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Real Estate Investing Framework

[This is an edited version of a talk I recently gave at a MOI Global event.]

I’d like to summarize some of the lessons I learned from helping to run a buy and hold real estate portfolio:

Lesson 1: Find a framework

Before my involvement, I had no prior experience in the real estate industry.  So I needed a framework.

As you might know, my main investing model is value investing. So I chose value investing as my framework. I stopped viewing it like an isolated real estate operation, and started to view it like a regular investment.

Lesson 2: The need for a simple valuation heuristic

My second problem was, that I needed a simple valuation method.

I discovered a very simple one: the rent multiple. Basically, it’s comparable to a Price-to-Sales (P/S) ratio. You take the price of a property, and divide it by the yearly rent revenue.
 
After that, I needed a heuristic of what is expensive and what is cheap. In the current market condition you often see multiples of 25, and even 30 or more. This is quite expensive. In more calmer market conditions you see multiples of 20 or less. A multiple of 15 is reasonably cheap and a multiple below 10 might be described as deep value.

There are two ways to calculate this multiple. First, you can calculate it based on the most recent effective numbers, or secondly, you might use what might be called an intrinsic value multiple, where you take the realistic gross rent you expect, once you take control and implement the obvious quick wins. Of course, it’s more conservative to use effective numbers vs. the projections. Personally, I like to use both, and also like to apply a margin of safety.

After that, I needed to decide on what I consider fair value. In the end, I’ve decided to use a multiple of 20 as a proxy for fair value. The reason why I don’t mark-to-market is that it’s a buy and hold portfolio, so the owners are not interested in market gyrations. This gives the framework a certain stability, and takes the speculation out of the equation.

Lesson 3: You need comparable metrics

My next problem was, that I needed useful metrics to aid our decision-making.

It turns out that the real estate industry uses quite fuzzy metrics. You hear terms like gross yield, net yield, or return on investment. People that use those metrics often seem to exclude very key elements, such as financing costs, taxes, or the fair value of the employed equity. My best guess is that the purpose of these fuzzy metrics is to help the sellers (and their agents) inflate their numbers and make them look better than they are. This is supported by my impression that there seem to be enough real estate investors that keep using those fuzzy metrics, and don’t make the effort to find better ones.

Okay, so what was the job I wanted to get done? My main goal for finding a metric was to compare the real estate performace with the performance of a public stock portfolio.
 
I ultimately decided to use the after-tax return on equity. I want to stress after-tax, as a lot of people in the real estate industry seem to keep using pre-tax numbers.

To calculate the after-tax return on equity, I first calculate the after tax free cash flow. Again, without adjustments, and without exclusions of key elements. 

On the equity side, I use my fair value proxy. A lot of real estate investors use their cost basis, because this boosts their returns. This doesn’t make sense to me, because I want to take into account the opportunity cost of the employed equity. That’s why I use my fair value multiple of 20.

So now, this allows me to compare apples with apples and have a useful framework for capital allocation decisions, especially between real estate opportunities and public stocks.

Lesson 4: What are the performance drivers of buy and hold properties?

The next question I had, was to identify the main performance drivers of buy and hold properties. Basically a simple checklist to help me evaluate new opportunities.

I see three main drivers of performance:

First driver: Untapped growth potential: the best buy and hold property is one with untapped growth potential, first in terms of development potential (e.g. turning unproductive spaces into new units) and second, untapped rent potential (meaning: that the current rent is below comparable market rent that you could charge).

Second driver: A reasonable purchase multiple: in the best case scenario, you want to purchase a property with a low multiple, which results in an instant capital gain when you mark it up to fair value.

Third driver: Leverage: the more debt you have, the less equity you have to employ, which of course boosts your after-tax return on equity. With debt, you also have a yield from paying back the principle. This builds up equity. But over time, this reduces your returns, so you might need to re-finance periodically to keep equity low. Personally, I’m not a big fan of leverage. But if you operate with a large enough margin of safety, leverage makes sense and boosts your returns.

