The quickest way to calculate investment returns

Ever find yourself plugging numbers into an excel sheet to work out your investment returns? It's probably a good idea to have a comprehensive sheet for working out returns on properties you own. What about an easy formula for quick calculations on potential deals?

Here's the quickest way that I've found to calculate cashflow return on investment:



Yield, loan and costs are expressed as percentages of the purchase price or property value. The result of this formula is cashflow return on investment. That is, what return on your initial capital investment you can achieve based on the net cashflow from the property. It does not account for returns arising from capital appreciation.

Yield
No rocket science here, just gross yield. If your property achieves 12,000 in rental income per year and it's valued at 100,000, then your yield is 12%.

Rate
Simply the interest rate payable on your mortgage financing. The calculation assumes an interest only mortgage. If your rate is 5% then that's the number to use.

Loan (or loan-to-value)
This is the amount of your loan, expressed as a percentage of the property value. If you've borrowed 75,000 on a 100,000 property, then your loan is 75%.

Costs
This may be a little different from typical calculations. Here costs are expressed as a percentage of property value. It's actually remarkably simple to calculate. Here's a quick scenario: you pay management fees of 10% of your gross rent, you set aside a further 10% of gross rent as a maintenance budget and you incur further admin costs of 5% of gross rent. In total that's 25% of your gross rent incurred as costs.

Your gross rent is the same as your yield. So if you pay 25% of gross rent as costs and your yield is 12%, then you're paying 12% x 25% = 3.0% of the property value in costs. The great thing about this calculation is that it can remain pretty constant - expressing amounts as percentages means they scale according to property value. Choose numbers that work for you once and you can use the same numbers as a general rule for quick calculations.

Worked example
Here's a quick look at the formula in action. Say you're looking at a potential deal and you want to quickly work out your potential investment returns from the net cashflow it generates. Notice that you do not need to plug in the price into the calcuation (see note below on what this formula should not be used for).

Scenario: a property yields 12%, it can be 75% loan financed at a rate of 5%. Running costs for the property amount to 3.0% (as in the costs example above). What is the cashflow return on investment?

Just plug in the numbers:



And calculate. The answer is 21%.

Without a calculator
You can do this in your head or on paper pretty easily. Loan percentages tend to stay fairly constant and it seems that many investors know ahead of time what percentage they're working with. Rates don't move around all that much, certainly if you're comparing returns across a range of deals at the same point in time, then the rate is likely to be the same for all of them. So, 5% x 75% = 3.75% and dividing by (1 - 75%) is the same as dividing by 25%... or multiplying by four.

The whole formula then becomes: ( 12% - 3.75% - 3% ) x 4 = 5.25% x 4 = 21%. Beats plugging numbers into a spreadsheet to work out return on investment.

What you should not do with this formula
This formula must be kept in context. The fact that the purchase price does not directly appear in the calculations does not mean the price is irrelevant! If you keep all the numbers fixed and double the price, then the formula would show the same return on investment number - this is clearly not true!

The trick is that yield and property price are inversely related. If you double the price then you'll halve your yield - so update the numbers accordingly. This formula should therefore not be used to determine what price you should pay for a property. If you want to try different price scenarios, just remember to adjust the yield and cost numbers accordingly.

What you should do with this formula...
... is take a snapshot of investment performance. The formula answers the question "Taking property price as given, what are my investment returns?".

Trip to Silicon Valley: Part two

We recently took a trip to Silicon Valley in an attempt to secure investment for Portfolio Executive. Here's part two of what happened. (You can read part one here).

Wednesday continued...

It all happened so casually. Casual conversation in the car. Introductions to new people. As it turned out, a few of us were connected through having studied at the LSE. Before we knew it, we were sitting in the front room of this hugely impressive home, down the street from Eric Schmidt’s house, engaging in business conversation with some amazing people. A guy from Google. A guy from Cisco. A hundred million dollar deal-maker. A veteran venture capitalist who owns a hugely successful VC firm. And all these business minds were focussed, for a whole hour, on our product, on our business. It was unbelievable.

