisPersonae.org

www.Exploriem.org

Appendix

Zokol Crescent Treescape Model– Rate of Return
(or why trees are a good investment)

The Do-It-Yourself Model

Case 1 20 years

Year Cashflow

0 ($400)
1 0
2 0
3 0
4 0
5 0
6 0
6 0
7 0
8 0
9 0
10 0
11 0
12 0
13 0
14 0
15 0
16 0
17 0
18 0
19 0
20 $ 19,500.00 100%

IRR 20% p.a.

Average House Price

$325,000

House Price Increase (Low Estimate)

6.00%

Case 4 20 years

With AC Savings

Year Cashflow

0 ($400)
1 $5.50 7.33%
2 $6.00
3 $6.50 $    0.50
4 $7.00
5 $7.50 10%
6 $10.42
6 $13.33
7 $16.25 $    2.92
8 $19.17
9 $22.08
10 $25.00 33%
11 $30.00
12 $35.00
13 $40.00
14 $45.00
15 $50.00 $    5.00
16 $55.00
17 $60.00
18 $65.00
19 $70.00
20 $ 19,575.00 100%

IRR 21% p.a.

$75 AC Savings

Zokol Crescent Treescape Model– Rate of Return
(or why trees are a good investment)

Experts-Do-It Model

Case 1 20 years

Year Cashflow

0 ($800)
1 0
2 0
3 0
4 0
5 0
6 0
6 0
7 0
8 0
9 0
10 0
11 0
12 0
13 0
14 0
15 0
16 0
17 0
18 0
19 0
20 $    19,500.00 100%

IRR 16% p.a.

       
       
       
     Prof Bruce @ 9:20 am

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City Planning

and

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and

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and

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and

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and

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and

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         Why Invest in Real Estate?        

       
   Posted on
       Sunday 1 November 2009  
     
   
       

Introduction

I tell most of my SMEE (Small and Medium Sized Enterprise) clients
(and my students) that real estate investing is usually a good idea.
Homeownership and owning your own business premises makes sense to me in
most cases. Why is that?

Well, here are a few of my reasons:

1.     Forced savings— most people are really bad at saving* so, if
at a minimum they own their own home or condo or (for entrepreneurs)
their own business premises, every month that they make their mortgage
payments, they are paying off (‘saving’) some of the principal. This is a
type of ‘wealth effect’—it creates equity on your personal balance
sheet (which everyone should have) or your corporate balance sheet. It
is kind of a hidden part of your ROE (Return on Equity) too. Even people
who are pretty good at saving their money may eventually succumb to the
temptation to spend their savings. However, if their savings are tied
up in bricks and mortar, they are going to have to do more than turn on
their PCs and use Internet banking to, say, buy that holiday of their
dreams. Getting at your real estate equity can be relatively
straightforward using something like a home equity Line of Credit or
re-mortgaging your house, condo or office building (or putting a
‘reverse’ mortgage in place, something an elder might do, for example,
if they are real estate ‘rich’ but cash poor) but, at least, it requires
some effort and will give you time to reflect on whether this is really
what you should be doing.

(* I ask my students every year, how many of you can save, say, $600
per month? Usually, one or, at the most, two students raise their hands
(out of 45 or 55). When I re-phrase the question and ask how many of
them could pay rent of $600 per month, well, most of them can do that.
So if you had a mortgage of $600 per month (on a very small flat), they
would be ‘forced’ to save a bit of money every month…)

2.     Get rich slow—real estate is not a get rich quick scheme. But
most markets have some real estate inflation and, at least, real estate
markets don’t usually sink as fast as say tech stocks did in the great
bubble burst of the early 2000s. So if general real estate inflation is
say .75% per annum and you have 25% equity in the deal then you are
adding an extra 3% p.a. to your ROE. Obviously, if general real estate
inflation is higher than this, and it often is, this factor will play an
even larger part in creating investor wealth.

3.     If you own your own business premises, you have a
diversification of risk. (I advise SMEEs that they should generally keep
their real estate in a company separate from their operating company so
that if something happens to the operating business, they can always
sell their real estate holdings and, hopefully, live to fight another
day).

One of my tech clients needed more and better office space. We
looked at leasing 15,000 square feet of Class A office space for his
cluster of companies. At that time in Ottawa, prime office space was
leasing for $18 per square foot per annum triple net (that means that
the tenant must pay all operating costs in addition to basic rent).
Operating costs including realty taxes were in the order of $12 per
square foot per annum so 15,000 square feet of space would have cost his
company in the order of $450,000 per year.

After Bill (not his real name) recovered from sticker shock, I
convinced him to buy his own building. He bought a beautiful two storey,
15,000 square foot, Class A office building for $100 per square foot.
He put down $500,000 and got a Vendor Take Back Mortgage (known as a
VTB—i.e., his financing came from the Vendor not a Bank) for the
balance. His annual mortgage costs were in the order of $85,000 per
annum and he took ownership of the building in a separate company. I
also convinced him to buy a house (he was renting up to that point) and
to pay down both mortgages as fast as he could. Now, a few years later,
Bill owns a beautiful $750,000 home and an office building worth nearly
$2m with almost no debt against them (and soon to be zero). So even if
his tech company somehow goes away (which I doubt—these are very
profitable enterprises), Bill can always sell his real estate for $2.75m
and not eat cat food when he turns 65.

In many enterprises and especially technology and consulting
companies, your key assets tend to walk out the door every night on
their way home. Or in a fast changing global economy, your technology or
key competitive advantage can become obsolete almost (and sometimes)
overnight. Real estate doesn’t usually go out of fashion as quickly*. If
you look at some of the longest lasting fortunes on the planet, they
tend to be (at their core) real estate based—like, say, the House of
Windsor, Emperor of Japan, Hudson’s Bay Company, the old Canadian
Pacific** Railroad Company or the Holy Roman Catholic Church.

(* I remember a time in the 1980s when my Dad got involved with a
group who wanted to build roller disco emporiums and, boy, did they
ever. I’ll never forget the principal behind these developments telling
me that Roller Disco (places where kids could boogie to disco music
while on roller skates; they went round and round in a counter clockwise
direction with lights flashing all over the place) was a ‘cash cow’.
Hey, when the kids got bored, they stopped the music and then they went
clockwise for awhile. I wanted to bale out of the operating company
faster than if I was a paying passenger on the Titanic. However, we
managed to exchange our interest in the operating business for the
underlying real estate—the Roller Disco operating entity went broke less
than two years later and we turned the real estate into a cool office
for a new high tech company specializing in CAD systems which were just
new at the time. Real estate has legs; roller disco was just a fad.)

(** CP got huge real estate concessions in prime urban locations in
return for the near-impossible job of laying railroad track over the
Rockies to what was then a nothing town called Vancouver. Decades later
the stock price for CP moved up when the company started selling off its
real estate portfolio.)

4.    If you own rental property or if part of your home of office is
rented out, your tenants are helping you with your ‘forced savings’
since they are paying off the part of the principal on your mortgage
every month for you. This in a way compounds the wealth effect. When
someone else is paying off all or part of the principal on your
mortgage, this benefit comes accrues you. Now it’s true that you can’t
use it for what my wife calls ‘IGA money’ (money you can touch, feel and
spend on stuff) every month but when you sell the property (provided
you sell it for what you paid for it or more), you will get the cash in
your jeans from the pay down of your mortgage… Of course, you can always
re-mortgage your properties without selling them and get the cash,
tax-free that way.

5.     Hopefully, your real estate portfolio is providing you with
some cash-on-cash return too so that every month you are getting more
‘IGA money’.

6.     You will have security of tenure since the Landlord (yourself)
won’t raise your rent every five years or so, especially if you are
doing well financially. There seems to be a rule in life that costs
always rise to whatever your income is. This is as true for a company as
it is for an individual; Landlords just have a sixth sense about these
things and can keep on increasing your rent until you simply have to
move.

7.     Brand equity—you do develop a kind of brand equity in your
location over time and if you own the real estate, at least you are
developing brand equity in your own property not someone else’s.

8.     Brand equity is important because it helps you build up your
credibility; credibility and trust are hugely important in sales—people
like to buy from people they like and trust. The two things often go
together. Did you ever buy from someone you didn’t like and didn’t
trust—not too often I’ll bet?

       That’s why mega corporations spend so much money building
their brand; it’s so that when one of their sales people is in the
trenches competing for a sale and trying to close the deal, they often
get the nod over the competition because they are a known (read trusted)
commodity. Imagine if you were hearing an insurance pitch from somebody
who worked for the ‘Pirate Insurance Company’ of Kinakuta versus
somebody who worked for Clarica. Which one would you be more likely to
put your trust in and trust your family’s future to?

      Companies spend money on marketing their brand not just so you
can watch the Super Bowl on free TV—they spend money on ads so they can
increase sales but not in the way most people think of it. By spending
$$$ on TV ads to establish a new brand (like Clarica did in 2002 and
2003), they don’t actually expect 100,000 people to suddenly call their
call centre and order life insurance. They know better than that.

