Bear with me as I explain my thought process for valuing an investment. I'll tie it back to my reason for real estate.
The key to investing is to determine the intrinsic value of an asset and pay less than that number. How do you do that?
Well, you can figure out what something's worth by estimating the future cash flows of it then discounting it back to its present value.
For example, let’s say I had a crystal ball and I knew a particular investment would generate $100,000 in free cashflow over the next 5 years. Knowing the exact amount of cash that will be generated allows me to put a precise dollar amount to the true value of the investment.
How much should you pay for an investment that generates $100k over 5 years?
The answer is: it depends.
It depends on the yield you demand for that investment. The less you pay, the higher the yield. For the example above, say you decided to pay $500k for the investment. It is expected to generate $100k in profits over the next 5 years.
Let’s do the math:
$100,000 / $500,000 = 20% return
That’s a great return, but that’s not taking into effect the time value of money. The 20% is earned over a 5-year period so the annual return would actually be much lower than that.
Annualized Return = 20% / 5 years = 4% annual return. Not so great.
What does this have to do with my reason for investing in real estate?
Well, discounting cash flows back to their present value to arrive at a price is quite simple to do. It’s a simple concept with simple calculator math.
As with many things in life, it’s much easier said than done. Let me explain.
The hard part is being able to accurately forecast said cashflows. Without an accurate forecast of the future cash flows, you are flying blind.
The reason I chose real estate is because the only other option I considered was stocks of public companies.
Let’s compare the two:
Public Companies: To determine the value of a company, I need to forecast the future cash flows of said company. Public companies are usually big and complex. They are often multinational. They have many moving parts. They have thousands of employees. They have many product lines, markets, and competitors. Trends go out of fashion. Bad managers replace good ones. Competitors try to kill your business. Innovation is always necessary.
The point I am making is that the task of predicting future cashflows for a public company is vastly more difficult than a simple residential rental building in Portland.
In real estate, I felt I could gain an edge in my ability to accurately predict cash flows due to the simple nature of the real estate business. There aren’t a whole lot of income or expense inputs that go into a real estate investment.
You have rents and fees on the revenue side. Then, you have property tax, insurance, and maintenance. You also have utilities and a few other things on the expense side. That’s it. Easy math.
I learned something from the great Charlie Munger. In investing, added difficulty doesn't earn extra credit. I admitted to myself that I cannot confidently forecast a public company's cashflows. Very few can. But, I can forecast a real estate asset's cashflows.
That's why I chose real estate as my primary investment vehicle – because I like to play games I know I can win.