Issue #32 - Don't make these EMOTIONAL mistakes. Also, the Real Estate Capitalization Rate - what is it and how can you use it?

Hey everyone! Thank you for being here. I have a quick intro thought for today, as I write to almost 600 of you (and counting).

With so many readers, coming from diverse backgrounds and stages of life, sometimes it's hard to thread the needle to satisfy all readers each week. 

We have 18 year old's fresh out of high school eager to start making that chedda. 

We have 20-40 year olds, some single, some married with kids, presented with all the challenges that life throws at us.

Some that are early in their earning years, some that are makin hay already.

We have absolute beginner investors, and some of the smartest financial minds that I know.

CFAs, MBAs, PEng, and Portfolio Managers/Investment Advisors with all the accreditations you can imagine. 

People that have net worth's in the several millions of dollars, and a few in the hundreds of millions.

We have some that absolutely hate the stock market and entirely focus on real estate investing. Some that focus specifically on stocks and almost no real estate (except their principal residence). And we have folks that are steadfast entrepreneurs, preferring to allocate their capital in their own businesses. 

All this is to say, we have one helluva mix of curious and bright minds in this group. And it's fucking awesome. 

Anyway, the whole entire point of writing this journal is to brain dump everything personal finance, stock market investing, and real estate investing, that I have learned and am still learning from books, my career, direct investing experience, and from the mentors and family and friends in this epic group.

And one thing I've learned is that there are many ways to skin the investing cat.

What I am trying to do here is present a common sense style approach to managing your personal finances, mastering your emotions, and how to be a great investor.

I like to keep it light, fun, and sometimes I rant and swear. As you can see I'm already droning on here...

Anyway, I'll sign this off now before I get into trouble with my Editor in Chief (my dad, gramps, Mr Edward Nicholas Gudewill).

Glad to have EVERYONE here, please forward to your friends and colleagues to subscribe if you are enjoying the Journal.

1. Personal Finance

I simply refer readers to Section 2. bullet header number 3.

Self Control Bias

• Tendency to prioritize short-term satisfaction over long-term goals, leading to insufficient saving and excessive spending.

Don't be a gazelle all the time. Sometimes it's ok.  

Better to be a Lion and earn more, spend less, invest the difference, forever and always.

2. Stock Markets

“You don’t want to be a no-emotion person in all of your life. You definitely want to be a no-emotion person making an investment or business decision.” - Warren Buffet.

As always, Warren has the best advice - don't be emotional when it comes to investing. I recently re-read some of the content from the CFA Institute (of which I am still an active CFA Charterholder) on emotional biases that affect our decision making, and lead us to poor results. Here is a short summary, so you can avoid them.

Loss Aversion Bias:

• People feel the pain of losses more than the pleasure of equivalent gains.
• This can lead to holding losing investments too long or selling winning investments too early.

Overconfidence Bias:

• Overestimating your ability to make good decisions, leading to excessive trading or underestimating risks.
• Can result in a portfolio that is not well diversified.

Self-Control Bias:

• Tendency to prioritize short-term satisfaction over long-term goals, leading to insufficient saving and excessive spending.
• You may take on too much risk in an effort to make up for past mistakes.

Status Quo Bias:

• You prefer to maintain the current state of affairs, avoiding change even if it's in your best interest.
• Can result in a failure to reallocate assets or adjust strategies in response to changing circumstances.

Endowment Bias:

• Valuing an owned asset more than an identical one not owned, leading to reluctance in selling or overestimating its value.
• This can cause inefficient portfolio allocations.

Regret Aversion Bias:

• The fear of making decisions that could turn out to be wrong, leading to inaction or overly conservative choices.
• Investors might avoid selling losing investments due to fear of regret.

Affinity Bias:

• Making decisions based on a connection or feeling of familiarity, leading to investment in companies or sectors one personally likes.
• This can result in a lack of diversification and a bias towards certain investments without considering their objective merits.

3. Real Estate

The most widely used term in commercial real estate: Capitalization Rate.

It's dawned on my that I've never explained what 'cap rate' actually means. 

Simply, the capitalization rate is the properties net operating income (rents less operating expenses) divided by the price you pay.

A property worth $1,000,000 that has $50,000 net operating income, has a 5% cap rate.

It's another way of saying, cash flow yield, or dividend yield, or earnings yield (the opposite of the "Price to Earnings"). These are all somewhat interchangeable. 

There are a few great things about calculating a cap rate:

1. it's simple, easy to calculate, and widely used in the industry.
2. you can quickly compare different investment properties by comparing cap rates. 
3. you can determine whether a property is over or undervalued vs the market conditions.
4. algebra makes it easy to determine any of the three variables: net operating income, cap rate %, and property value.

There are some drawbacks, of course, as with all things in life. 

For example, it does not include the cost of financing costs. If you are investing in a deal with a 5% cap rate, you might think that's tremendous. But then you realize the 5 year mortgage rate is 6.5%. Not so great after all. Because your operating income isn't sufficient enough to cover the 6.5% interest rate, you'll need to feed your property with more of your own cash in order to pay the mortgage.

Furthermore, since it is a point in time static number, it tells you nothing about how your future cash flow will perform. 

Finally, comparing investment property cap rates in different locations is a no no. You can't compare a grocery store in Vancouver with a 5% cap rate and then tell me the equivalent grocery store in Timbuctoo that has a 10% cap rate is a better investment. Timbuctoo might not exist in a few years, so that 10% cash flow today might mislead you in a property that will end up worthless.

Cap rate indeed is one of the key metrics to get familiar with if you are interested in commercial real estate. 

Take some time to get familiar with it, but be wary of it's drawbacks if someone is quoting you 12% cap rates located in Timbuctoo.

1 Quote

“You don’t want to be a no-emotion person in all of your life. You definitely want to be a no-emotion person making an investment or business decision.” - Warren Buffet.

A Question

Any of you do intermittent fasting?

Evidently I do it, not on purpose, but because I can't be bothered to make breakfast - would rather start working. And no matter what I eat in the morning, I'm still the SAME amount of hungry by noon.

So, basically, it's a waste of my time. 

Glad to know there's some health benefits to it tho!

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Thank you

Eddie Gudewill, CFA
 

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