The Value of Education

Felix Salmon (one of my favorite financial writers) writes about MOOCs—Massive Open Online Courses—on his blog today.  I am a huge fan of online learning.  In just a few months, YouTube has done more to improve my culinary skills than the substantial collection of cook books (with exception to my Pierre Franey books) and food magazines stored, for years, on my apartment’s limited shelf space.  Mr. Salmon’s point is that easy access to the best that higher education has to offer, lectures from great teachers at top universities, will engender increased desire for more higher education.  In other words, demand for college education should increase. 

While I’m not sure this will happen as he describes, it is clear that classes accessible to anyone with an internet connection, like those offered by Coursera (I took several classes on this platform and loved the experience), will change how we learn and may impact the cost of higher education.  Perhaps this system will defray the costs of obtaining a degree.  A student who wants a computer science degree, for example, can familiarize herself with the discipline by taking several free online courses.  In the process, she could earn credits towards her degree.  This might limit the number of credits for which she needs to pay.  Online classes may also improve her academic skill level, which would enable better grades and reduce the incidence of dropped classes while in a costly college environment.  In this way, college may become more accessible to lower income students.  Replicate this millions of times, and the impact will be phenomenal. 

You don’t need a degree to acquire skills (employers often seem not to know this).  Even without an increase in diplomas, online education will improve the general skill and knowledge level of our workforce.  This should lead to a higher quality workforce.  It could also increase entrepreneurial activity.  

I can point to my own example as evidence.  As mentioned, because of online learning, my cooking techniques have improved.  So has my knowledge of programming and statistics.  I didn't need to pay several thousand dollars to sit in a class to acquire these skills.

Ultimately, it is people, not machines, property, securities, or other tangible or intangible assets, which generate true wealth (higher living standards).   As always, the value generated in our economy depends upon our collective efforts.  It depends upon human skill, knowledge, and health.  From my perspective, this is where the power of the information age will have its greatest impact.  By disseminating information and knowledge in new and ingenious ways to one and all, allowing us to more easily combine and improve upon that knowledge in ever more clever ways.  Of course, this will take time.  There will be lots of failures.  But the future is bright.

The State of the Consumer

We all hear that seventy percent of our economy depends on consumer spending.  While the magnitude is an exageration, it is nonetheless an important driver of our economy.  As a dominant retailer, Wal-Mart is often used as a bellwether of consumer spending activity.  So news that Wal-Mart executives are worried about customer spending is raising some concern among analysts and journalists.  The Washington Post article (linked above) does a good job of offering possible reasons for weakness in the consumer sector.  What the article fails to mention is that it is possible consumers may have shifted their spending patterns, and we may yet see sales increase at other, higher end stores (not likely, but possible). Nonetheless, several factors are at play which may weaken consumer spending, principal among these being the reinstated payroll tax and higher gasoline prices.  Even so, my firm belief is that, while our economy is far from healthy, the trend of an improving economic climate is durable, and will continue.  Of course, I am known to be wrong from time to time.

More on Discount Rates

The cap rate discussed in the previous post on home valuation are just industry speak for the more generic term discount rate. This is also known as the hurdle rate, required return, and other terms.  This rate is critical for valuation. Riskier investments demand higher returns (higher discount rates).  Safe investments are more expensive, for a given cash return, than riskier investments.

For example, as of this writing, a Treasury note which pays a coupon (annual interest payment) of $40.00 per year plus an additional $1,000 on the due date (maturity) of August 15^th, 2018 costs $1,171.70.  A GE Capital (rated AA) bond, which pays the same coupon of $40.00, and the same $1,000 on the same due date costs $1,040.00.  These bonds are otherwise identical: they pay the same coupon and the same principal (face value) on the same exact day, yet the Treasury note costs more than 12.5% more than the corporate bond. 

The same can be said for all other investments.  For a given cash payment, the riskier it is, the cheaper it should be.  And this is where your judgment comes into play.  If you think a local cap rate is too high and leads to too low a bid price for a home, you can adjust it lower, which would raise the bid value for the home.  Just don’t go overboard.  You want to make a wise investment, even if you plan on staying in the home forever.  Remember, the return to you is the rental rates you would have otherwise paid.  You should want to save those rental payments for the least amount of money.  In other words, pay less. 

How to Value a Home

Many people assess home values by looking at comparable sales.  Perhaps you are looking at a 3 bedroom home in a cozy suburban community, and you see a similar property located 2 blocks away which sold last month.  There’s your value!  If they are truly similar properties, this is probably a good proxy for the market value of the home at which you are looking.

But you ought to know its value as an investment.  This is a called a fair value assessment.  Though a home is an essential good, like clothing, cars, and computers, it is a financial investment, and evaluating it as such makes perfect sense.  Consider that you can purchase a home and rent it to others with the expectation of income.  Or that your alternative to owning is renting.  Home ownership should always be a buy versus lease decision.  There is a line which favors ownership on one side, and renting on the other.