      They understand that all the marketing in the world doesn’t
sell much, if anything—they need a separate process to harvest the
goodwill that they have generated in their marketing blitz. All that
their marketing has done is increase the propensity-to-buy. The separate
sales process involves a huge team of focused, Clarica sales people—the
sales team is like the ‘facts on the ground’ in military/political
speak. They are in the trenches with consumers selling one customer at a
time. Each in-the-trenches sales team member has a greater likelihood
of making the sale because of the mass marketing that Clarica has done
but that is all that marketing dollars can do—increase the probability
of a sale and only if there is actual selling activity going on.

9.     Owning your own location instantly builds credibility with
suppliers, bankers, employees and others whom you depend on too.

10.  If you want to make any changes to the premises, you can without
investing your money in someone else’s building or having to ask
permission.

11.  Once you have paid off your mortgage, you can either continue to
have the operating company pay rent and enjoy another income stream or
you can benefit from ‘tax-free, unearned’ rent. The latter is another
type of wealth effect* (which is also why you want to pay off your home
mortgage as fast as you can pretty much everywhere in the world today
except perhaps the USA where mortgage interest on your personal home is
tax deductible which changes the calculations a bit).

      (* This wealth effect is also quite real. Suppose you own your
own building and the mortgage is fully paid off. Now you decide to
reduce your rent to zero. Your operating company’s net income goes up by
an amount equal to the rent they paid in the last year of the mortgage,
an amount equal to Y dollars. Now in Canada, related inter-company
dividends are tax free so you could dividend out the equivalent amount
to your real estate holding company. Whereas before you had income in
the holding company (of course you had some offsetting expenses too),
you now have inter-company tax free dividends.

      For your personal home, it works a bit differently. Let’s say
you have a home worth $300,000 and you have finished paying off the
mortgage. And let’s say you could rent it out for $3,000 a month. If
your marginal tax bracket is 50% say then you are left with $18k after
tax less whatever costs you might have against this. But if you stay in
the home yourself that means that you are enjoying the benefit of living
there on ‘unearned rent’ (a British term) of $36k a year—which isn’t
taxed. Unearned rent is also sometimes referred to as ‘imputed rent’.

      Another way of looking at it is if you moved out of the home,
rented it for $3k a month and rented another exactly equivalent house
for yourself (you have to live somewhere after all) at $3k a month, you
are gaining $18k in after tax income but paying $36k in after tax rent
yourself so you end up actually losing $18k on the whole deal. It’s
weird but true—people who have paid off their home mortgages may not
understand the exact mechanics of this wealth effect but they sure feel
it. They tell me things like: “I seem to have more money than I ever did
when I was working. I just seem to have more cash around these days…”

      ‘Unearned’ rent is a concept that originally seems to have
derived from a British sensibility that owners of real property are
somehow undeserving of a return on capital. No doubt this is a
class-based concern. There have been attempts to tax homeowners who have
no mortgages on their residences on their ‘unearned’ rents—one attempt
in Switzerland and one in Australia that I know about. Both were roundly
hated by the populace and were rescinded shortly after introduction in
Switzerland and never actually implemented in Australia.

      One also has to think that taxing unearned rents would work
against thriftiness on the part of homeowners and against social order
too. Evidence abounds that people who own their own homes tend to see
themselves as having more of a stake in their societies—they tend to
vote in civic elections, participate in volunteerism and form the
bedrock of a civil society.

      In addition, home equity and real estate equity more generally
are the bedrock source of friendly capital for startups. The work of
Hernando De Soto in LDCs has shown that until they: a) recognize private
property rights, b) give clear legal title in (and civic addresses to)
real property to sitting owners and c) develop a competitive market for
financing of real property (a system of mortgage financing), they can
not unlock real estate capital for redeployment to productive,
entrepreneurial uses.)

12.  It is often cheaper to own than to rent especially in low
interest rate countries like what Canada and the US are experiencing
today.

13. You should want to own your own real estate without partners if
you can swing it. There are still: ‘Two chairs up in Heaven waiting for
the first two partners to get there and still like each other.’ (Anon.)
But if you do take on a partner to acquire real estate, make sure that
you both have the same financial incentives and goals*.

(* In a bankruptcy of one of my Dad’s (Jack) real estate partners,
five properties jointly owned by Jack and Les (not his real name) were
caught up in major court proceeding along with 75 other projects. A
major, publicly traded real estate business wanted to buy all 80
properties out of Bankruptcy including the halves of the 5 projects that
Jack owned with Les.

Two things saved my Dad—he had had the good sense to enter into
first right of refusal agreements on all 5 properties with Les and he
had me to negotiate with the major realty company, we’ll call DevCo.

DevCo was buying Les’ half of each of the 5 properties in question
for $400,000. Our internal valuation carried these projects at $2.2m and
that was just for our halves. Andy Jenkins (not his real name), V.P.
for DevCo, told me that we had two choices—sell our half interests for
$400,000 or stay in and become partners with DevCo. “Why not be partners
with DevCo,” he said. “We are a national company with a national
network of leasing and operating executives.” Why not, indeed.

Our concern was that DevCo had a lot of other vacant buildings near
these properties—geez, they could actually make money by taking tenants
out of our buildings (where they would own 50% and we would own 50%) and
putting them in buildings that they owned 100%. After a couple of
years, we might have been lucky to get an offer from DevCo for our half
interests where we did not have to pay them for accumulated losses just
to take our share off our hands.

I hate 50/50 partnerships anyway. No one is in charge; no one has
final say; it’s a recipe for stalemate and disaster. If you are going to
have partners, at least have someone own 51% and you know where the
buck stops.

So we exercised our rights of refusal and offered to buy Les’ halves
for $400,000 (it’s like a right to match). Jenkins and his boss went
nuts. They told me they would ‘see us in court’ where they would argue
the ‘greater good’ theory—that the Bankruptcy Judge should override our
rights because the greater good (i.e., DevCo’s greater good) demanded
that all 80 properties be dealt with in one fell swoop.

A couple of days before the hearing, Jenkins asked me what we wanted
for our half interests. I told him $2.2m and he blanched. I argued that
he was still getting a good deal—he had Les’ half for $400k and ours
for $2.2m for a total of $2.6m on buildings we valued at $4.4m so he was
getting them for about 50% of their value anyway. He said: ‘See ya in
court.’

Ten minutes before the hearing began, Jenkins asked again. I said
‘$2.2m’. We dickered for a few minutes and settled at the courthouse
door for… $2.1m.

This got Terrace Investments Ltd. going—eight years later (in 1990)
we acquired the Ottawa Senators franchise from the NHL for $50m; some of
DevCo’s money was in that deal.)

14.  Owning your own real estate gives you more financial
flexibility—borrowing based on real estate collateral is usually much
easier than say using your IP to secure a loan. The financial markets
are much more developed and flexible for real property (at least in NA)
than for Intellectual Property. Home equity loans are generally readily
available to homeowners if they have a good credit rating (and sometimes
even if they don’t). Home equity loans are the largest single source of
capital to start your own business. They are also used by homeowners if
they get into financial trouble or lose their jobs*.

(* Appraisers are the gatekeepers to the mortgage system. Lenders
both major institutional lenders (like Charter banks) and secondary
lenders as well as most private lenders, base much of their loan
decisions on two things—their LTV (Loan to Value Ratio) and the
Appraised Value, AV.

The Loan Amount (LA) is determined by the following simple formula:

LA = LTV x AV.

So if the Appraised Value is equal to the Purchase Price, PP of a property you just bought, the Loan Amount will be:

LA = LTV x PP.

However, Appraisers tend to be conservative people and they are
often being paid by the Lenders or, even if you are paying for their
services, you must use the Lenders approved Appraiser. The Lender is
usually sending them a lot more work than you are, so naturally they
tend to look at things from the Lender’s point of view. I find
commercial appraisals are anywhere from 5% to 10% below FMV, Fair Market
Value.

LTV ratios vary. Most residential lenders will lend 75% of the AV.
You can get mortgage loan insurance from CMHC (Canada Mortgage and
Housing Corp.) or private firms (e.g., GE Capital Mortgage Insurance)
which will reduce the amount of equity you require to as little as 5%
(i.e., increase the LTV ratio to as high as 95%).

Commercial lenders are even more conservative and their LTV ratios
are typically 65% for office, commercial and industrial buildings and as
low as 50% for land (if they will even do it at all).

Commercial lenders also may only loan against the Quick Sale Value,
QSV of the project which is often much less than the AV. The QSV is what
they can get for your project in a power of sale or forfeiture.
Therefore, we find:

LA = QSV x LTV, in some risky commercial projects. Many of these
projects get off the ground either with very large amounts of equity or
secondary financings.

Secondary financings include second mortgages, mezzanine financings,
cashflow financing and lines of credit. Every form of secondary
financing is really a form of equity; only the first mortgage is truly
debt. Secondary and tertiary financings almost always have the right of
redemption—which means that if the first mortgage goes into default,
they have the right to cure the default and take possession of the
property either through a Power of Sale proceeding or Forfeiture.

What you are typically hoping for in these circumstances is to build
your project, get it off the ground, prove the revenue stream and drive
the AV up so you can refinance the project and take out the secondary
financings within a reasonable amount of time.)

