Monday, June 11, 2007

Use other people’s money - Recap of discussion

I was very glad to see a keen interest in my recent topic of discussion – “Buy a company with debt or with cash?” I hinted that there may be a personal finance lesson to be learned, and I will speak to that below.

The company-buying scenario proffered in my previous post is one that I lived through (of course I changed the names to protect the innocent). I joined a company several years ago that had been purchased by some venture capitalists, and by an individual for whom I had worked previously. I joined as the deal was being consummated, and dealt with a lot of buyer/seller issues. It was awkward at times, as I was clearly pro-buyer (that’s who hired me), but I still had to deal with the sellers at times. The motto “It’s just business” sometimes didn’t seem to fit. Things got nasty – I sometimes wonder why rich people squabble over very small sums of money. Perhaps that’s how they got where they are?

The interesting part of the whole transaction was where the money was coming from.

First off, the two previous owners were forced, through negotiation, to give the new company a 5-year, interest-only loan. This was a very successful business, so they could be reasonably assured that their money was safe. Plus, they were each pulling in a massive interest check each month. It provided more than enough spending money for their months in Florida. : ) Even more interesting was that the buyers made it an interest-only loan. I had previously worked for another company that had an interest-only loan on their building, and quite obviously, they weren’t building much equity in the place, besides a bit of appreciation. When it comes to a transaction like a mortgage on our house, we are told by every expert that an interest-only loan is just unhealthy (and I agree). I know they are used in San Francisco and other red-hot markets, because otherwise young people can’t buy a house. Nevertheless, I feel pain for people that use such loans. And yet, an interest-only loan was used to partially finance this purchase.

Secondly, and much more interestingly, the venture capitalists were handling the money of some extremely wealthy folks about town. These were the “blue bloods” of my hometown – people with net worth’s of $50-600 million. Big, big-time cash. This transaction was rather small for guys like this. This VC firm was put together and funded to buy small to medium-sized companies, with the intent of holding them for awhile. They felt this size of business was not normally targeted by private equity, and they wanted to profit from it. I agree with them – these folks are going to make a lot of money at this.

But then I thought to myself, “Why even bother borrowing here?” I mean, really, what’s the point? One guy in the group had a $600 million net worth. Their combined net worth easily exceeded $1 billion. Why are the VC’s over at the bank borrowing $10-20 million? Why are they negotiating tooth-and-nail with the former owners over a small, interest-only loan? Why don’t they just put up the cash, own it outright, and take in the profits? It’s streamlined, it’s simple, and you’re beholden to no one.

The answer was two-fold: Return on Invested Capital, and taxes. I will speak more extensively on ROIC, but these guys paid a helluva lot of attention to taxes. I don’t have as extensive an understanding of taxes as they and their tax accountants do (as a CPA, I worked in the audit department of my old CPA firm), but I can tell you that they structured this thing to be as tax-efficient as possible. My two scenarios were entirely based on pre-tax calculations, for discussion purposes.

The real reason you borrow in this case is to achieve the highest Return on Invested Capital you can. There is a way to annually make money, and own a business, using less of your capital. You go to the bank and you borrow. By borrowing, you are able to control an asset, and profit from it, using the least amount of up-front cash as possible. As the poor simpletons we are (sorry, it’s hard to match wits with $600 million!!!), we do the exact same thing when we buy a house. Most of us use a mortgage because that’s all we can afford to do. But as I’ve pointed out here, if you absolutely have to have a house, a mortgage could end up being the most profitable way to do it. It allows you to retain more of your cash now, which can be used to invest in stocks and/or rental real estate.

Plonkee nailed it right on the head – when you borrow (option 2), you get a year 1 Return on Invested Capital of 37.8%, before taxes. Option 1 yields a year 1 ROIC of 17%, and is less tax efficient. These ultra-wealthy folks look at this, and the choice is simple – borrow. Use other people’s money to achieve a superior return. For folks like this, emotions do not factor in – they run the numbers, they trust their advisors, and they gun for maximum return.

Full disclosure: company cash flow suffers a bit in option 2, as you’re making a large loan payment ON TIME each month. This business was a cash cow – we had a few struggles, but they were mostly timing issues - nothing we couldn’t handle.