Housing has traditionally been considered financially safe.  That is, until the recent bubble popped.  As Professor Robert Shiller has long contended, residential real estate is far riskier than conventional wisdom assumes. 

Real estate ownership is not a high flying investment.  For investors, it is principally a source of income, more bond than stock.  While it does have some business (equity) characteristics, like operating expenses, on the whole, it is a bond type investment.

Some might ask why they should worry about overpaying, since most of those costs will be spread out over a long period of time via financing.  In addition, there are tax benefits to ownership.  Such people may be more interested in owning because they fell in love with a particular property, or feel they need to get in before prices head higher.  I offer the following reasons to hold your wallet and not to overpay:

·         Overpaying will increase your mortgage payments. For example, consider a home with a fair value of $300,000.  If you overpay by ten percent—in other words, you pay $330,000—then financing 80% of the purchase value with a four percent 30 year fixed mortgage will cost an additional $115 each month.

·         Given the example above, you will also pay an additional $6,000 in cash for your down payment.  You could otherwise invest this money, or use it for an emergency fund.  Now it will go into your overpriced home.

·         Prices in your neighborhood may “correct.”  In other words, after you overpay, other buyers may adjust and pay less for similar properties in the future.  If you go to sell shortly thereafter—for example, in an emergency—you may sell at a loss, if you can sell at all.

·         Even if you sell a decade later, for say, $400,000, your return on asset (the return on the total purchase price), will be about 2%.  If you had paid $300,000 to begin with, your return would have been 3%.  I don’t know about you, but I’d rather have the higher return.  It matters.

·         If home values adjust downward or flatten, you may not be eligible for a home equity loan, since you might have little or no equity.

I hope I have convinced you that overpaying, even by just 10%, is not such a good idea.  But how do we assess a fair value?  You will need to collect the following information:

·         Rental rates for homes similar to that which you are looking at purchasing.

·         Estimated operating expenses (utilities, repairs and maintenance, insurance, local taxes, and supplies) for local property rentals.  As of this writing in February of 2013, typical operating expenses range from $4.50 to $5.25 per square foot per year, depending on local taxes, property condition, utility rates, land area, and other factors.

·         Local cap rates (discount rates for multi-family—or apartment—buildings in your area.  You can find these by asking local realtors or real estate investors)

·         A basic outlook for the area in which you are looking

o   How is the local job market?  Are people earning enough to sustain the rental rates you’ve researched?

o   Is there a local building boom bringing new supply of real estate to the market?  This might be a sign of unsustainable supply, which will apply downward pressure on rental rates.

Armed with this information, we can now look at a hypothetical example.  I will use the following as my numbers:

·         Rental rates for a 2,100 square foot, 3 bedroom, 2 bathroom property are about $2,200 per month.

·         Operating expenses are about $4.52 per square foot for a total of about $9,500 per year.

·         The local cap rate is 6.5%

·         Your area looks stable, with moderate job growth, some higher wage jobs coming to the area to help buttress support for rental growth, and reasonable municipal finances for stable real estate tax outlook.  Water and Sewer taxes, however, may rise in the coming years to support upgrades to the county storm system.

With this information, you make the following calculations:

1.    Annual rent: at $2,200 per month, annual rent is $26,400 per year

2.    Annual operating expenses: given above, these are $9,500 (this includes real estate taxes, repairs and maintenance, utilities, and other basic expenses)

3.    Net operating income is $16,900 per year (this is the annual rent from the first calculation, minus the annual operating expenses from the second calculation—or $26,400 - $9,500)

4.    Valuation is $260,000, which is about 10X annual rent (this calculation is made by dividing the annual operating income from the third calculation by the cap rate of 6.5%—or $16,900 ÷ 6.5%. In other words, you expect to get an average return of 6.5% per year)

For this home, a price above $260,000 means you are better off renting.  This methodology is a good gut check, will force you to do some basic due diligence, and make some financial considerations. 

Regarding some considerations you might make, you may decide that a 5% return is reasonable, in which case this home is worth $338,000. If you go through this process, however, at least you've conducted research and thought it through in a structured manner. 

There are other valuation methodologies, such as DCF, which allow you to model factors like renovations, but they are superfluous in this example.  I also didn’t mention other, even more basic considerations, such as whether you plan on staying for a while.  This was only meant to introduce the concept of evaluating buy vs. lease decision and homes as investments.  Approaching home ownership in this way will help you make better decisions. 

The Sorry State of the Investment Industry

Today’s New York Times reports on how financial advisors sold so called sophisticated and complex investments to investors who didn’t understand them.  The types of investments mentioned aren’t suitable for most people, and should never be marketed to mom and pop savers.  But, of course, salespeople always have a catch with which to lure prey.  The catch is usually topical, a need common to most people.  Today, that need is for a better yield for income (How would you like to earn a better yield on your savings?).  Tomorrow, it’ll be something else.  But we should always be skeptical and on guard.  I hope to cover appropriate due diligence in future posts, so stay tuned. 