What’s important to note is that I don’t view price increases as a driver. For a lot of real estate investors, this is their main goal and their main performance driver. In contrast, my main goal is to grow the underlying fundamentals. When rent increases by 10%, the value increases by 10%, because I keep the valuation multiple constant. That means that I only consider value increases when there is a corresponding rent increase. If a value increase is not based on fundamentals, I view it as speculation and don’t consider it.

This change in attitude helps focus our energies on increasing the underlying value, and not on being distracted by the fluctuations of the market.


Posted on by Remo Uherek

Investing Lessons from Running a Startup

[This is an edited version of a talk I recently gave at a MOI Global event.]

I’d like to share some of the lessons I learned from being a startup founder, and how these can be applied to investing:

Lesson 1: I’m a better investor because I was a founder

As Warren Buffett famously said: „I’m a better investor because I’m a businessman. And I am a better businessman because I am an investor.“

This rings very true to me, and I can confirm it based on my own experiences.

I was in the middle of my startup, back in late 2008, when I discovered Warren Buffett and Benjamin Graham. My main takeaway for my business was that I realized how bad our gross margins were. At the time, our gross margin was around 30%, and we were burning money. Then, when applying this insight over a period of 3 years, we were able to double the gross margin to 60%, which helped us to achieve break-even and ultimately lead to selling our business. Without those gross margin improvements, it would have been much more difficult.

Lesson 2: “Creative accounting”

The second lesson is what I call „creative accounting“.

We were sending our investors monthly updates. But, brained-washed by the venture capital industry, and suffering from our own insecurities, we believed that everything that didn’t go „up and to the right“, was hurting our story. So we made a conscious effort to keep the story going, by applying what we called „creative accounting“.

We took advantage of the grey areas, and applied somewhat loose and not very consistent accounting practices. We played with the capitalization of certain expenses, to move them off the profit and loss statement. We recognized revenues in different ways, sometimes at the start of a project, sometimes in the middle, and sometimes at the end of a project.

In good months, we rolled over revenues to the next month, to have a head-start and create a cushion. In bad months, we scrambled to recognize everything we could, to avoid reporting bad news.

So based on these experiences, I’ve learned to become more skeptical of accounting statements, because there is always room for “creativity”: adjusted numbers, not expensing stock options, playing with accruals, playing with revenue recognition, and similar tactics.

Lesson 3: Seek owner-operated businesses

The next thing I learned is what it means to be an owner-operator.

I’ve been a founder of my own startups, but I’ve also managed startups that other people have founded. A founder is an owner-operator. He holds a large stake, and the whole responsibility lies on his shoulders. There is „skin in the game“ and a sense of „ownership“. It’s a different quality than managing someone else’s company.

When the company is mostly you, you cannot escape. You have to „go forward or go under“.  We had very tough periods in our startup. On multiple occasions, I was very close to giving up. But I didn’t, because I was an owner-operator. As a manager, you can quit much more easily. It’s a different situation.

That’s why in my investing today, I gravitate towards owner-operators. I’ve been one, and I understand them much better than hired managers. 

Lesson 4: Strong sales organization

Number 4 on Phil Fishers 15 point checklist is: “Does the company have an above average sales organization?“

I had to learn this the hard way. For the first two years, I was the only sales person in our company. It wasn’t working well. I had no prior sales experience, and I wasn’t enjoying the job. I realized that we need to build a sales team.

So I took a deep dive: I read sales books, went to sales seminars and hired our first sales manager. We ended up hiring 4 sales managers in one year, and quadrupled our revenues.

So today, I have a much better sense for what Fisher means by „above average sales organization“.

Lesson 5: Strong marketing & lead generation

A sales organization cannot be effective without a strong lead generation. If all you do is cold sales, you likely won’t get very far. You need qualified prospects and hot leads. 

Here we had an advantage. Because it was one of the areas we were above average.