There is another aspect of option 2 that I find very interesting. Each year, as you pay off the 7-year term loan, you own more and more of the company. In year one, you generate a before-tax profit of $3.78 million, but you also build $2.57 million in equity. If you combine those two numbers, you earn a first year return of 64%! I think you have to figure that in. You put in $10 million, and after one year, you now have $16.35 million. It wallops the return of option 1.

My apartment building is much the same way. I put approximately $60,000 down on a $300,000 building, and besides repairs and maintenance (which can admittedly be a bit costly every once in awhile), that’s the last bit of capital I will put in the building. The business itself makes the payments (rents from the tenants). So I put $60,000 in, and in 30 years I will own a building that will probably be worth $400,000. Not to mention the excess cash it generates each month and the big depreciation tax write-off.

When choosing option 2, where you’re investing $10,000,000 instead of $36,000,000, some people wondered if you could earn an equal or greater return with the rest of that unspent $26,000,000. I do not live the lives these people live, but I would have to guess yes. Personally, I would not be concerned with this. My approach would be to invest the right amount of money, in the right places, for the right returns, and at the right time.

That’s the lesson I take from this experience - invest the right amount of money, in the right places, for the right returns, and at the right time. One might argue that middle class folks cannot afford to make financial decisions in the same manner that rich people do. I argue that you cannot afford NOT to emulate them.

Right now I have a 5.5% 30-year mortgage. Due to some previous prepayments, I’m probably ten years along on the amortization schedule. We itemize on our taxes, so I am able to take the mortgage interest deduction, and we are in the 28% tax bracket. That means that any prepayments I make on my mortgage would generate an after-tax return of 3.96%. I CAN BEAT THAT! Let’s be clear - when I have that damn mortgage paid off, it will feel better than watching Paris Hilton return to jail – this will be an emotional day! However, if I run the numbers and keep my emotions out of it, I realize that my excess month-to-month cash can be put to work a lot harder than prepaying on my mortgage. So we stopped prepaying years ago.

Why are people averse to debt? Simply put, debt equals risk. And risk = increased blood pressure. It is better, or it feels better, to owe no one anything. I look forward to the day when all mortgages are paid off – I will probably be a wealthy guy by then, and with no monthly mortgage payment, I will have a myriad of life’s options in front of me. But I cannot be in a rush to pay off a mortgage that in effect produces a 3.96% return for me. There is a better way.

As we invest our cash in the smartest ways I can dream up, I am giving myself the very best chance to be sitting on a big brokerage account 10-15 years from now. And 20 years from now, when the mortgage is finally paid off? Who knows how much we’ll have by then?!?!?

Thanks to everyone that commented in the previous post. It’s great to have you all here as readers. Cheers!

14 comments:

plonkee said...

I liked this question, but I wouldn't have guessed it was a real(-ish) deal.

Its certainly true that you will make more money if you leave your emotions out of it. But I think that you shouldn't. You should weight your emotions in as well.

For example it would cost me £X in opportunity costs to pay my mortgage early and I gain £Y in emotional benefits by paying it off early. For me X > Y so I won't pay it off early. But for someone else, the results might be different.

After all, this isn't business, its my life.

Q said...

plonkee, gaining $Y in emotional benefits is a great point to make. like i said, i know i am going to feel positively chuffed when I get my mortgage(s) paid off. in the meantime, i just keep running the numbers and telling myself that the bigger return will lead to greater wealth, and that peace of mind will lead to massive emotional benefits. point well taken on business vs. life.

Mr. Cheap said...

If you really believe the moral of the last post (maximize ROI and look for high-yielding opportunities elsewhere), shouldn't you never pay down your mortgage? E.g. wouldn't an interest only mortgage be ideal (as you mention), or in a case like your's, shouldn't you extend your amortization back to 25 years (and pull out all equity) every time to renew?

I'm not sure how you'd calculate ROI on an investment you were WITHDRAWING money from, but I'd imagine it could only improve things (considering ADDING money would be bad)

Mr. Cheap said...

