I wrote last week about how using Other People’s Money (OPM) can make your investment returns increase exponentially (read the article here) provided that you perform your due diligence and don’t expose yourself to unnecessary risk.
I mentioned how we can learn from banks – institutions who have mastered this concept vis-a-vis the fractional reserve banking system: A bank can take your $10,000 deposit and loan it out ten times (9 to 1 leverage) and create money out of thin air.
I always think it’s great to learn from the masters of financial wizardry. To reiterate what I said last week, I like banks. And credit unions. They loan me money at great, fixed rates of interest for extended periods of time. I want to learn and profit from their examples.
As an aside, do you know what the best business model in the world is? The answer is the actuarial (insurance) industry. I don’t care what type of insurance you are contemplating purchasing – vehicle, home, flood, health, key person, etc.
The common thread is that you are betting you’re going to experience a loss and the insurance company is betting you’re not.
The house always wins.
But most individuals aren’t capitalized well enough to absorb the risk of their home burning down. And banks aren’t comfortable with maintaining 80% exposure if the homeowner doesn’t have insurance. (I mean, if someone had to borrow 80% to purchase the home, it’s not likely they’d be able to conjure up 100% of its replacement value in the event of a total loss). That is why banks require home insurance when they underwrite the mortgage.
The reason that insurance is the #1 business in the world is because it is the only business that is fully capitalized up front. Think about it. You pay premiums, and you may never experience a loss. If you do, the company has already been capitalized millions of times over by others and can afford to make you whole.
Contrast this to selling widgets. You have to first own or rent a widget manufacturing facility, purchase raw materials for widget making, pay people to put widgets together, and pay other expenses such as the light bill…before you can make a profit on your first widget.
But at least in the widget example, you’d be in Robert Kiyosaki’s B Quadrant (read Cash Flow Quadrant by Kiyosaki for background on this). The absolute worst place to be economically is in the E or S quadrants because you are limited to trading your time for dollars. Your limit isn’t necessarily your value, it is your time.
Sorry for the digression – back to this week’s topic.
If we consider the commonly accepted definition of investment returns (I used Investopedia’s so you wouldn’t have to take my word for it), we know that ROI = [investment return] divided by [cost of investment] x 100%.
We showed last week how OPM increased your ROI, and we showed how banks are the masters of this concept.
But do you know that there is a way to achieve an infinite return?
Q: I thought infinite was limitless, boundless – if I have an infinite return how do you define it in dollars?
A: Infinite return is defined in the sense of rate of return.
Take the standard ROI calculation and consider what happens when the actual dollar amount of return stays the same, but the cost of investment goes down.
For example, a $2,000 investment return on $4,000 invested equals 50% ROI.
But a $2,000 investment return on $1,000 invested equals 200% ROI.
Do you remember the term asymptote from high school math class?
(a straight line associated with a curve such that as a point moves along an infinite branch of the curve the distance from the point to the line approaches zero and the slope of the curve at the point approaches the slope of the line)
The upper boundary condition is any investment return that had zero associated cost.
Q: But dividing by zero is undefined, not infinite!
A: Right, but since ROI asymptotically approaches infinity at an infinitely small denominator, it is, for our purposes, infinite.
One example, probably not a good one, is when you pick up a coin laying on the ground. Your return was infinite because you didn’t have any cost. Some of our shrewd readers will no doubt highlight the fact that there is a limit to both how many coins are on the ground as well as how many such maneuvers your body is physiologically and mechanically capable of in a given (finite) time period. And that’s a valid rebuttal.
Q: What is the best example of an infinite investment return?
A: It’s done in real estate all the time. A real estate syndicator aggregates capital from many investors to purchase an asset. The asset could be an apartment complex or a new development or construction product. The syndicator adds value in the sense that the result is greater than the sum of its parts.
This could mean that the apartment complex is underperforming the market. By making improvements, rents can be increased and therefore the asset’s value increases because value is a derivative of cash flow.
In the development example, the syndicator brings value by way of connecting the dots – acting as the contact between the engineering team and the team of contractors to build an asset.
You need to be able to build an asset for less than what you could sell it for the day that it is finished (regardless of cash flow), otherwise your investment is underwater from day one.
In both examples, as the market absorbs the new product or the old product that has been revitalized, the value continues to increase as cash flow increases.
Financial institutions are happy lending from 70% to 80% on an asset’s value.
When the value of the asset has increased enough (typically in a real estate syndication the budgeted time period is 5 years), the asset is refinanced.
Q: What? You pull cash out and push the loan payoff further down the road? That’s not responsible!
A: You are correct if we are talking about a fake asset – a toy, credit card, your own home (something that takes money out of your pocket). But you are DEAD WRONG if we are talking about a real, cash flowing asset.
When the asset is refinanced, the investors are recapitalized according to their initial investment. It is not only possible, but also highly probable that a given investor may see a return of 100% of his or her initial invested capital and yet retain proportional ownership in the asset. (Lee Math, as defined last week, suggests that we ignore the time value of money for now.)
When you continue to own and receive returns from an investment in which you no longer have any capital invested, the returns that you receive are infinite according to our above-referenced discussion.
Q: Is there anything better than an infinite return?
A: In my mind, knowing and acknowledging that your return is infinite is tantamount to the actual return. Because, why would you sell the asset (trade the goose that continues to lay the golden eggs for a mere pile of today’s dollars) when the return is infinite?
Q: Is the concept of infinite return limited to real estate?
A: No. Any investment in which you no longer have any cash in the deal can produce infinite returns. Another example – if your security position increases in value and you sell an amount of securities equal to your initial investment; future returns are infinite.
However, infinite returns are most attainable and most predictable in the real estate world.
As you think about that, consider the type and scale of investment returns in your portfolio. If you conclude that your actual returns are closer to the long term stock market average of 8% to 10%), download our eBook below and learn how to ratchet your returns to infinity and beyond.
Until next time,
Dr. Lee Newton
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