15. Nations that are made up of homeowners and business owners who
own their own real estate are usually more robust societies where
ownership of real estate conveys a sense of permanence and social
responsibility and civic pride.

16. Buildings don’t tend to run out on you—if you operate a
consulting business, your assets go home every night. They can always
find new jobs and your IP goes with them. If you own a tech business,
your market position can melt away virtually overnight. (Don’t think so?
How about URL shortener www.TinyURL.com being knocked off by competitor
www.bitl.ly because the latter makes long URLs into 20 character URLs
instead of 26 characters. Plus Bit.ly did some other smart things like
make it easy to copy the new URL to your editor and let’s you see how
many people have clicked on those short URLs that you have created, a
very useful traffic number to have.

      Here is an example:

https://www.dramatispersonae.org/EnterpriseOfTheCity/HomePage/KingOfExxon.htm
(76 characters) becomes: (20 characters) or
https://tinyurl.com/y9p6ba6 (26 characters).)

Sample Calculation of Internal Rate of Return, Cap Rate (Capitalization Rate) and ROE (Return on Equity)

Calculating your ROE is really not a simple thing. Almost certainly
the best way to calculate it is to use the IRR (Internal Rate of
Return). This takes into account the time based value of money and can
produce an accurate rate of return for the overall project, your equity
portion of the financing and the sub-debt position (second mortgage
financing, VTB (Vendor Take Back) financing, debenture financing or
mezzanine financing…) if any. I show how to calculate the IRR for a home
owner at: https://www.dramatispersonae.org/SampleIRR2.htm.

This is a simple example but it demonstrates some important
principles—the IRR on your equity is highly sensitive to leverage. For a
25% down payment, your IRR is 22.1% p.a. With just 5% down, it jumps to
56.4%.

So if you take your 25% equity and buy 5 homes with 5% down instead,
you are going to end up with a much larger cash-on-cash return than if
you just have one property. For one investment property with 25% equity
in it, I show cash returned over 5 years is $89k. For five investment
properties with 5% equity in each, I show cash returned over 5 years is
$254k.

If you would like to download the spreadsheet in .xls format to your
PC, please do so. GO GET IT. Now that you have it on your PC, you can
fool around with the assumptions and see what different amounts of
leverage do to your returns and risk profile. You can change other
assumptions and conduct your own sensitivity tests…

If you are feeling really ambitious, you can try your hand at our
‘perpetual motion machine’—this model is designed to answer the
following question: “How many rental homes do you need to buy (or build)
and how much of your mortgages do you need to pay off before the system
produces enough free cashflow that will then allow you to buy (or
build) more rental properties without pumping in any more equity?” GO
GET THIS ONE TOO:
https://www.ottawarealestatenews.ca/PerpetualHomeBuying.xls.  (Thanks to
former student, Ryan Pearce, for developing this model with me.)

Minto Construction, a large Ottawa-based company, is living proof
that this model works after a fashion. One of the Founders of the
company, Irving Greenberg, once told me that the best day in his
business life was when the Government of Ontario under (Conservative)
Premier Bill Davis introduced rent control in Ontario circa the 1970s.
After the introduction of rent control, Irving made more money than ever
from his residential rental property. First, there was less competition
as builders, developers and investors foolishly fled the market and, as
a result, his vacancy rates fell. Second, he was able to buy his
competitors cheaply and add substantially to his portfolio. Third, he
was able to pass on rent increases every year since such increases were
‘government approved’ and tenants had nowhere else to go anyway.
Fourthly, he could be picky about his tenants and damage to his units
and maintenance costs went down. Fifthly, he could pass on the costs of
upgrades, repairs and maintenance to his tenants again in additional
government approved rent hikes every year.

Rent control was a travesty in my view—it certainly didn’t help those
who most needed help, aka the poor who are disproportionately single
mothers.

Minto ended up with tens of thousands of rental units in Ottawa,
Toronto and Florida and tens of millions of dollars in free cashflow
too.

The Cap Rate

Most real estate professionals do not use the IRR however—they use
Cap Rates to compare one project with another. The Cap Rate
(‘Capitalization Rate’) is an approximate measure, as all financial
measures are anyway. But they are way more approximate than the IRR is.
Nevertheless, it’s a handy first order of magnitude measure. The Cap
Rate can be determined by simply dividing the Gross Operating Income of a
property by its Selling Price.

One way to look at the inverse of Cap Rate is that it is an
approximation for the number of years it will take you to earn back your
capital. It is widely used in the commercial real estate sector. The
higher the Cap Rate, the better it is for the Buyer and the worse for
the Seller.

Another way to look at the Cap Rate is that it is a rough measure of
your rate of return on the project—it measures the rate of return on the
overall project not your equity (unless you finance 100% of the
property with equity).

For a project with financing that is provided by both equity and first mortgage, we can determine the Cap Rate as shown below.

Cap Rate = ROR, where ROR is the Rate of Return for the entire project.

ROR = (NOI + CRF (i, A)  x  (Selling Price  or Purchase Price–
Equity))/Selling Price or Purchase Price, where NOI is the Net Operating
Income, CRF is the Capital Recovery Factor, i is the cost of borrowing
and A is the amortization period.

Thus,

Cap Rate = (NOI + CRF (i, A) x (Selling Price – Equity))/Selling
Price. Basically, the NOI + CRF (i, A) x (Selling Price – Equity) is the
Gross Operating Income for the project.

If the Amortization period approaches infinity, the CRF = i. In this
case, we can say that the Cap Rate can be calculated as follows:
Cap Rate = (NOI + i(S.P. – E))/ S.P., for A à infinity.

As the Equity in a project approaches zero (100% of financing is debt), we can calculate the Cap Rate as follows:
Cap Rate = (NOI + i x S.P.)/ S.P., for E à zero.

But NOI will be zero if E = 0 assuming that the selling price is
jacked up to the point where all income is used to support debt. In that
case, we have:

Cap Rate = (i x S.P.)/ S.P., for E approaching zero and NOI approaching zero or Cap Rate = i. Q.E.D.

What we have done in typical engineering fashion is to look at the
boundary conditions for our formula and discovered that under certain
circumstances, the Cap Rate is simple equal to the cost of borrowing.
This gives you a first order of approximation for determining a Cap Rate
for a project and explains, in part, why real estate is so sensitive to
changes in interest rates.

The higher interest rates are, the higher the Cap Rate will be and,
hence, the lower selling prices will be. The opposite is also true.
Obviously, Buyers want to purchase property with the highest possible
cap rates and Sellers want to sell at the lowest possible cap rates.

Real estate is highly cyclic and moves largely with interest rates.
As we found out above, higher Cap Rates imply lower Selling Prices but,
by definition, it also means lower Purchase Prices.

Do you want to make money in the real estate business?

Then buy when everybody else is selling (i.e., when Cap Rates are the
highest and interest rates are the highest) and sell when everyone else
is buying (i.e., when Cap Rates are the lowest and interest rates are
the lowest). A simpler way to put it is: “Buy low, sell high.”

Now this is easier said than done. People are very sheep like. We
like to buy what everyone else is buying. Ever bought a suit and had the
sales person tell you: “This is really in this season—everyone who is
anyone is buying this.” They tell you this because it works.

It’s hard to buy real estate when no one else is and interest rates
are high. Everyone will tell you not to—your CFO, your auditor, your
bank, your spouse, your BOD (Board of Directors), your CAO, COO, even
your CTO (Chief Techie) will not want you to—she or he will want more
dough for their department instead—it’ll have a better ROR, or so they
will tell you. But you are the CEO and, at the end of the day, the
decision is yours.

The best deals I ever did (and if only I had stuck to Real Estate and
not got into hockey and other distractions) were when the real estate
markets were depressed. I bought some land in Ottawa near a major,
east-end shopping centre in 1983 when interest rates were 19%. The land
cost me $1 per square foot for ten acres. In 1984, I got an offer for
the land at 50 cents a square foot—I thought I was in real trouble. But I
went to my Dad and he reminded me about rule number 1—buy low/sell high
and I declined the offer.

By 1985/86, interest rates were down by half and I sold four acres
for $10 per square foot to an auto dealer and the other six acres to an
industrial company for $12. We made about $4m in three years on an
investment of $450k; you don’t need to do an IRR calculation or ROR or
ROE on deals like this—they are good deals. (That money too later found
its way into the Sens, ugh. Money in NHL hockey seems to go on a one way
trip—in, but never out.)

In 1994, the real estate biz was again in a slump. (These down cycles
seem to come about every seven years and real estate tends to lead the
national economy into a recession and lag it coming out which means it
usually lasts longer than the general recession. But when real estate
bounces up, it bounces in a hurry and you have to start selling right
away if you want to time the market). I bought 60 acres of industrial
land in Kanata for just 15 cents a square foot. I couldn’t believe
it—people were just giving the stuff away—prices were lower than at any
time since the Depression of the 1930s for goodness sake. By 1999, in
the tech boom, serviced industrial land in Kanata was selling for $6 to
$8 per square foot, if you could find it.