Data is Not Enough

When facing a significant financial decision—such as whether to refinance, buy or lease, or choose between different investments for your small business—having data is very helpful, indeed essential.  But you need a framework with which to evaluate the merits of the data.  You need a framework to weigh pros and cons, make assumptions, and effectively evaluate your decision and goals.  Conversely, having a framework is not enough.  You also need at least some relevant data to back up whatever assumptions and predictions you are making.  No data means you are flying blind. 

You may know how to operate your car, but with no road signs, you’ll likely get lost.  Not knowing how to operate your car on even the most well marked roads, you could end up dead.  Also, it goes without saying to never drive while intoxicated, because your operating skills and ability to interpret the signage are both compromised. 

GDP Growth Aside, Economy Appears Steady and (Slowly) Improving

While data on fourth quarter 2012 GDP growth is disappointing, we should take comfort that are in the midst of a steady recovery, as evidenced by today’s decent economic reports from the ISM and Labor Department.  The economy added jobs, and manufacturing is expanding.  The Fed continues to pump the system with low cost money (in some cases, borrowing rates are lower than the cost of inflation, making it better than free).  Low mortgage rates for refinancing are one method of getting more cash into the hands of consumers. Unfortunately, that avenue has been held back by tighter mortgage underwriting, high unemployment, and other factors, but it is helpful nonetheless.  Here’s hoping that the economy keeps gaining steam for the remainder of 2013.

Refinancing (Part 1)

If you’re a homeowner with a mortgage, you may have an opportunity to lower your monthly mortgage payments.  The ability to fix and perhaps even lower a large portion of your living expenses is a key benefit of home ownership.  (Of course, this must be weighed against some of the negatives, such as property tax, maintenance, and a large, illiquid investment.)  But how do you know if refinancing is a smart decision? 

Mortgages are like bonds.  In financial parlance, a mortgage is an annuity like cash flow stream.  Like a bond, which (usually) disburses interest semiannually (twice a year), mortgages provide cash flow (usually) once per month.  If mortgage rates fall, many homeowners have the option to refinance for lower payments.  If you could lower your payment by $300 per month, that is a bond like stream of income back in your pocket.  You’ve just saved $300 per month.  But there is a cost.  Fortunately, like bonds which provide coupon payments, your $300/month savings can be valued.  This is what is known as the present value of future cash flows.  This is a classic investment decision.  The value of your mortgage savings (or bond), should exceed the cost of refinancing, and other costs as well.  Let’s look at an example.

Barbara financed 80% of the purchase price of her home with a mortgage five years ago.  She borrowed $225,000 in a 30 year fixed rate mortgage at 5.5%, and can now refinance at 3.25%. Is it worth it?  Here are some considerations and numbers she needs to evaluate:

• She should be reasonably certain she will remain in her home for at least 7 years
• Her current monthly mortgage payments are $1,277.53
• She’s been paying for 60 months, and her outstanding principal (assuming she has only paid the actual amount due, not more, not less) is now $208,036.36. 
• Refinancing costs will be $7,500, and she will roll these costs into her new mortgage
• The new rate will be 3.25%
• Instead of paying her mortgage off in 25 years, she will now be back to square one, and her payoff date will be pushed back to 30 years (she is extending mortgage payments an additional 5 years)

If she rolls the closing costs into the equation, she needs to borrow about $216,500 (I rounded up a little from what she actually needs).  Her new payments will be $942.22, for a monthly savings of $335.30.  Every month.  For 25 years.  If this were a bond, this much money received each month would be worth about $68,800.  Think about that.  You can get a bond worth more than $68,000, which pays more than $330 per month for 25 years, for just $7,500.  Of course, that’s not the whole picture.  There is one last cost which is not explicit in this picture.  That cost is the extension of five years of additional payments that the borrower (mortgagee) needs to pay.  We need to calculate this value and deduct it from the value of the savings.  The value today of an additional 5 years of payments of $942, beginning in 25 years, is $23,426.27.  This cost will need to be deducted from the $68,800 value of the savings.  When you also deduct the $7,500 in closing costs, you are still left with a benefit of $37,879.89.  That’s no small amount.  But the real benefit is felt month after month, in the form of $335 of savings, for 25 years.  This is definitely a good deal. 

I’m sure many will have plenty of questions regarding my example.  I plan on revisiting this topic in the future to help clarify the concept.  Feel free to comment and let me know what you think.

Welcome to Hurdle Rate!

This blog is concerned with the use of financial concepts—financial reasoning—to make good choices.  Finance is a discipline with a deep tool kit to assist practitioners in economic decision making.  The purpose of this blog is to help readers understand and utilize these tools.  I hope this blog serves as true investment vehicle, providing healthy returns in the form of financial education for its readers and for myself.  Along the way, I’ll opine on current business and economic topics, books, food and wine, and pop culture.