And so it began. Mike kicked off with a product demonstration. He did an excellent job and held the attention of everyone in the room. Then the conversation started. From the moment Mike finished, there was not a moment of silence for the next hour. There were all these business minds offering great advice, excellent insight and very challenging questions. Then there was Mike and I. I was 100% not in the right state of mind. I don’t know what happened, but as soon as they started questioning, I switched on. It must have been the adrenaline. It was a constant back and forth. Questions were being thrown in from all angles and on different aspects of the business. It was intense.

We emerged from the exchange relatively unscathed. I have pages of notes from the evening and some very valuable advice, all of which will impact our future direction. Even now I can’t get over it: things like that just don’t happen in the UK.


Thursday

We had one call scheduled with another friend who’d successfully had his startup funded and had subsequently sold his company for multiple millions. He’s an impressive guy, I’ve known him for years and I really value his experience and advice.

This was a real mock interview, no advice, no pointers: just left to crash and burn if that was where we were headed. In the event, the mock went well. We managed to get across our main points about the business. We hadn’t quite nailed the opening information we wanted to get in (the key points that make us exciting, see above). Final tweaks were made and we had everything in place – we were ready for our big meeting the next day.


Friday

Meeting day. Taking account of all the preparation we’d done before the trip and during it, we’d spent the best part of two solid weeks preparing, revising, going back to the drawing board and tweaking our pitch. We’d had preparation with some of the Valley’s finest: current funded startup entrepreneurs, others who’ve been acquired, even investment bankers and commercial lawyers. We’d done just about everything we could within our network.

We arrived at the office and waited around for about 15 minutes until we were finally met by one of the investment team. We were taken in to meet the rest of the team. After a few uncomfortable moments, we were asked to go into our product demo. We hadn’t even delivered the key points we wanted to get across in our first 30 seconds. Mike took the laptop and the four decision makers stood behind us. Within seconds we were interrupted and everything was completely off track. We managed to get across the key points of the first screen but that was it. The investors bombarded us with questions and it was a non-stop onslaught between them and us. In the front of my mind I knew I had to get across all of our key points – as they were what made us investible.

Luckily we managed to get across the points about our industry experience and the lead-gen potential quite easily – they fitted in neatly when answering the investors’ questions. The other two points about our UK investor interest and our potential distribution deal where not so easy to weave into the conversation. In the end I felt our time running out so I just blurted out the points – “We have a UK investor who’d like to invest and we’re also looking at a distribution deal”. It was completely unprompted and that’s exactly how it should have been, only at the start of the conversation rather than being awkwardly rammed in the middle.

It was definitely clear that there was interest in our business as the investors had a lot of questions and were having their own ideas about potential product directions. But the fact of the matter was that we left that meeting room, after just 15 minutes of interrogation, feeling like we’d been hit by a bus.

For the next couple of hours Mike and I were walking around like zombies. It felt like we’d lost all grasp of reality. We had very little to say and every now and then there’d be a round of expletives followed by a brief exchange of disjointed statements… then back to stunned silence. We were in shock.

We hung around a bit then headed back to San Francisco on the Caltrain. It was about 6pm, we’d just arrived back in San Fran and we were hailing down a cab… when my phone rang:

Me: “Good evening, Shazz speaking”
Investor: “It’s ** here, from **. We would like to fund you.”
Me (overcompensating for my excitement with a monotonous drone): “Thanks very much.”

I think I came across as being sarcastic. Then the investor tells me the terms of the investment offer. Let’s call it $X for Y%.