Our core product was sponsored postings on blogs, what today is called influencer marketing. To not be misleading, we required every blogger to label their sponsored posts. And not only label them with something like „This is an ad“. Instead, we branded the label with our company name, and most importantly, included a link to our website. So each campaign for our clients, be it NIKE or RedBull or Disney, turned out to be a free campaign for ourselves. It was a marketing flywheel. And it was our #1 lead generation source.

So, in order to assess the sales capabilities, you need to be able to understand the whole marketing & sales funnel.

Lesson 6: The Flywheel Effect

Ever since reading Good to Great by Jim Collins, I keep thinking about flywheels.

I’ve learned that great companies have a strong, self-perpetuating and ever-increasing engines. Our viral marketing tactic was a one example. Network effects are another example.

So my lesson is: look for strong flywheels.

Lesson 7: Innovator’s Dilemma

The Innovator’s Dilemma describes why established companies have great difficulties to cannibalize and re-invent themselves, and why startups can be so disruptive.

It was one of the favorite business books of Steve Jobs, and he was a master of solving the dilemma. 

In times of ever faster technological change, it’s important to keep this concept in mind, and seek companies that have demonstrated that they have the courage and stamina to solve this dilemma.

Lesson 8: Certain things don’t show up in the accounting statements

I’ve learned that certain things don’t show up in accounting statements.
Hiring procedures, HR practices, company culture, early R&D experimentation all don’t show up at all, or only much later. 

As a startup, we had a strong company culture. It was a matter of necessity. We couldn’t afford to pay market salaries, and the job required every team member to put their heart & soul into the company.

Startups not for everybody, but if done right, they create a strong culture and a high level of productivity. If a company can preserve this startup ethos, it can be a huge asset. 

So the lesson is: don’t forget the soft factors.

Lesson 9: All eggs in one basket / Take something off the table

As a founder, especially a young founder who has no meaningful assets outside his company, you are not only concentrated, you are hyper-concentrated. All your eggs are in one basket, and as this would‘t be enough, the odds are stacked against you. 8 out of 10 startups fail.

It’s not a healthy situation, because you are over-exposed. That’s why it can be good to take a portion, say 10 or 20 percent of your stake, off the table, if you have the opportunity, to reduce the psychological pressure. Not right away of course, but maybe after 2 or 3 years, depending on how your startup develops.

So while insider buying is usually a good sign, insider selling doesn’t need to be bad. It could be prudent from a personal capital allocation perspective, and also a risk-taking perspective. If essentially your whole net-worth is tied up in your company, it might be hard to take the necessary risks to maximize long-term potential. So you need to understand the motive of insider selling before drawing conclusions too fast.

Lesson 10: Be a Learning Machine

Books have been super important for me. Whenever I faced a problem, I ordered the best books on a the topic, and tried to apply the best practices. That’s how I learned how to organize myself, how to build a sales team, how to build a positive company culture, and much more.


Posted on by Remo Uherek

Hell Yeah or No

Four words. This is the simplest and most useful decision making concept I have come across. I reflect on it regularly and it helps me to say “no” with more conviction.

If you’re not saying “HELL YEAH!” about something, say “no”.

When deciding whether to do something, if you feel anything less than “Wow! That would be amazing! Absolutely! Hell yeah!” — then say “no.”

When you say no to most things, you leave room in your life to really throw yourself completely into that rare thing that makes you say “HELL YEAH!”

Source: Derek Sivers

Both Warren Buffett and Bill Gates agree that “focus” is the single most important success factor.

Steve Jobs famously said: “People think focus means saying yes to the thing you’ve got to focus on. But that’s not what it means at all. It means saying no to the hundred other good ideas that there are. You have to pick carefully. I’m actually as proud of the things we haven’t done as the things I have done. Innovation is saying ‘no’ to 1,000 things.”

I hope you find this idea as useful as I do. “Hell Yes, or No!”

(Image by andeecollard)

Posted on by Remo Uherek

Cleaning up my Mac

My hard disc was almost full, so I was faced with a choice: buy more space or clean up. I chose to do a cleaning session and now have 40% free space. Here’s how I did it.