A client of mine is looking at buying a building in Ottawa for his
packing supplies business. He is following my advice—own your own real
estate. The SodaPop Building is selling for $4.8m. His biz will occupy
about half the premises and the other half he will rent out. The Cap
rate for his acquisition is:

Cap Rate (SodaPop Building) = (NOI + CRF(I, A) x (S.P. – E))/ $4,800,000 = ($301,736 + $313,864)/ $4,800,000 = 12.825%.

From his point of view (as the Purchaser), this looks pretty good.
Cap Rates for industrial property can easily climb to 9, 10, 11, 12 or
even more which would mean a much lower cost of acquisition for Paul
(not his real name).

As discussed above, another way to look at the inverse of the Cap
rate is that it is a rough measure of how long it takes to get your
money back. Another useful engineering approach to problems is to check
your units, viz:

Inverse of Cap Rate units = $/($/yr. + $/yr.) = $/$/yr. = yr.

So Paul’s new project will take 7.8 years to return all of its
capital back to Paul (his equity) and to his debt holders. That is
pretty fast if you think about the average homeowner taking 20, 25 or 30
years to pay off their home mortgage which many actually never
accomplish.

But Paul should be much more interested in when he gets back his
equity—this means he can turn around and do something else with his
equity—buy more real estate, buy more equipment for his packing supplies
biz, go on a nice holiday, buy a boat, whatever.

You get an approximate time for Paul to get his money back by simply
dividing his Equity by the NOI. This works out to $1.2m divided by
$301,736 or roughly 4 years. The IRR is a much more precise tool but it
seems that the industry is just much more comfortable with a ‘rule of
thumb’ cap rate approach.

Now let’s look at the cap rate for a small investment property. Let’s
use as a n example, a multi-residential building, “Langlier Place”
which has 12, 1-bedroom units and 36, 2-bedroom units. Note that it is
important to know whether the cap rates you are using are effectively
net or gross cap rates. The cap rates calculated above used gross
operating income; for small investment properties it is typical to use
net operating income where NOI is found by subtracting operating costs
that the owner must pay from revenues received. The operating costs do
not include either depreciation or mortgage interest. This is because
cap rates remove from their calculation the debt structure of the owner.
Obviously, a large well funded REIT, Pen Fund or Insurance Company will
have a lower COF (Cost of Funds) than a typical private investor.

Therefore, for cap rates to be useful to compare one property with
another similar one (similar in terms of quality, location, age, etc.) ,
you need to remove the impact of different capital structures.

Langlier Place—Owner’s Pro Forma Langlier Place—Appraiser’s Pro Forma
Revenues

                                      YEAR 1                 YEAR 2               YEAR 3

Rent                               $688,000                $694,000             $698,000
Parking and Laundry      $  24,000                $ 24,800              $ 26,400
Total                              $712,000                $718,800             $724,400

Expenses

Realty taxes…………………………………………………… $ 52,800
Water………………………………………………………….. $  9,800
Hydro………………………………………………………….. nil*
Insurance………………………………………………………. $  7,800
Maintenance and Repairs……………………………………… $  5,500
Painting………………………………………………………… $12,000
Supplies………………………………………………………… $ 1,300
Elevator maintenance…………………………………………… $ 1,100
Accounting and Legal…………………………………………… $ 3,000
Superintendent…………………………………………………. $ 22,000
Mortgage Payments** (Principal and Interest)………….………$404,186
Total Operating Costs…………………………………………. $519,486
Potential Gross Income

12, 1-bedroom units @ market rent of $900 each……………. $129,600
36, 2-bedroom units @ market rent of $1,325 each………….. $572,400
Sub-total……………………………………………………… $702,000

Additional Income

Parking, 42 spaces @ $55 per month………………………… $  27,720
Laundry, 5 w/d @ $30 per month…………………………….. $   1,800

Total Potential Gross Income………………………………… $731,520
Less vacancy allowance of 6%………………………………………….-$ 43,912
Effective Gross Income………………………………………. $687,628

Operating Costs

Realty taxes…………………………………………………… $ 52,800
Water………………………………………………………….. $  9,800
Hydro………………………………………………………….. nil*
Insurance………………………………………………………. $  7,800
Maintenance and Repairs……………………………………… $  5,500
Painting………………………………………………………… $12,000
Supplies………………………………………………………… $ 1,300
Elevator maintenance…………………………………………… $ 1,100
Accounting and Legal…………………………………………… $ 3,000
Superintendent…………………………………………………. $ 22,000
Property Management (3% of Effective Gross Income).…….… $ 20,629
Total Operating Costs…………………………………………. $135,929

Net Operating Income…………………………………………. $204,914 Semi-Net Annual Operating Income………..…………………. $551,699
Selling Price…………………………………………………. $6,500,000
Cap Rate…………………………………………………….……..8.49%

(* Paid by Tenants.)
(** Mortgage is a Canadian mortgage of $4.2 million with an interest rate of 7.25% and amortization period of 20 years.)

You will notice that the Cap Rate for Langlier Place is calculated
using a ‘semi-net’ operating income. This shows how difficult and
seat-of-the-pants Cap rates can be. As long as you know how the cap rate
you are being quoted was used, this can be a useful way to compare one
property with another. But what if someone is using NOI and someone else
is using a semi-net number and someone else is using gross income? Use
cap rates carefully.

The ROE

Another simple (and very approximate) way to measure returns is as follows:

Total ROE = ROE (Cash-on-Cash Portion) + ROE (General Real Property
Inflation) + ROE (Average Principal Repaid) + ROE (Tax Advantage on
Unearned Rents)

Here is an example taken from some work I did for a client of mine
who bought an 80,000 square foot industrial building, in part for their
own use and in part to lease out to third parties (most of whom are in
their supply chain so that there were some operational synergies that
don’t show up in these calculations). I have changed the numbers a bit
to protect their identity.

Sample Calculation of Approximate ROE for Acquisition of Soda Pop HQ

Cost to Acquire Soda Pop HQ Building 80,000 s.f. $60.00 per s.f. $4,800,000
Equity 25% $1,200,000
First Mortgage 75% $3,600,000
Annual Payment 6% 20 year amortization ($313,864.41) per year
Total Rent 80,000 s.f. $9 per s.f. per year net $720,000 per year
less vacancy allowance 10% ($72,000) per year
less real estate commission on rents 5.00% ($32,400) per year
Total Net Rent $615,600 per year
less annual payment of mortgage ($313,864.41) per year
Total NOI $301,736 per year
Cash on cash ROE 25% per year
plus approximate Annual Inflation in Building Value 0.75% p.a. 3% per year
plus ‘wealth’ effect of AVERAGE annual principal repayments $180,000 per year 15% per year
Total approximate ROE 43% per year

Why Not Invest in Real Estate

I realize the title of this section can be read in two ways—why not
invest in real estate or why not to invest in real estate. I wish to
address the latter here.

What are the negatives of investing in real estate? There are many
risks and real estate investing is not all rosy. Here are a few pitfalls
to watch for:

a) Transaction costs are significant especially if you trade
frequently. Transaction costs include: legal fees on completion,
accounting fees, Land Transfer Taxes, adjustments on closing (e.g., for
pre-paid realty taxes), GST (Goods and Services Taxes in Canada on
certain types of real estate like residential rentals and almost all
commercial property), withholding taxes for non-residents (income tax
withholdings), realtors fees, etc.

b) Lack of liquidity—real estate sales and closings can take a long
time. Widely-held stocks, for example, can be sold in a few hours or
days.

c) Bad tenants.

d) Cost overruns on construction or renovation.

e) Storms and other natural disasters.

f) Vacancies.

g) Outdated design, floor plans, uses (e.g., a few years ago,
everyone wanted to build server farms until they realized that servers
are small and getting smaller and more powerful all the time and, hence,
don’t take up a lot of floor space).

h) Delays in completion of new construction or renovation.

i) Long planning cycles made more difficult by NIMBY (Not In My Back Yard) behaviour.

j) Long delays in acquiring building permits.

k) Low appraisals.

l) Degradation of the neighborhood/bad neighbours.

m) Increased costs—hydro and insurance especially.

n) Surprise maintenance.

o) Dishonest property managers. (It is surprising how much
residential rent is still collected in cash. A dishonest superintendent
who runs off with one month’s rent from all your tenants can bankrupt
you in a hurry.)

p) Down cycles in the market.

q) Being upside down on equity (see below).

r) Negative changes in tax regimes like increasing capital gains
taxes, reductions in allowable Capital Cost Allowance deductions against
income and other income, rapid increases in realty taxes and gross
leases where the costs can not easily be passed on to tenants.

s) Real estate is an intensely local business; success by you in one
market does not necessarily translate into success in another.

t) RISING INTEREST RATES.

So there are a lot of risks in owning real estate and there is no way
to avoid these risks entirely. One way to improve the odds is to buy
low which we talked about above. A good friend of mine, Barry Lett, a
real estate veteran and a survivor of many real estate down cycles, once
told me: “You don’t make money when you sell real estate; you make it
when you buy.” If you buy low enough, it makes up for many sins later
on.