Investor: “Would you like to let me know your decision now or come back to me?”
Me: “I’ll discuss with Mike then give you a call back.”
Investor: “You have five minutes, call me on this number…”

I had a mini spreadsheet already set up on my phone, so I put in the numbers to see the valuation. Comparing it to the terms of the potential UK investment deal, I wanted to negotiate. I quickly got on the phone to a friend whose advice I trust (he’s the one who had his startup acquired) for some quick input. This investor does not negotiate, but I was going to try. I think we knew we’d take his initial offer, but I felt it was also important to at least attempt a negotiation. It was exactly five minutes since the call from the investor ended and I rang him back:

Investor: “Hello, ** speaking”
Me (in a confident tone, hopeful on the negotiation): “Hi **, I’ve discussed your offer with Mike. We have terms on the table that give us a higher valuation. To bring this deal in line, we’ll be happy to accept $X for Z%.”
Investor (in a tone that said “better luck next time”): “I’m sorry we do not negotiate, but we appreciate the effort”
Me (knowing full well I had little hope of pushing the negotiation further): “Ok, we’re happy to accept Y%”.

(That’s got to be the most ridiculous attempt at a negotiation I’ve ever heard! Glad I did it though.)

And so the deal was done. We’d come to Silicon Valley seeking investment – and we got it. We’re now relocating to California to run our company.

Trip to Silicon Valley: Part one

We recently took a trip Silicon Valley in an attempt to secure investment for Portfolio Executive. Here’s what happened.

We first got in touch with the investors a few months back by sending them details of our business. They liked it and they invited us to meet them in California.

We flew out on the Monday before our Friday meeting to allow us time to meet with various people ahead of our investment meeting. The week played out something like this:

Monday

Arrived late.

 

Tuesday

We had dinner with a friend who has secured in excess of $1m funding for his business. I believe that with his leadership and intelligence, his business will be a great success. We presented him our product, thinking we were ready and that his feedback would amount to minor tweaking of our demo. Cue bombshell.

Our demo was boring. It failed to hit the main points that our potential investors would want to see. We spent hours with him, trying to figure out the appropriate key points to get across for each part of our product. We were comprehensively prepared for quick-fire questions that would drill down into the specifics of our business model and strategy, but we’d lost focus on effectively demonstrating the product, the pains it solves and therefore the real value of our proposition. It was a huge knock. Our confident delivery of material descended into broken statements. Accurate insight was replaced with expletive after expletive as we struggled to redefine our focus.

The evening ended late and we took away some excellent insight and guidance on how to effectively demo our product. We called it a night. The next day’s focus would be to prepare from scratch.

 

Wednesday

We had three pitches lined up: 10am, 2pm and 8pm.

Our 10am conference call was with a friend in investment banking. I’ve known him for years - he offers top-tier insights and he’s a hugely talented banker. The style was focused more on the business questions for which we were well prepared. We got some excellent feedback and points for improvement were tweaks rather than rewrites.

We then had two hours to completely recreate our product demonstration. The whole product had to be covered in no more than two minutes. So we went through each page of the user experience, succinctly noting down the key takeaway points for each section. The main points to highlight were the pains being solved and how we made money at each stage. In actual fact, deciding what to say was not hard. The challenge was trying to cover everything within two minutes. We also had to allow for the likelihood that we would not actually have two minutes to demo – we’d probably be cut off or interrupted soon after we started.

We decided that the following information would be the most crucial to deliver within the first 30 seconds:

·      What our product does

·      Our background and experience in the field

·      The size of the market and therefore the opportunity

·      A potential distribution deal that we had (without revealing any specifics due to confidentiality)

·      A potential UK based investor had expressed an interest

We then cut down our whole product demo to just two pages of the site: 

·      The first showing the management pain we solve, the time we save and the way we make money

·      The second showing the huge lead-generation potential of the business from the more advanced functionality

It would take us about 15 minutes to demonstrate our product fairly comprehensively in a normal scenario. When you understand your product in intricate detail and have developed each feature based on a customer need, it can be extremely difficult to zoom out and select only the most crucial parts.

We had a 2pm pitch in downtown San Francisco with the same friend we’d met the night before. This time we demoed to his whole team. We went over our demo once and the response was excellent. There was a marked improvement from the night before and we could see the guys grinning as we effectively checked off many of the points for which they were looking. They suggested some further tweaks, which we incorporated, and we left their office with a rush of confidence.