Clean up iTunes
Here I found the most potential. I stopped the syncing of podcasts with my iPhone and deleted all podcast episodes. I also deleted all synced iPhone apps, and backups of old devices. This alone saved 50+ GB.

A clean up with CleanMyMac
On Twitter [thank you Philippe] I was recommended to buy CleanMyMac. I did and it turned out to be a very useful piece of software. Helped me clean another 30+ GB. It found old junk such as old software updates that were never deleted. It helped me uninstall unused software and visualize which folders use how much space. It also has a useful updater, to auto-update all the software on your Mac.

Deleted duplicate files with Gemini
Then I bought Gemini, an intelligent duplicate file finder. It let me sort all duplicates by size. I then manually reviewed, and then deleted the largest 100-200 files out of the ~3000 files it found. This saved another 10+ GB.

General cleanup
I went through old folders and found lots of things worth deleting. As a bonus, I also deleted my old bookmark collection. I haven’t used it in years and many links were broken/outdated anyways.

My time investment was 4-5 hours. My Mac feels faster and has 200+ GB of free space. Mission accomplished!

(Image by manoftaste-de)

Posted on by Remo Uherek

Why I stopped drinking alcohol

This thread reminded me that it is now 10 years since I stopped drinking alcohol. I haven’t had one drop since.

Sometimes people ask me: Why not just one glass? Why stop completely? Why not enjoy life?

The simple answer is: It simplified my life.

It’s easier to quit something 100% than 98%. It eliminates the decision. There is no internal debate ever again.

Other benefits include: I save money; I sleep better; no hangovers; I can drive anywhere without worrying about driving back; and potential health benefits of course.

Also, I completely removed one vector that could possibly ruin my life.

I just learned that a new industry of non-alcoholic social beverages is emerging. Examples are Kin and Three Spirit. Similar to non-meat meat.

In 10 years, I experienced no social awkwardness or negative reactions. I did experience that my non-drinking often unconsciously reduces the drinking of the people I hang out with. An effect I did not expect.

How did I do it? I went cold turkey. One day I got rid of all alcohol in the house, and never bought anything again. Done.

(Image by sfllaw)

Posted on by Remo Uherek

How to choose a money manager?

You’ve inherited some money, or sold a business. What now?

Most people don’t have the skill, time, or willingness to manage their own investments.

One option is to entrust your funds to a professional money manager. But how to choose one?

I would recommend the following checklist:

1. Skin in the game
The first question I would ask: “What percentage of your net worth have you invested in the way you are recommending?” If it’s not a significant portion, I would quit the meeting right here and walk out.

Some years ago, I helped a friend get his finances in order. He owned some products that the private banker had recommended. “A great opportunity”, the banker said. I asked him: “Do you own any of these funds and certificates?” He smiled and said: “No, I’m saving to buy a rental property.” A prime example of “Don’t listen to what people say. Watch what they do.“

2. Aligned incentives
Make sure that the incentives between the manager and yourself are aligned. How does the manager get paid? Does he charge a high management fee? Does he get paid when the performance is negative?

Personally, I prefer and recommend the old Warren Buffett Partnership model: 0% management fee, an annual hurdle, and then a 25% performance fee. A high water mark ensures that a negative performance needs to be made up before the manager is paid. Simply said: the manager should only make money when you make money. Here’s a clip of Charlie Munger commenting on this topic.

3. Aligned investing philosophy
How does the manager choose investments? Which criteria are applied? What is the minimum time horizon? The approach needs to make sense to you, and you need to understand the basic concept. The manager should also be able to show a track record of the applied approach. Ideally his own, or at least of the people/organizations that inspired him to use this approach.

Applying this checklist does not guarantee investment success. But it might help you prevent painful mistakes, and stacking the odds in your favor for finding a good manager.

(Image by teegardin)

Posted on by Remo Uherek

How to identify great capital allocators?

This was the topic at the recent MOI Global Zurich chapter dinner I attended. Here I summarize my notes and thoughts on this topic.