Now there area  few other things you can do to somewhat de-risk the
process—you can invest in more than one building, in more than one type
of real estate, in more than one neighborhood and in more than one city
as well as perhaps more than one country. To learn more about some real
estate investing rules that I developed, you can refer to: If I were
King (or Queen) of Exxon, I would….:
https://www.dramatispersonae.org/EnterpriseOfTheCity/HomePage/KingOfExxon.htm.

One last note. Former Chief Justice of the SCC (Supreme Court of
Canada) Bora Laskin once said that insurance companies are larger firms
that exist to take advantage of smaller companies and individuals. He
obviously took a dim view of the industry. I have always wondered why
more real estate investors don’t self-insure. This would only apply to
large sophisticated investors, of course. But if you owned 50 or 100
separate buildings in say a couple of cities, perhaps it would make
sense to only have liability insurance on them. I mean what is the
chance that all 50 of them will burn down at the same time? You would
need to do some careful analysis but you might well be better off paying
your ‘property insurance’ to yourself—build your own sinking fund and
self insure. After 30 or 40 years, I am guessing you would have quite a
sizeable fund that when you sell your portfolio, guess what, it belongs
to you.

Conclusion

Now in our calculation of ROE above, there were no tax consequences
from unearned rents taken into account, so don’t look for them. This is
typical for commercial situations (unearned rent is a concept largely
confined to homeowner situations).

Nevertheless, our client’s financial position was immensely improved
by this acquisition of real estate; firstly, his cash-on-cash annual
return was 25% p.a., i.e., they were pocketing over $300,000 in cash
every year from their real estate ownership. The term ‘cash-on-cash
return’ refers to the cash portion of your return divided by the cash
(AKA cash equity) you have invested in the project.

Additionally, general real estate inflation adds 3% and average
principal repayments add another 15% to their ROE. As noted above, we
have assumed general market inflation in these types of buildings is
.75% p.a. which results in a 3% bump in ROE. That’s due to the fact that
all of the increase in building value is going to ownership. Ownership
in this example has 25% equity in the deal so we multiplied by a factor
of 4. Obviously, as the mortgage is retired, the percentage of equity in
the deal goes up, and the ROE derived from general market inflation
goes down but we already qualified this approach as an approximate
methodology anyway. (The key benefit to being an equity owner is that
all increase in value comes to you. Of course, if anything goes wrong,
you are first to be wiped out—your debt holders have prior claim on the
assets. Right?)

I have also used a simple and approximate way of calculating the
order of magnitude of the wealth effect from annual principal repayment
in the above example. I divided the principal amount of the mortgage by
the amortization period—this gives the average amount of principal paid
off a year (obviously, less principal is paid off in the early years and
more in the latter part of the mortgage period). Then divide this by
the equity invested in the project and you get the ‘wealth effect’ part
of the ROE from simply paying off the mortgage. Bottom line—pay off your
mortgage as soon as you can. Reducing debt (all debt) is one of the
fastest ways to securing your financial future and simplifying your life
too.

This seems to be a bit of contradictory advice—I showed earlier on
that having five homes is better than having one—your cash on cash
return is greater but it comes from having more leverage (debt). But
actually the two concepts are internally consistent—by using more
leverage, you are producing more cash which if used to pay down debt
(instead of buying toys, say), actually reduces debt faster.
Comprehendo?

Another way of looking at leverage is that by allowing you to buy say
five rental homes instead of one, if you have a vacancy in one, your
occupancy rate falls from 100% to 80% not from 100% to zero.

As long as you are not upside down on equity (i.e., your rate of
return on your equity is less than the project’s overall rate of
return), leverage is a positive thing. In high inflationary periods like
the early to mid 1980s when interest rates were 19% to 21% and
inflation was 12%, investors would buy real estate and accept the fact
that their returns on equity were less than the overall project’s return
and, indeed, were often negative. In simple terms, this means that they
had to pump cash into their project’s every month. Say you purchased a
$10 million office complex that was losing $15,000 a month. That means
that somehow you have to come up with at least $180,000 per annum to
keep from losing your project. However, if this type of real estate is
increasing 1.5% above the inflation rate and the inflation rate is 12%,
the selling price of the project is going up 13.5% p.a. or $1.35 million
every year.

So investors would gamble that they could keep the property long
enough to benefit from inflation. If our imaginary 1980s investor kept
this building for two years and sold it for $10 million x (1.135) x
(1.135) or $12,882,250, he or she would have made $2,882,250 less the
cash he or she pumped in during that period ($360,000) or $2,522,250! We
are of course ignoring transaction costs for the moment.

But this is intensely risky—1. you might run out of cash before you
can sell it or 2. a person by the name of Paul Volcker might become
Chairman of the US Federal Reserve and raise interest rates to 21% and
crush inflation. So you are playing musical chairs and when the music
stops, someone is always left without a chair. Make sure it isn’t you by
buying smart—i.e., buy properties where cap rates are high enough that
you don’t have to pump in cash every month to stay alive.

Prof Bruce

Postscript: Real Estate Insiders

It is interesting to look at the investing behaviour of SIOR (Society
of Industrial and Office Realtors) members when they invest their own
money. In Professional Report (Summer 2006), Maura M. Cochran and Peter
L. Holland show that: “Almost 40 percent of the (SIOR) respondents
require an initial capitalization rate in excess of 10 percent, a
surprising number in this era of cap rates plunging into the range of
four to five percent in certain markets for certain classes of assets.”

Only 6% of SIOR respondents were willing to invest with a cap rate of
less than seven percent and more than a quarter of them in 2003 were
looking for IRRs of 26 percent or more!

What’s good for the goose is good for the gander—if Realtors are looking for these types of returns, so should you.

It is interesting to note that this type of behaviour does not only
apply to commercial Realtors—residential Realtors tend to keep their own
houses on the market a few weeks longer than they do for their clients
and get higher prices as a result (typically about 3% more).

Expectations

A person’s expected IRR tends to fall as they get older. My students
consistently score in the 20% to 30% range; that is they won’t lend a
$1,000 to their Prof until they get to these types of returns. As they
age, they end up lending money to their banks by the time they are 65 or
so at less than 3%!

Typical expectations of IRRs on equity are:

Retiree: under 6%
Middle Age: 8% to 12%
Student: 20% to 30%
Major Corporation: 20% to 30%
SME (Small and Medium Sized Enterprise): 20% to 40%
VC (Venture Capital):  30% to 40%
Vulture Capital: 40%+
Real Estate Speculator/Land Speculator: 100%

These are per annum percentages.

Having said all this, there aren’t many alternative investments that
can produce the types of returns year discussed above—year after year
consistently and at a reasonable risk. In the commercial ROE example I
gave above, their risk profile is especially low because they are
sitting owners (i.e., owner occupiers) and most of their tenants are
tied to them through their supply chain and so not likely to bolt on
them.

Of course, nothing is risk free. By having some of their suppliers in
their building if there is a downturn in their industry, they are all
affected negatively at the same time.

Having said this, I like having some third parties in the building
with the owner—they might be part of your supply chain and they can help
to pay some of the freight; in effect, they are paying off some of the
mortgage principal for you. Owner-occupied buildings with some extra
third party space can form interesting and synergistic communities of
like-minded enterprises—ones that support each other and buy and sell to
each other too.

I also like to have the real estate held in a separate company with
the operating company paying an arms-length, market rate for their
space. This is good discipline for the operating company (they will
price their products and services at levels that are appropriate to
their true cost of inputs) and a worthwhile diversification of risks for
the owners.

When buying real estate, it is good discipline to calculate your
return on equity as well as look at other financial ratios but I have
found that no matter how much analysis one does, at the end of the day,
every investment is a matter of faith and confidence: faith that things
will somehow work out and confidence that if they don’t, you can fix
them.

Postscript 2: More recently I wrote: “What You Need to Think about Before You Purchase a Home”. This blog entry (https://www.eqjournalblog.com/?p=984)
has a number of useful links including a spreadsheet which helps
demonstrate (and calculate) the different types of returns that arise
from the purchase of residential real estate.

       
       
       
     Prof Bruce @ 11:40 am

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         Why Large Companies Buy Cashflow Not Ideas        

       
   Posted on
       Sunday 1 November 2009  
     
   
       

I often get asked by inventors: “I have a great idea, why can’t I just sell it to a big firm for a bundle and let them run with it?”

Large, established firms don’t buy ideas—they buy cashflow and, while
this is often disappointing when inventors hear this, there are logical
reasons behind this position.

First of all, ideas are in infinite supply which makes them cheap.
Ideas by themselves are practically worthless—it is the ability to
execute on an idea, to turn it into a business model, then a business
plan, to put a product manager in charge, to produce it, find launch
clients, to market it broadly, to improve it and to put money on the
bottom line that companies and their stakeholders value.

Secondly, large companies reject almost all unsolicited proposals,
especially in the United States. A toy and game company, for example,
will return any unsolicited proposal in its original envelope with a
legal form letter basically saying they did not look at it and that they
don’t want to look at it. They live in fear of litigation—if the
proposal is at all similar to one they are already working on, their
litigation risk is very real.