If you really believe the moral of the last post (maximize ROI and look for high-yielding opportunities elsewhere), shouldn't you never pay down your mortgage? E.g. wouldn't an interest only mortgage be ideal (as you mention), or in a case like your's, shouldn't you extend your amortization back to 25 years (and pull out all equity) every time to renew?

I'm not sure how you'd calculate ROI on an investment you were WITHDRAWING money from, but I'd imagine it could only improve things (considering ADDING money would be bad)

Q said...

Mr. Cheap,

Excellent point. I think for retirement purposes, you want to have your house paid off at some point. I am always saying that the big fat brokerage account is what's going to get you to retirement. Owning your house is a big help, too.

Or maybe a 40 or 50 year mortgage would be a better fit? I am so used to the idea of a 15 year or 30 year mortgage, it's hard to get my head around a 40 or 50 year deal.

Plus, as I've stated, I really am looking forward to the day when my mortgage is paid off. I just espouse the view that it's smarter to, during your 20's, 30's, and 40's, use excess cash to invest in stocks and mutual funds. If you get to the promised land by age 45, whatever the promised land is for you, then at that point you could attack the mortgage.

Mr. Cheap said...

Well, even if that's the case (paying off your mortgage would make you happy beyond the dollars-and-sense of the investments), wouldn't a more rational approach be to pull the capital out of your property, invest it at a higher return elsewhere, then when that alternative investment had grown to exceed your mortgage, liquidate it and settle up the mortgage (which should occur SOONER then you would have paid off your mortgage otherwise, since its earningn a better ROI?)

Q said...

Mr. Cheap,

That's technically an option, but not the balance I wish to strike for my family.

The balance that others are striking is to invest a little, prepay a little. The balance I'm striking is a cheap 5.5% no points mortgage (rates are higher now), and as much investing of my cash as I can, while still chipping away at the mortgage.

BTW, in the column I wrote, I had mentioned that I was ten years along in my 30 year mortgage. My wife and I did prepay on our mortgage for the first few years. I then changed my investing philosophy and started plowing all excess cash in the market.

Dough Roller said...

Q,

First, excellent question and response. The question of the proper/healthy way to use debt, if at all, is a good one for us all. Second, in response to some comments, I see a big difference between the use of debt in your example and the use of debt for a mortgage on a primary residence. When you have an income producing asset (e.g., a business, apartment building, etc.), the use of debt that can be supported by the income stream is a good way to increase returns, as you demonstrated in your example. I don't think the same applies to a mortgage on our homes. They don't generate income to cover the debt service, which is why an interest-only loan (in my opinion) is not the best option, except perhaps in some rare circumstances. Anyway, great post.

Mr. Cheap said...

Doug and Q: Sorry if I'm beating a dead horse, but this feels like something important that I should understand.

Couldn't you take the perspective that your primary residence produces "income" in that provides you shelter and saves you from paying rent.

If you approximate this income as what you would pay to rent a comparable residence, you now have an income stream you can maximize by use of debt.

I'm very debt / risk adverse myself (I actually prepaid on an INVESTMENT PROPERTY mortgage!), but more and more I've felt that I'm being irrational when I do this (and would feel similarly with my principle residence if I was paying a low, after-tax rate on its interest).

Q said...

DR and mr. cheap,

For me, it's exactly as DR said - there is a proper and healthy way to use debt.

Several folks made the point that buying a house is different than buying and owning a business. So true. But can a personal finance lesson be learned from the business world? I think so.

I was so fascinated by this deal, watching these ultra-wealthy folks at work. The fact that someone with $600,000,000 dollars would be party to a small multi-million dollar loan was just fascinating to me. But then you run the numbers, and you see it's the most efficient use of capital.

On a personal level, there are different ways to efficiently use our capital. One is frugality - I really should stop spending $10-15 week at Starbucks. Another is investing - as a CPA, I am a slave to the spreadsheet. If you start projecting out the next 15-30 years, including what you expect to pump in to the market and at what rate, it's staggering. What's worse is if you don't pump as much in at the beginning - your tally at the end of 30 years is remarkably smaller.

My Starbucks addiction is a prime example of why you should invest all that you can NOW. A rough calculation shows that, with an 8% return, spending $520 this year at Starbucks will leave me with $5,233 less dollars at retirement! Yikes!