I understand capital allocation as follows:

How do companies spend their limited resources, be it capital, time, or mental resources, so that they create the maximum amount of value per invested unit of capital?

So it’s all about value creation, efficiency and high returns on invested capital, however you want to define it.

So how to identify a great capital allocator? First, try to find people with a solid record of value creation. Growth in earnings per share or free cash flow per share could be useful metrics. Exceptional customer loyalty, products that solve real problems, or a full R&D pipeline with promising improvements could be qualitative factors to look for.

One shortcut is to look for owner-operators. People who own a large stake of their company and are the driving force. Especially if those people already have a strong track record.

A case study by Phil Ordway of good capital allocators was mentioned.

Then we discussed a number of topics and companies.

Amazon
Jeff Bezos was mentioned as a great capital allocator. Because he is obsessed with creating customer value, and takes a very long-term view. He has a deep understanding of capital allocation from his 8 years working on Wall Street (including working at a hedge fund). Plus, he is the owner-operator.

Disruption / Innovator’s Dilemma
Disruption is a real challenge. Many companies are faced with the Innovator’s Dilemma, being stuck with path-dependancy and an inability to cannibalize their still profitable, but increasingly obsolete, business units. Steve Jobs was a master of breaking this dilemma. Mark Zuckerberg seems to be pretty good at it as well.

BMW vs. Tesla
So what should a company like BWM do, faced with the disruption created by electrification and autonomy, or more generally speaking, by software and data? Should they compete with the Google’s and Tesla’s of the world on software, and potentially lose a lot of money, or would it be better to milk the current cow and slowly decline?

Warren Buffett and his textile business
Warren Buffett was faced with the same situation in his early textile business. He did a very sensible thing. He did not try to save the business at all cost. He took the profits, and reinvested them more productively. In his case, buying great and profitable companies like banks and insurance companies. And when his textile business started to lose money, he shut it down completely. He faced the facts and acted accordingly. He wasn’t romantic about it.

Mergers & Acquisitions
Acquisitions only make sense when done sensibly. Buy great assets, and don’t overpay. A lot of times, mediocre acquisitions are made, for way too much money.

Stock buybacks & Dividends
If its own stock is undervalued, it creates value for a company to buy back shares. If buybacks don’t make sense, paying a divided is better than acquiring a mediocre business, or starting a mediocre project.

Apple
What should a company like Apple do? So far they have been heavily buying back shares and paying out dividends. So it seems that the current management can’t find better opportunities internally or externally to deploy the cash.

To summarize, there seems not to be a single way to identify great capital allocators. It all depends on the specific circumstances. Personally, I like the owner-operator approach. This might be a great shortcut to find, and then partner with, great allocators. In fact, when I look at my personal portfolio, this is exactly what I ended up doing in a lot of cases.

(Image by 401(K) 2012)

Posted on by Remo Uherek

Consider Using a Pen Name

We live in a time where the default is to use your real name for writing. This was not always the case, as I learned in Benjamin Franklin’s biography. 300 years ago the default was to use a pen name. For good reason, as speaking your mind could be dangerous.

This got me thinking. Why don’t we use pen names more often today?

There are clear benefits: You can create a completely different persona. You can speak your mind even more vocally. And it overall feels lighter as the personal downside is smaller, which could especially be helpful for introverts.

Here are some famous pen names I wasn’t aware of:

  • Mark Twain (Samuel Clemens)
  • George Orwell (Eric Arthur Blair)

Have you always wanted to start a blog, write a book or create YouTube videos?

So here’s today’s idea: Why not start with a pen name?

Source: https://www.flickr.com/photos/thomaseagle/429240455/
(Image by Thomas Eagle)

Posted on by Remo Uherek

How to Block Spam Calls

Marketing and spam calls are annoying. A great way to block them is by installing a spam blocker app on your phone.

I am using Truecaller and also the local.ch app to block spam calls. Depending on where you live there might be other local blockers to complement Truecaller which works globally.

Bye bye spam calls!


Posted on by Remo Uherek