Thirdly, they know that most startups based on a gadget or gizmo will
fail. The reason that major stores stock any item is that the suppliers
they deal with will each have multiple products in the channel, will
back those products up with major marketing muscle and will stand behind
their products if there is a recall. They also integrate their supply
chain into their inventory systems and they are much better off with a
few big suppliers than many smaller ones. So one-product companies
almost never catch on.

Fourthly, they know that even if a successful small competitor
emerges they have two solid options—a) they can squeeze them out by
lowering their prices or by buying more shelf space or b) they can buy
them out.

In the latter case, they often squeeze them first and then buy them out relatively inexpensively.

Large firms know that small competitors can develop new goods and
services far faster and far more cheaply than they can. So it is
rational for them to simply wait and watch for the tall poppy to appear
and then either squeeze it out, buy it or both.

Prof Bruce

Postscript: If an inventor does get a meeting with a large firm and a
deal does result, it doesn’t necessarily result in any benefit for the
inventor. Robert Kearns, the inventor of the intermittent wiper, had a
terrible experience in his dealings with a large car company.

There is a saying amongst intellectual property law lawyers: “A patent is only worth what you are prepared to pay to defend it.” Kearns lost his marriage and years of his life in an all consuming patent infringement battle.  

For most entrepreneurs, it is fast execution that counts a lot more
than hiring expensive patent agents and spending years, first patenting
the idea and, second, defending it. Remember that a patent application
requires disclosure so your competitors can reverse engineer your
product or service and then scheme to get around it.

In one case I am familiar with, a large firm paid $10,000 for access
to an idea (LED Xmas light strings) and then did nothing with it for 20
years. The inventors got the first $10,000 but nothing else.

I tell most inventors of gadgets and gizmos to either simply publish
their idea and allow it to enter the creative commons and be satisfied
to simply take credit for being first with the idea or to put it into
the marketplace themselves. In the latter case, I also tell them to
treat it like a hobby—maybe an expensive hobby but not one that will
wreck the financial state of their family. I tell them to use bootstrap
capital (like finding launch clients who will foot some of the bill) and
build an inexpensive website perhaps based on a Yahoo Small Business
platform—a fully e-commerce enabled, customized site can be set up for
about $40 per month plus a 1.5% transaction fee and a one-time set up
fee of $50. This won’t break the bank…

If it takes off, great. If it doesn’t, so what? Most inventors tell
me that they have the next Trivial Pursuit or Frisbee or Hula Hoop. But
the chances of that are probably less than the odds of winning a major
lottery like Lotto 6/49. Remember, you not only have to have a great
idea, but be able to execute on it as well which the inventors of the
above did do successfully.

In the 6/49, the winner must pick all 6 numbers correctly from the
set of numbers 1, 2, 3, … 49. Dr. Fred Hoppe, Professor of Mathematics
and Statistics at McMaster University, has calculated the odds of doing
that as 1 in 13,983,816 or about the same probability as flipping 24
heads or tails in a row.

Estimates are that there were 12.2 million self-employed persons in
the US in 2003 (U.S. Department of Labor, Bureau of Labor Statistics).
To this number, you would have to add the number of persons employed by
others who wish to become self employed and subtract the number of self
employed who wish to be employed by others but can’t find a job. Let’s
assume these cancel out and that each self-employed person has one
serious new idea per year (experience tells me that the rate of idea
generation by entrepreneurs is actually much higher than this—one of the
problems that entrepreneurs tend to have is that they have too many
ideas and a lack of focus is often a problem in terms of their eventual
success or lack thereof).

In a generation of 25 years then you might see 305 million ideas
generated by this group of which seven turn into Apple, Hula Hoop,
Microsoft, Frisbee, Trivial Pursuit, Intermittent Wiper and Google. Your
odds? 1 in 43,571,429. So make it a hobby until it proves otherwise.

       
       
       
     Prof Bruce @ 9:15 am

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        Filed under:

25 Steps to Business Success

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Internet– the Internet is Eating a Hole in the Global

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Why Businesses Fail

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         Negative Cost Selling        

       
   Posted on
       Friday 30 October 2009  
     
   
       

Best Of Kanata
How to Explain to your Clients that by Buying your Product or Service, It will be a Negative Cost to Them

My friend, Richard Rutkowski, a former City of Kanata Councillor is
an intriguing person—very sure of himself, a good marketer, a good
promoter and a sure handed politician (now a successful REALTOR with his
own Brokerage.)

I asked Richard a few years ago if he did something else beyond being
a REALTOR and, sure enough, he hauls out this cute little magazine
called The Best of Kanata. Now this is really low tech—essentially,
local businesses advertise in it, so that is one revenue stream for
Richard.

It costs about $600 for a half page and there are lots of pages.
Then, people buy these books for 20 bucks and in the back of the
magazine, there is a ‘member’s card’ about the size of a credit card,
which entitles them to 10% off at all stores and services featured in
the book.

When I did a Google search at that time, there was no mention of it. So, Richard hadn’t even bothered with a web site.

Well, this is a pretty simple business and local businesses advertise
in it like crazy because they like Richard and it works for them and it
is relatively inexpensive.

Richard sold around 5,000 copies of the book each year, so you can figure out for yourself the economics pretty easily.

The business model has more depth to it than it might first appear.
Revenues are generated from advertisers and book purchasers. But it
turns out that Richard’s clients are also his suppliers and his
suppliers are also his clients.

Advertisers supply ads, which form the content of the book. Plus they
supply the 10% off cards that drive sales to the public. But
interestingly, the advertisers also stock the books for sale to members
of the public. If you place a half page ad in the book for, say, $350,
and you sell the book for $20 of which you get to keep $10, you only
need to sell 35 books before your ad costs you nothing.

Think about the compelling value proposition that Richard can present
to a single customer—you can buy an ad for a negative cost if you can
sell more than 35 books.

In this way, his clients form one of his top sales channels. Another
sales channel consists of local charities and other good causes. The
Kanata Food Cupboard, for example, sells each book for 20 bucks and they
get to keep 15. Minor hockey teams use it too—to raise funds for hockey
tournaments, for example.

The cost to start the Best of Kanata was negative—Richard was able to
pre-sell enough advertising so that the cost of printing the first book
was more than offset by deposits from advertisers. They gave Richard
50% of the cost of their ads upfront because they trust Richard and
because they want Richard to succeed since it’s in their best interests
that he does.

The value proposition to the retail customer may also involve
negative costs. Let’s say you go into a sports store in Kanata to buy
your daughter a $800 snow board. You go to the cash to pay up and the
clerk tells you: “Why don’t you buy the BOK for $20?” “No thanks,” you
say, “I am spending enough already on Brandi!” “What I meant to say is
that if you buy the BOK, you get a 10% discount on whatever you buy here
and in any other store in Kanata, starting right now.” “If I understand
you correctly, if I give you 20 bucks for this Book, you’ll give me $80
off the snowboard?” “That’s right, you give me $20 and I give you $80
so the Book costs you a -$60 and the membership card will work for you
until the end of the year…”

Selling a book for a negative cost should be pretty easy even for the most sales-technique challenged clerk.

These kinds of value propositions are not exploited nearly often
enough because owners and managers don’t usually spend enough time
really understanding their own businesses from their client’s point of
view.

I have thought that there is a big, scalable business in this
model—how about the Best of Dartmouth, Best of Mississauga, Best of
Saskatoon, Best of Manhattan!

I think creating businesses via entrepreneurship should aim to
provide an individual with more value than if he or she just had a
J.O.B. but maybe there is a more subtle message here.

Perhaps, we should each have one micro business that we hang onto for
life; that never gets shared with anyone, no partners, never is pledged
to a Bank for a loan and, thus, something that we can fall back on in
troubled times.

It would be pretty cool if every man, woman and child on the planet
each had a Personal Business (PB) that stayed with us throughout our
lives and, if things get messed up, well, we have (as my father would
say): a fallback position or an iron reserve. My father lived through
two World Wars and he really understood the need for both.

A PB4L does not include things like the guy who tells you: “I can
show you how to make a million! Just send me ONE dollar, and I will tell
you how.” And, of course, the answer is: “Get a million fools to each
send you a dollar to tell them how…”

They have to be real businesses. One way to find inspiration I think
would be to go get a copy (from your library) of the Encyclopedia
Britannica and look for crafts from the 1930s. Say, for example, making
high end paper for socialites and important persons who want acid-free
paper to preserve their writings. Who knows what you might find there.

Prof Bruce

       
       
       
     Prof Bruce @ 6:18 am

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Bootstrap Capital

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Bootstrap Entrepreneurs– Case Studies

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Personal Business for Life, PB4L

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Value Differentiation and ‘Pixie Dust’

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         Should Every Person on the Planet        

       
   Posted on
       Saturday 24 October 2009  
     
   
       

Have a PB4L (Personal Business for Life)?
(Originally appeared in the Ottawa Business Journal, Oct. 2009)

For the last few years, I have become increasingly certain that
people in the 21st Century may need what I can only call a Personal
Business. There are so many changes going on in the local, national and
global economy and so many things can and do go wrong, that it might not
be a bad idea after all to have a fallback position.