Similarly, if I direct cash towards prepaying my mortgage, a 4% annual return, I will be shortchanging my investment future.

Anonymous said...

As plonkee pointed out - for the non-investment/residence side of the coin, the emotional and personal issues need to be addressed.

Could I have made more money investing than I did by prepaying the mortgage on our house? - yes, almost certainly. But my late husband was both spendthrift and risk adverse and putting a little extra into mortgage principal was something I could talk him into.

I think a lot of the advice in the mainstream media (vice the PF blogs) is that MOST people don't have the discipline to actually do the step of investing the difference. I'm not sure I would have 20 years ago.

Sam said...

So really, your scenario choice depends on what else you can do with the remaining money. Start with scenario 2 - you can get the business for $10 million. The question is, would it be worth it to instantly "invest" the remaining $26 million by paying off the loans? Neglecting taxes (which you did, but one wouldn't do in real life), the question is whether or not you can make more than 9% on your $26 million.

In this case, as in many others, the percentages can be deceiving. Sure, you can get a higher ROIC percentage on your $10 million than on your $36 million, but there's less of it to make that great percentage, too. To make the decision, put the whole picture together in dollars instead of percentages, and you'll have your answer. My guess is that either (1) the loan terms were quite advantageous, or (2) the tax aspects of this were the primary concern.

Now let's consider the mortgage discussion (the subject that got me thinking about this kind of stuff in the first place, and consequently looking into interest only loans). Kudos for your analysis, though I do it slightly differently myself - I look at pre-tax returns (since that's what is available for most types of investments). In my case, one question was whether to pay down my second mortgage (30 years at 6.68%) or a car loan (5 years at 5.14%). While the mortgage has a higher rate, the deductibility meant that it's about a wash. (In practice, I'll probably pay off the car first, because I'll like having the bigger monthly outlay disappear.)

In deciding to pay off the house loan, I compare its interest rate - 6.68%, pre-tax (since it's deductible), with the nominal rate on anything else. For CD's (about 5.5%), I'm better off paying off the loan, but if I'm willing to consider equities (average of 8% is reasonable), then I'm better off investing it.

IMHO, Interest Only on a house is a great thing, assuming you pay enough down that you won't risk foreclosure if property values fall. "Home Equity" only pays you what a mortgage rate would be, pre-tax, and costs a lot more to borrow than it pays - I have short-sighted friends with 4% mortgages that prepaid, and now have home equity loans closer to 8%. They're paying 4% to borrow their own money!

The problem isn't with the rates on IO loans, it's when people get to buy overpriced homes that they can't really afford. Since the payments are lower per $1000 borrowed, people borrow more $1000's, and it's the greater borrowing, not the repayment terms, that do them in. People buy a home they can't afford, the price drops, they have no equity, and are out. People who paid cash for that home would lose a bundle under the same circumstances, it would just disappear from their positive accounts rather than appear as a debt.

(Like the business problem, the answer is ultimately in the dollars, not the percentages...)

The other problem with IO loans comes from the fact that they are usually ARM's, too - and if someone was stretching to make the payments and the rate adjusts upward - ouch! A cash investor could step in a repay at that point (enjoy the teaser rate ride, then get off when the pain arrives), and an investor with equity could refinance.

It turns out while I was hopeful of using this to my benefit, in the end I couldn't get an IO loan with a competitive long-term fixed rate (either the rate adjusted early, or was too high to begin with), so I went 30 years, set up automatic payments to avoid the visual pain, and whenever I get depressed, I look at my positive investment balances (Roth IRA, 401(k), instead of trying to figure out how much less I owe on the house than I COULD owe...

Indeed, for many people, the Roth IRA approach would be VASTLY superior to paying off the house (not only to you get investment returns, but they are tax free going forward as well, which is a HUGE windfall). Instead of paying for the "emotional" benefits of a early paid-off house, try training your emotions to follow the $$$. Isn't that what they mean about "laughing all the way to the bank"?

Benjamin Bach said...

Great article !

QUALITY STOCKS UNDER 5 DOLLARS said...

sounds like the real estate guru's