A tale of two investments
Mar 26, 2016
I have a hypothetical proposition for you. Well two actually, but you need to decide which of these is
more appealing and better for you in the long-term.
Option 1 - A leveraged convertible note
I've got a special arrangement through a friend who can get you into a somewhat limited
investment. It's a really hot company right now, everyone is trying to get on
It's usually a minimum $1M investment.
The arrangement we've got in place means we'll let you buy in with as little as
$200K. But you'll still have a holding at a $1M valuation! It's structured in a way
that means you'll need to pay the interest exposure on the
note until there is a liquidity event or until the term of the note, at which point it converts into
ownership. And there's operating costs and a management fee
that you'll need to fund. All these costs are variable but expect them to be in the range
The term of the note is 30 years. And similar companies have grown on average over 7%/year
over a 30 year period.
You can liquidate your holdings early and at any time, subject to market conditions. It'll
typically take anything from 90 to 180 days to find another party to take over your position
for you to be able to liquidate. And if you do it within the 30 year term there will be
additional contract termination costs to pay.
If all this sounds appealing there's a $42K non-refundable application fee to get it setup.
Option 2 - Take a sabbatical
Take 4 years off. Well, not "off" necessarily. But you'll receive an average wage for 4 years.
The only condition is that you're not allowed to be employed by anybody.
Go on an extended holiday. Go back to school. Spend time with your family. Start a business.
Do whatever you want. Just don't take a job somewhere.
So what do you do?
Put years of considerable savings into the thing everyone else is? Or spend 4 years searching
for something with higher returns?
What would it take to create something that offers more than a 7% annualised return per year? 10%?
Y-Combinator expects their companies to drive that kind of product growth per week. Yes I know
that's not directly tied to revenue at that early stage, but over the long-term it should be a rough proxy.
4 years gives you the luxury to try a bunch of things to see what worked.
Surely you could find something in that time that would provide
a nice additional income stream. Worst case at the end of those 4 years you go back to work, right?
And you at least got to spend a bunch of time with friends and family.
The fallacy of investment in home ownership
If you've not already realised Option 1 isn't actually a convertible note for a company, it's buying a house. Specifically
it's the proposition anybody thinking about buying in Sydney is currently weighing up.
Except nobody talks about it in these terms.
We've been sold a collective delusion that buying your home
is an "investment", that "owning your home is The Great Australian Dream", and that "rent money
is dead money". So most just march blindly forward along with societal expectations on
how they should manage their money without pausing to question what they're actually doing.
Let's break down those numbers:
$1,025,478 is the median house price in Sydney
I've assumed the buyer can front up the $205,095 to meet standard lending criteria and avoid additional fees for mortgage insurance, etc.
$42,221 are the estimated costs associated with purchasing a property of that value in Sydney.
The Reserve Bank of Australia estimates the ongoing running costs of owning a home are at least 2.6% per year.
The NAB mortgage calculator estimates monthly repayments of $4,399, principal & interest
at a 4.99% variable rate.
The numbers in other Australian capital cities will be lower but the general shape of everything will be the same.
Let me debunk some of the myths and preconceptions around home ownership, so we can
get back to a rational place to compare the two options.
It's not treated like an actual investment
Nobody treats it like an actual investment. If buyers did then they'd think about
what they're doing more critically. Does that Option 1 sound compelling enough to justify the exuberance
we see around home ownership? If people were taking out a $1M dollar loan for absolutely anything
else they'd question the numbers a lot more. They'd be more cautious. They'd assess the true opportunity
costs associated, look at what the alternative options are. At the very least they conclude it's actually a more efficient
deployment of capital to continue renting + buy an investment property than it is to own your home.
If the government seriously considered it an investment they'd treat it as such from a tax perspective.
You'd be able to claim the ownership, interest, and depreciation costs as deductions. Like in the US. And
we wouldn't even be debating whether "negative gearing" was a blight on the economy because we'd just
take it as understood that houses, all houses, were a bona-fide asset class.
But that isn't happening.
Because we don't treat it like an investment. Because most of the things
we prioritise for in a "home" are deeply personal and detached from a sound valuation. Does it feel
like a home? Could I imagine raising my family here? Do I like the shops nearby? Is it close to that
one particular school I want my children to go to? Does it have the space I need for all of the material
possessions I've accumulated over the years and can't bear to part with?
All perfectly valid reasons to buy a home. Just don't fool yourself into thinking they're investment criteria.
And don't get me started on the moral dilemmas of having the primary vehicle of wealth creation for individuals
built upon the requirement of making it more unaffordable for people to put a roof over their head.
At best owning your own home is a massive inflation hedge. Gone are the days of someone owning and living
in one house their entire life. You start with something just barely affordable. Your salary goes up. Equity
in the property goes up. The family grows in size.
And then you sell it, to buy something bigger. In a nicer area.
The equity you gained is just parlayed into a deposit + costs on a bigger house, with a bigger mortgage. You're not net ahead
because even though you struck it lucky timing wise and got a few years of 15% growth, *the rest of the market increased
by 15% too*. The same pattern repeats ad-infinitum until you decide to downsize and reign in your lifestyle.
Hardly the dream of wealth and independence we've been sold.
But the leverage!
Where else can you get 5X investment leverage? Or 10X if you're willing to pay mortgage insurance?!