Maybe we should each have one micro business that we hang onto for
life; that never gets shared with anyone, where we take no partners and
never pledge it to a Bank for a loan and, thus, have something that is
uniquely ours that we can fall back on in troubled times. As my late
father, Professor O. J. Firestone would have said: “You need an iron
reserve.”

A PB4L does not include things like the guy who tells you: “I can
show you how to make a million dollars! Just send me ONE dollar, and I
will tell you how.” And, of course, the answer is: “Get a million fools
to each send you a dollar to tell them how to…”

They have to be real businesses. One way to find inspiration I think
would be to go get a copy (from your library) of the Encyclopedia
Britannica and look for ideas from the 1930s. Say, for example, making
high end paper for socialites and demanding persons who want acid-free
paper to preserve their writings. Who knows what you might find there.

Let me share with you an example. A few years ago, Ryan North, a
former student of mine and an IT professional, started Qwantz.com in the
learn-by-doing part of Entrepreneurialist Culture, one of the courses I
teach. Qwantz.com is an online dinosaur comic strip.

The only problem Ryan had was that he couldn’t draw. Like most
entrepreneurs, he turned a weakness into a strength. His comic strip has
six panels with three dino characters—all images are taken from free,
publicly available clip art. The key is that the panels and characters
NEVER change. They are the same, day-to-day.

What changes is the dialogue between the characters—T-Rex is a large,
stumbling, know-nothing and chauvinistic loud mouth. The other two
characters are: Dromiceiomimis (the tan coloured dino in the middle
panel) and Utahraptor (the orange one), the latter two are loving, warm,
smart and wise. From this somewhat inauspicious start, Ryan has become
an internationally known writer who creates and self-publishes the only
daily comic strip with images that never move or change. It is the
subtlety of the dialogue that creates interest and a strangely
compelling read that becomes more interesting the more you read it.

It doesn’t hurt that Ryan is brilliant and quirky. Here is T-Rex’s take on entrepreneurship:

Ryan’s daily routine is to get up and answer his fan mail for about
an hour. Mixed in are requests for merchandise. That is one of Ryan’s
revenue streams. He sells a ton of t-shirts and, wisely, he handles the
money while outsourcing fulfillment.

After an hour or so, he turns his mind to the comic of the day. By
noon, he’s done and ready for the rest of his day. He travels widely,
does appearances at comic conventions where he signs copies of his books
(such as Your Whole Family is Made of Meat) and had time to fool around
developing an advertising engine (Project Wonderful) that was
profitable within ten days of its launch. He makes a ton of money and
has a wonderful life.

Ryan in a Tree

Ryan started Qwantz.com with less than $100. His marketing budget was
around $20. He bought the domain name poo.ca and put up cardboard
cutouts of T-Rex around the University with this domain name on it and
nothing else. Students started checking out the mysterious site and got
hooked on his comic.

(If you type in poo.ca it still resolves to the Qwantz.com URL. The
comic has been continually published since Feb 1, 2003. Revenue streams
include: merchandise, appearance fees, book sales, Project Wonderful
ads.)

Now a PB4L is not just a fallback position. It can be a contributor
to pulling people out of poverty in LDCs around the world. It was not
government Five Year Plans that brought India and China out of
poverty—it was the unleashing of the entrepreneur class in those
countries that did it.

Prof Bruce

Professor Bruce M. Firestone, Entrepreneur-in-Residence, Telfer
School of Management, University of Ottawa; Executive Director,
Exploriem.org; Founder, Ottawa Senators; Real Estate Broker and Mortgage
Broker Email: bfirestone@partnersadvantage.ca Blog:
https://www.eqjournalblog.com/ Twitter: https://twitter.com/ProfBruce

Postscript: If you would like to read more about the concept of PB4L,
you can download a Word Doc on the subject from our server at: https://dramatispersonae.org/PB4LPersonalBusinessForLifeCEEDSpeechOct2009.doc.
It is available as a Word Doc so you can quote from the article or use
it in a responsible fashion as required. The only thing we would ask is
that you quote the source.

Postscript 2: subsequent to writing this I added another example (https://www.eqjournalblog.com/?p=2012) to the PB4L folklore. I repeat it here as well:

I collect stories about Personal Businesses for Life (PB4L) for this
blog and also for my students because they can learn a great deal from
people who have already bootstrapped an enterprise, made it successful
and kept ownership of it—away from Banks, VCs, Angel investors, angry
creditors, partners, ex-spouses, what have you.

I have told my students that a good source of ideas for PB4Ls might
be to visit their local Libraries and look at old copies of the
Encyclopedia Britannica. I would recommend pre-World War II and even
pre-World War I vintage encyclopedias—what they are looking for are
‘ancient’ crafts that they can reuse and recycle.

Former snowboarder, Aaron Draplin, created a $1 million per annum
business based on an old recipe—authentically crafted, offset printed
sets of Field Notes.  

Field Notes Nostalgia

I am an inveterate note taker and the nostalgic look and feel of their website and product really appeal to me. See: https://fieldnotesbrand.com/. Their tagline, taken from one of their ancestors, is too precious for words: “I am not writing it down to remember it later, I’m writing it down to remember it now.”

There is a lot of truth in this—I don’t care what anyone says, there
is something quite different between writing something down using pen
and paper versus recording it on your tablet, say. Many authors over the
years have told me that they produce a completely different style of
writing if they eschew a computer (or for that matter a typewriter) and
write a novel by hand. No one does that anymore and it shows.

When we designed the Palladium (now called Scotiabank Place), you
NEVER saw the architects of record (Gino Rossetti and his son, Matt)
without their Field Notes and Sketch Pads. I asked Matt why, with all
the CAD software he has access to, he still used his sketch pad. He told
me: “Here’s why: I can create much more complex, much more graceful
architecture, much faster, with my sketch pad than with a computer. It
is much too confining.”

I still haven’t found any better way to control a business, even
large businesses, than through the daily making of lists of things to
do. I insist that people around me do that. Folks I know who use their
smartphones or PCs to control their calendars and to-do lists are much
less accurate and productive, I am sure of it.

This is not to say that I don’t love the tools we have available to us today. I am on record as saying: “I’m like the Scarecrow in the Wizard of Oz: I have half a brain. My computer is the other half.” So this post is not an argument against technology, just its misuse.

To survive today, you need to be innovative as well as productive and
I think Field Notes or just a simple pad of paper can still help you
with all of that.

Now Draplin and his partner, designer Jim Coudal, sell these 3” x 5”
books for $9.95 in sets of three. They have developed numerous sales
channels including their website, attendance at agricultural fairs and
250 retailers who have to apply to be accepted into their network. This
reverse snobbery works for them—these retailers have to prove that they
buy-in to their philosophy which includes: authenticity, “Made in the
USA”, use of local materials, a heightened sense of the importance and
central mission of design and fashion, transparency, and nostalgia for
community values of days gone by. Their clients go out of their way to
suggest to them which retailers might qualify…

They bootstrapped the firm—no VC money. Their marketing is based on
video documentaries they produced for an online community that focuses
on the Founders’ experiences with the development of Field Notes as well
as those of their suppliers, retailers and customers—they understand
that they work within a business ecosystem that nourishes them and that
they, in turn, embrace by involving them in the whole, evolving story of
Field Notes. Customers can post examples of how they use Field Notes
and learn from each other’s experiences with the notebooks.

Now let me tell you a story about Jeff Cavanagh from Thomas Cavanagh Construction.

A few years ago, I asked him: “Hey, Jeff, do you have a Blackberry?”

“No, Bruce, I got me a Strawberry instead.”

“What’s a Strawberry? I haven’t heard of a smart phone called the ‘Strawberry’.”

“Well, it’s this here little black, pocket-sized notebook of mine
where I write down all the things I gotta do with this little pencil.”

“But don’t you miss not having email, your calendar and a bunch of apps on your cell phone?”

“Nope. Look at it this way. Let’s you and me suppose that Sir
Alexander Graham Bell had invented email instead of the telephone, that
his patent in 1876 was for email not voice communications. OKAY?”

“Sure.”

“Let’s further assume that voice did not become possible until Tim
Berners-Lee invented the Web in 1991. So we reverse the order of
invention, OK?”

“Got it.”

“Then imagine the conversation you and I might be having today. It
might go something like this: ‘Did you see this new fangled thing that
just came out—it’s called a tell-a-phone. You can get someone on the
other end and you can actually hear what they are saying. You can pick
up nuances in their voices, you can laugh together, you can plan
together, you can negotiate and you can do it all in real time. It’s
almost as good as being there.

‘No more waiting, sometimes days, for someone to answer your email.
No more misunderstanding stuff just because you were trying to be funny
or sarcastic and it fell flat in yer email.

‘Or suppose you need something done urgently, you can actually get
some action by impressing upon someone the importance of what you are
saying by raising or lowering your voice—people are good at picking up
tonality on the tell-a-phone…’”

There is a lot of wisdom in this. The best way to do things might
just be a bit old fashioned—like having F2F meetings, like writing
things down, like making phone calls. Clearly, Draplin and Coudal have
found something special that people want and, by combining it with
modern marketing and distribution, they have created lasting value for
themselves and their families.