Later in the evening we met with another, hugely talented and very experienced, friend who deals on a much larger scale – habitually doing deals no smaller than $100m in size. This would provide invaluable feedback from a very different perspective. I’d spoken with him earlier in the day asking if he could bring along any friends who could offer further insight into our product and business. He said he’s see what he could do.

By this stage it was late. We were jetlagged, exhausted and we’d been intensively working on our pitch since we arrived.

So we arrived at Menlo Park and my friend picked us up. He took us to his friend’s house. We drove through streets lined with what I remember as impressive executive homes and mansions. Apparently many CEOs of top companies in the Valley live there, including Google’s Eric Schmidt. We pulled up in the drive of an impressive looking home much like something you might expect to see on MTV Cribs. We were totally unprepared for what happened next.

I'll finish the story in my next post.

First tools come online for selected users

After weeks of additional coding, we're finally there: our first tools are ready to be given a glimpse of daylight, but only to a selected handful of users.

Portfolio Executive will ultimately offer a full suite of tools tailored to the needs of buy-to-let property investors and managers. We believe in innovation at every step, and so the first tools in our range have challenged conventional methods and redefined processes.

Our selected users will benefit from automatically generated tenancy documents, together with rent accounts and alerts. Previously, creating tenancy documents was a laborious process taking anything up to half an hour. Surprisingly, there were only a small handful of other sites that automatically created the documents -- and all of them left plenty to be desired.

What's so unique about our system is that it takes under a minute to set up a whole new tenancy, complete with alerts and rent accounts. We spent days looking at all of the data we needed to capture and redefining user interactions until we had stripped it down to the bare minimum.

We went from about 16 individual data fields to just four -- because we figured out innovative ways of extrapolating what the other 12 fields should be. There are also a few scenarios in which our data capture form dynamically changes itself in real time to account for what the user has entered, thereby ensuring the form is always 100% relevant to the user.

These first tools will stay accessible only to our selected user group until we are satisfied that any major bugs have been captured and we have had adequate opportunity to listen to feedback and make changes where necessary.

From banking to business

I've just started blogging for LSE. At the moment it's only available to current students, but there should be an external version in the pipeline. My first post:

--

Moving from the big world of investment banking to the small world of startups is not what it seems. The challenges in banking are huge and varied, but there’s something about the industry that just doesn’t seem real.

Startup business on the other hand is very real. The anxiety you feel when you wonder if a deal is going to go your way is intense. It’s like being the star of a fly-on-the-wall documentary where you – and only you – determine the success or failure of your business. The adrenaline rush from closing your first deal as an entrepreneur gives you a high that makes you feel like you can take on the world.

Startup business is real business. It’s gritty and at times dirty. The challenges, the excitement, the sleepless nights – they all come as a package. I love it.

A little about me…

I set up the LSE Entrepreneurs society during the final year of my Economics degree. Following graduation I followed the status quo and went into banking. I had some great experiences there, and I’d certainly make the same decision again, but I quickly developed an allergy for the industry! I decided to step on to a different track and follow my passion for startup business.

...and my business

That was in April 2006. Since then I’ve grown my real estate portfolio which I’ll be further expanding as the economy continues to plummet. I’ve also innovated a yield-enhancing concept of serviced flatshares for professionals. I packaged this into a management company that enables investors to double their returns, and allows me to capture over 100% return on investment. With those companies nicely ticking over and quietly expanding, I’ve got a team together to create my next business: PortfolioExecutive.com.

Over my coming posts I’ll be following the progress of Portfolio Executive. Our first tool is due to come online very soon and we’re currently in the process of raising a round of seed funding. It’s exciting times. All the latest experiences (and no doubt some horrendous mistakes!) will be available right here.

Residential property derivatives

Derivatives allow investors to make financial gain from particular assets without actually owning said assets. They've been around for years, but recently they've made the cross over from more advanced commercial property structures into the realm of residential property deals being closed by Joe Bloggs buy-to-let investor. Well, not quite, but it's certainly getting there.