--- L. Iterally Everyone
Well to start, my margin account with my stock broker covers at least half of my capital requirements on
any trade. So even the most exotic of trades I'll get 2X leverage without any effort. If I'm trading FOREX
margin requirement for currencies like USD is 2.5%, so 40X. Bonds go as low as 1%, so 100X. Same is true
of some US Mutual Funds.
Don't feel like a trading on margin? I don't blame you. How about some warrants? Citi have some available
that let you acquire an interest in an Exchange Traded Fund.
Those bastions of consistent long-term gains.
It's closer to 3X leverage, minus some interest costs. But there should be no on-going costs.
The dividends make the interest payments and pay off your loan to buy the rest of your share in the
fund (if it falls short you'll have a final payment to make in 2020). And you'll possibly be able
to claim the interest costs as a deduction.
All those numbers are based on a total of 15mins searching on 2 websites.
So that's to say there's plenty of other options with comparable or better leverage for anybody
who takes the time to look. All of them more liquid. None of them with the exorbitant operating costs.
Rent money is dead money
Imagine there's a new development with a house you'd just love to live in. Actually there's two identical
houses, side by side, for the exact same price. Do you buy and move in? Or buy, rent yours out as an investment,
and pay rent to live in the identical one next door?
For the sake of clarity and consistency we'll use the same median Sydney house prices. The upfront costs are
approximately the same whether you've moving in or renting out so lets just call that a wash for simplicity.
It's what happens next that matters.
You've got those repayments of $4,400/mo.
You've got ownership & operating costs the RBA estimates to be $2,600/mo.
You no longer have to pay any rent
Renting yours, moving in next door
You'll probably take an interest-only loan on an investment property, so your repayments are only $3,400.
Your ownership & operating costs are still $2,600/mo.
You have to pay rent, probably around $3,000/mo.
But you also receive rent for your property, $3,000/mo.
So the rent is a wash. The operating costs are the same. And the mortgage repayment is $1K/mo less as
an investment... because we took an interest-only loan. Why was that?
Because as an investment we can claim all the costs, including the interest repayments. And so there's
less of an incentive to be paying off the principal. That $400/mo shortfall between the rent received is
a deduction on your tax return. As is the $2,600/mo in operating costs (well, most of it). So that's $3K/mo,
$36K/year in tax deductions on your annual return. If you happen to be on the highest marginal tax rate
you're over $16K/year better off renting.
And you're still living in the exact same house!
I need to point out that if/when you sell the properties the way the gains are treated are vastly different,
with the home you owned and lived in letting you pocket the gains tax free. But see my previous point regarding how
this is just parlayed into larger homes and bigger debt. Those gains need to be tax free to allow that hamster
wheel to spin. And I maintain you're not actually ahead as a result.
All this is to try and illustrate what most people think they know about home ownership is horribly wrong.
With our expectations just slightly adjusted lets revisit what it takes to start a company.
Starting a company is lower risk than you think
The cost of starting a software/SaaS type company these days is virtually zero, all you need is a credit
card and time. Most IaaS and PaaS providers have incredibly generous free and low-cost plans that
are production capable. I know from experience that the free plans from a previous employer
are more than capable of running production services of a reasonable size.
You'll no doubt want more money at some point. To hire more people. To pay professionals to do a better
job on various things (like design). But lets assume now your primary limiting factor for getting a new
idea to market is actually time.
So how do we get you more time? Let's re-assess that Option 2.
Keeping the money
is $1,527/week, or $1,162/week after tax. That's just a
shave over $60K/year after tax. For anybody who's in a position meet the standard lending criteria for
for that median Sydney property they'd need to have saved at least $200K. Closer to $250K to cover stamp
duty and legals.
This is the basis for Option 2. Don't buy the house. Keep the money. Do something with the time you
just bought for yourself.
Think of the leverage!
As far as property investment goes, you've actually got relatively few levers. I mean you can build and
add more living areas, but the value of that depreciates the longer you hold the property. You could
give the bathrooms and kitchen a make-over, but they depreciate too.
Actually everything you can do to the property devalues over time. Property investing 101: land appreciates, buildings depreciate.
The entirety of your long-term gains will come from decreasing availability of land alongside increased demand from people.
Things that are also entirely out of your control.
Maybe I'm old-fashioned. I prefer investments where I can manage my risks. Where I can take action to
increase my returns. Where there's a probability of me doing more than simply getting the average market return.
You know, novel things. Like:
Increasing prices to increase margin.
Lowering prices to increase the number of customers.
Reducing my unit costs.
Providing good service to reduce churn.
Building new features to acquire new customers and/or new pricing options.
Content marketing to acquire new customers.
Paid marketing to acquire new customers.
Implementing an SEO strategy to acquire new customers
The problem is usually not having a lever, it's knowing which one has the most leverage.
The ultimate in flexibility
How serious are you about your idea? Want to increase your focus by removing the immediate distractions?
Want to increase your runway?
Take a working holiday.
Pack your bags and your laptop and head overseas. There's thousands of beautiful places to lose yourself
while you build an MVP. Almost all of them cheaper to live in than Sydney, most of them with faster internet :wink:.
Still not convinced?
When the market inevitably turns one of these options means you can double down your efforts
of building something great to keep afloat, while escaping to glorious beaches in South East Asia to reduce
your overheads and maximising your returns.
It won't be those with a $1,000,000 mortgage for the next 30 years.