It will be hard to knock off Field Notes, not because you can’t
create a nice looking notebook too but because you can’t (easily)
recreate their dedicated community of suppliers, retailers, customers
who have also become friends/fans and followers and who have together
formed a bond around the themes that the Founders have woven together
into a compelling story.

Prof Bruce

Postscript: More recently, I have come to realize that another
potential source for PB4Ls might be public companies (or, for that
matter, any established enterprise) that are discarding under performing
assets. A friend of mine (I’ll call him Tony) picked up a 180,000 sq.
ft. building in Kanata, ON from a Boston-based firm that was
retrenching. It came with six acres of vacant land.

Tony turned the building into a mini-office and mini-storage place
and started generating cash within months. The vacant land alone is
worth more than the price he got the mini-portfolio for.

The whole deal was accretive to Tony because: a) he got the firm that
was essentially dumping these assets to give him a Seller Take Back
mortgage for basically the whole of the purchase price and b) they left
behind so much office furniture and equipment that he was able to sell
it for more than his down payment. Tony has turned this opportunity into
a PB4L.

There is another opportunity that I am aware of (as of Dec. 2010):
Bombardier is basically dumping part of its real estate portfolio in
Milford ON (near Kingston). There is a 160,000 sq. ft. building there
that they used to use for (train) engine maintenance and it has a vast
hall with 38 foot ceilings. I visited it in October. All it needs is
someone with a soupçon of creativity to convert it into a PB4L.

Bombardier is selling it for around $15 per sq ft. It would cost at
least $120 per sq. ft. to build today and, in fact, you might pay more
in annual rent in a place like Ottawa than you can buy it for. Plus, who
knows? Maybe Bombardier would take back some financing on it just to
get it off its books.

The practical uses for it? Maybe storage (because of its high
ceilings, you can stack a lot of stuff there.) Maybe a film studio.
Maybe a recycling centre. Who know? Just add an entrepreneur and stir…

Another possible source for PB4Ls could be people who are about to
retire or would like to retire. A good source of opportunities would be
to get in touch with folks like Sunbelt Business Brokers. These guys get
a ton of action; they pre-qualify firms before they go up for sale. My
friend Greg Kells at SBB always seems to have his finger on a huge
number of businesses for sale in just about any sector you can think of.

Sources: Financial Post, December 6, 2010 story by Deborah L. Cohen: “Social media gives old medium new life”.

       
       
       
     Prof Bruce @ 3:26 pm

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Bootstrap Capital

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Business Models

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Guerrilla Marketing

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Rules? There are no rules in entrepreneurship.

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         Calculate the Real Rate of Return        

       
   Posted on
       Tuesday 20 October 2009  
     
   
       

For a New Retail Plaza

I get asked all the time, how do you measure the rate of return on
real estate. A typical real estate project has three types of return:
cash on cash (your monthly cashflow), real estate inflation (how much
can you sell it for after a few years) and the wealth effect (from
paying down the mortgage, often using OPM, Other People’s Money).

The best way to make this determination in my view, is to bring all
three types of return into one number, the IRR or Internal Rate of
Return. I was asked by a client of mine recently to produce a proforma
spreadsheet that would show him how, if he bought a piece of land and
developed a small retail plaza for his medical practice and a few
tenants, he would do over a seven year period.

I posted the spreadsheet in .xls format so any of my readers can
download it and use it for one of their projects. You can get it at: https://www.ottawarealestatenews.com/RetailPlazaCosting.xls.

The spreadsheet is linked to basic parameters so you can change
things like the cost of the land, the cost to construct, the interest
rate on the mortgage, the percentage of equity, real estate inflation
rate and the thing will automatically give you a new IRR.

In this example, he has to put down 25% in equity and he pays near
market rent for his own space. If he does that, his IRR over a seven
year period is a, not bad, 24.2% p.a. This is made up of his monthly
free cashflow (more than $100k per year), real estate inflation (that I
have assumed will add 2% per year to the selling price of the plaza over
seven years) plus the paydown of his mortgage: he reduces the principal
due on his mortgage by more than $250k over seven years.

This is an example of a development project but could just as easily be applied to an existing building.

Hope you find it useful.

Prof Bruce

ps. I am not suggesting that he sell the building after seven years. I just use that period to bound the analysis.

       
       
       
     Prof Bruce @ 5:46 pm

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Investing

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IRR

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         N > 22        

       
   Posted on
       Sunday 18 October 2009  
     
   
       

This simple equation is something that Maple Leafs GM Brian
Burke and Coach Ron Wilson may have to become familiar with. When we
brought back the Sens in 1992 to play in the National League after a
nearly 60 year absence, we set our goal from Day 1: the team had to get
22 or more points that year. Why? Because then we would not wear the
label ‘Worst NHL Team… Ever’.

That unfortunate label is something that the expansion Capitals own;
having scored just 21 points in their inaugural season (1971/72). Those
players who were with the Caps that year have had to live with that
designation ever since. Now middle aged, they still get asked: “Were you
on THAT team?” everywhere they go and they are sick of it. They would
certainly like some other team to have that dismal record.

Fortunately, both the Sens and the San Jose Sharks avoided this fate, each getting 24 points that year.

The Leafs are now tied for their worst start ever: just 1 point from
their first 7 games. That record over an 82 game season would yield
about 12 points, a true horror.

No one can really understand the pressure on Burke and Wilson but if
anyone can, it’s the first year Sens players, coaches (Rick Bowness,
Alain Vigneault), management and ownership. By putting the goal out
there (N > 22) and getting buy-in from everyone, we were focused on
achieving that and humans are uniquely capable of visualizing and
achieving goals.

The Leafs will get better and the Washington Capitals record is safe I
believe but if they need to reach into their bag of tricks, Wilson and
Burke might have to resort to simple goal setting to stay out of the
all-time basement.

Prof Bruce

       
       
       
     Prof Bruce @ 10:30 am

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         12 Things You Need to Know        

       
   Posted on
       Sunday 11 October 2009  
     
   
       

When Your Wife Asks You for a Divorce

A young friend of mine and I had breakfast the other day—he was
devastated. His wife had asked him for a divorce on the weekend and he
was reeling. I asked him; “Did you know that the vast majority of all
proposals are made by men and the reverse is true for divorces?” It made
him feel a bit better to know that he has company.

Here are 12 things you might want to consider if (unfortunately) your wife wants a divorce:

1. There are physiological factors that bind human pairs. There are
endorphins produced in the brain every time you are near the person you
love. This has a strong evolutionary biological function—to keep human
pairs together long enough to raise their offspring which, for humans,
takes an incredibly long time. When your wife tells you she wants out,
you will feel exactly like someone who is trying to kick a drug habit,
stop smoking cigarettes or stop drinking alcohol. It’s perfectly normal
but incredibly painful. Disassociation from people and objects around
you is also normal. The only good news here is that it will eventually
go away.
2. It will go away much faster if either you or she moves out. If you
see her every day, look at photos, day dream about her, talk on the
phone, you are simply reinforcing the production of these chemicals in
your brain—what you want to do is quit—cold turkey.
3. Focus on the short term financial plan. Don’t try to work out
everything in a weekend. Focus on, say, the next 90 days. Where is she
or you going to live, how much money does she need, do you need, what
will happen to the kids? Leave the big things—your pension plan, her
pension plan, the matrimonial home, the cottage, the long term living
situation for the kids to the next go around of negotiations. Right now
you have to get feeling better and so does she, but it will take you
longer since, in all likelihood, she has been thinking about this for a
lot longer than you have.
4. When you do get around to creating a long term plan, be generous. But
remember, your income may have been going up since your first job as a
teen but it can also go down when you enter middle age. Provide for that
possibility.
5. You can not (in most jurisdictions today) get rid of your family
obligations by declaring bankruptcy at some future date. These
obligations generally survive a bankruptcy filing. So make sure your
settlement is sustainable.
6. Decide whether support (paid by you or possibly by her) is tax
deductible in your hands (or hers). If you pay support, she will want to
receive it tax free and you will want to deduct it from your taxes so
this is a big issue to be decided.
7. Don’t let your lawyer or hers run the negotiations—the negotiations
will drag on for a long time and they may churn your account to maximize
legal fees and turn the whole thing into an endless legal nightmare.
Most settlements are reached by the principals not their lawyers.
8. You get to feel sorry for yourself for three days—the first day you
can have a (few) drinks, the second day, you can mope around, the third
day, you get some exercise plus get up, go to work and move on with your
life.
9. Don’t turn to drugs—legal or illegal. If you find yourself suffering
from depression, you should go to your family Doctor for help. But long
term, drugs will not save you.
10. Believe it or not, there will be another lady for you some day. Have hope for better days ahead.
11. Don’t bad mouth your soon-to-be-ex-wife to your kids or anyone else.
12. When she shows up at your daughter’s soccer match with a new
boyfriend, take it easy. Don’t do anything rash. Men can be very
territorial. Just move on with your life.

Prof Bruce

       
       
       
     Prof Bruce @ 8:58 am

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About the Author

Bruce is an entrepreneur/real estate broker/developer/coach/urban guru/keynote speaker/Sens founder/novelist/columnist/peerless husband/dad.

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