I'll be doing some comprehensive blogs on option structures packaged with leases and other bespoke agreements that allow investors to receive cash payments on entry, carry and exit - and all without putting a penny into the investment and never actually owning the property itself.

My background in investment banking has always given me an edge in structuring property deals, but it was really rammed home when I attended one the wealth events run by Tamkin Riaz and his TLC Entrepreneur group.

If you're keen, Google around or read the pig for some terms such as sandwich leases, lease options and rent to buy schemes.

Another great webinar was given by The Sophisticated Investor and you can download it for free from the site.

The economics of the property boom-bust cycle

Economic situations vary and there will always be factors unique to a given boom-bust cycle. There are however a range of broad principles that can often be observed over the course of the property cycle. The assumption is made that the economy starts from a stable equilibrium with limited infrastructure, which will of course not be true of all cycles. The boom-bust cycle can be split into five sections:

1. Start of the boom
2. Middle of the boom
3. Towards the end of the boom
4. At the peak
5. The crash

The boom-bust property cycle is directly related to:

• The general economy, because property is bought with money;
• Land values, because property is built on land.

1. Start of the boom
Assuming that the economy starts from a stable equilibrium, there are no rapid increases or decreases in prices, supply equals demand and price stability prevails. Population growth over time bolsters demand from businesses and individuals for commericial and residential property. There exists a disequilibrium in the market and either supply or prices (or both) need to change to restore equilibrium.

If supply increased to meet demand, prices would remain stable. Property density would increase (e.g. redevelopment of existing sites into more units); undeveloped areas would become developed; and infrastructure would increase to cope.

This does not necessarily happen. Landowners know that if they do not increase property supply, then prices must adjust in order to restore market equilibrium. That is, property prices are gradually bid up by the increased demand.

As a result, developments outside of prime central locations will occur, feeding through to an increase in infrastructure around the city centre. This in turn pushes up the value of undeveloped land in the city centre even further.

With undeveloped land values bid up, brownfield redevelopments become more attractive. Existing property is ‘over-enhanced’, for example by replacing an existing building with another of higher specification (more units).

As the limited supply of land drives price growth, it becomes just a matter of time before property speculators (novice investors) start entering the game.

2. Middle of the boom
Novice investors are mere speculators who believe property values can only continue to rise. They will therefore pay inflated prices for existing buildings, or buy new build property from developers also at inflated prices.

As prices rise, speculators spend more in order to gain a higher profit. Consumption in the economy falls as consumers use more income for property investment. The feel-good factor of boom time masks this fact and consumers often go a step further – making unsecured borrowings to finance further expenditure.

A paradoxical consumer position emerges: savings are increased in order to finance property investment, while consumption also increases as it is financed by unsecured borrowing.

3. Towards the end of the boom
With consumption fuelled by over-borrowing, the economy experiences a trade deficit. Domestic output also falls as money is withdrawn from the economy through consumer savings for property investment. That is, domestic output is unable to meet consumer demand and so imports increase to satisfy excess demand, and exports fall as more production is required for domestic consumption.

The resulting trade deficit must be financed and this is achieved through attracting inward investment into the domestic economy from abroad. Government gilt rates increase in order to attract foreign investors. This ultimately leads to rising interest rates.

4. At the peak
Investments are being made based on historical returns – speculators do not adjust their expectations to reflect the fundamental economics. Consumption continues to be fuelled by unsecured finance and second-charge loans. Lenders lend at higher valuations which are only the result of speculative excesses.

Investment, consumption, lending and borrowing are all in excess. Interest rates rise to cope with the trade deficit and consumer price inflation.

5. The crash
Higher interest rates curb consumer expenditure and help to bring inflation under control. Projected cashflows and present values of uncompleted capital intensive development projects fall. Investment returns look less attractive. The property development market slows...

...and so begins a chain reaction of events...



...the chain continues:



And so the market bottoms out and is ripe with opportunity for the professional investor.


Useful links:
* "Beating the property clock" by Ajay Ahuja
* Knowing where in the property cycle to invest