Why Do Investors Ignore Cash Sitting Idle In Their "Return" Calculations?

27 Replies

I have observed that investors consistently IGNORE the fact that their time sits idly in a bank account when they tout their "AROI" on their projects. This is quite puzzling to me and I was wondering why people do it.

People often let cash sit around waiting for the home run deal that only comes along every few years instead of having it in play in good projects consistently.

Why is this? Is it mainly to impress people at cocktail parties? Ideas? How much do you estimate this saps REAL returns for most portfolios?

Originally posted by Bryan Hancock:
Why is this? Is it mainly to impress people at cocktail parties? Ideas?

I'm too busy making money to attend cocktail parties. :wink:

Your gonna score more with consistent base hits than occasional home runs.

I have a certain level of cash I like to keep in reserves for the rentals. But once I can scrounge up enough extra cash I'm itching to buy another property. I am getting ready to close on a REO in 2 weeks. Just looking at it from a purchase standpoint it was not a homerun (asking price was $18,600 and I got it with a final bid of $20,000). What made this one special was the bank is giving me a construction loan up to 85% of the ARV then allowing me to refinance into a regular portfolio loan with them. If I do everything right I will have not spent a dime of my own money on the property.

I will take deals like this as much as I can. Besides cocktail parties aren't my thing, I prefer a cold sixer in a friends garage.

I think any good business person knows that cash sitting in the bank is not earning them the optimal return. But it is also a major pain in the butt to put that into your calculations until the end of the year in which you get your realized ROI. There are a million things to do when running a business, and some items are prioritized higher than others. Figuring out my a realized ROI for every project is a major pain and at the bottom of the list. I'd rather just do it once at the end of year and make any adjustments to my buying decisions then. Why wouldn't you want to impress people at cocktail parties? Last I checked, people with disposable income also like to lend money.

If you're that concerned about total returns counting all investments and idle money, keep it easy and track your net worth. Then it's easy to see what percent return you're getting year over year.

"Idle" cash has a value to me. It's FU money (pardon the language). It depends on your stage in life and where you are as far as your goals. I don't know if this is exactly your question. I've been out on a limb when I was young and I think that was a necessary risk. Now? No.

Bryan, assuming you are talking about many of us flippers who have often reported 20%, 25%, or 30% returns on one single flip investment that took us 90 days and then we touted 80%+ annual returns, we do that as it is an easy "apples to apples" comparision between individual investments and between us individual investors.

I would have to assume that all investors such as myself do in fact calculate their actual returns on their cash at the end of the year when they have all the info to properly calculate it at once. It really does not matter to include cash sitting idle in one single investment when you do many over the course of the year.

At least that is how I and several others I know do it.

I am not really referring to any particular group, but the context is a passive investor comparing their returns on a project basis to what they would get by investing passively in a fund. Waiting for the “200% AROI” project instead of consistently investing in 100% AROI projects that are easy to find seems silly to me if you have to let your cash sit idly for extended periods of time to find them.

I am not really referring to any particular group, but the context is a passive investor comparing their returns on a project basis to what they would get by investing passively in a fund. Waiting for the "200% AROI" project instead of consistently investing in 100% AROI projects that are easy to find seems silly to me if you have to let your cash sit idly for extended periods of time to find them.
I see. For the flippers, I pointed out why. For those in your example here, I don't feel the example is correct. How many passive investments deliver 200%+ returns? I have yet to see 1. More appropriately, investors who are passive who claim 40% annual returns but can only be in such home-run type deals for 4 months out of the year should darn well be factoring the time sitting idle. If they don't, I would not know why other than to make themselves look better.
One way or the other, I really don't care what they claim or how they calculate their returns, it is of no consequence to me.
For someone who regularly searcches for investors to invest in a fund and has to compete with these claims, I can see why you would want to take an issue with it. I think it comes down to you educating each individual who claims such returns that as opposed to your fund returns, their's is not consistent enough and the time idle must be factored in to the return calculations.

Bryan, you have a formal education in financial matters that recognizes the "use of funds" and the "velocity of money" that impacts the investment returns. Most real estate people are not as financially astute, IMHO. The short of it is that ignoring stagnet funds can make the buesiness appear to be more successful than it is. At current rates paid on deposites, there is an ecomoic negative return.
It also requires returns to be viewed on a weighted time line and if you were to consider the economic impact of opportunity costs missed, many are not doing as well as they should be.
So, while a few of us can consider such aspects, it's not worth the analysis.

I enjoy a good dinner party anyway...

Bryan,

Many investors consider the time they are invested as exposure to risk. Therefore they would rather a home run with short term risk than several base hits, each with market exposure/risk in and of themselves.

It is the element of "exposure to risk" that can drive a person to only want to engage in the markets for those rare home runs.

I think the average passive investor is not sophisticated enough to think in these terms. That is why they passed a law that banks have to report APR not interest rate. Humans have been trained to go after the biggest number and report on what looks best.

Just like some one reporting bragging about a 50% gain on a $1,000, that is great but are you really going to be able to accomplish that same move on $100,000?

Many of the sophisticated investors I know seem to be looking for the best After Tax Gain and comparing everything on that level.

Originally posted by Jason S.:
Bryan,

Many investors consider the time they are invested as exposure to risk. Therefore they would rather a home run with short term risk than several base hits, each with market exposure/risk in and of themselves.

It is the element of "exposure to risk" that can drive a person to only want to engage in the markets for those rare home runs.

I agree with the exposure to risk comment and that investors tend to avoid as much risk as possible, however, homeruns often come on rehabs requiring more time invested, so that does not follow the example quoted.
Playing devils advocate, I could argue that many base hits spreads or diversifies risk rather than the whole lot in one investment.
Originally posted by Will Barnard:
I agree with the exposure to risk comment and that investors tend to avoid as much risk as possible, however, homeruns often come on rehabs requiring more time invested, so that does not follow the example quoted.
Playing devils advocate, I could argue that many base hits spreads or diversifies risk rather than the whole lot in one investment.

Of course you are right and I could even quantify it and chart it with a portfolio risk equation - but Bryan was asking why so many investors think the way they do.

I would also add for Bryan that fund investors, IMHO, are different than the typical RE investor. It is difficult for the average seasoned RE guy to let go of control. Even TD buyers like to see their security on a particular property - though a TD buyer would likely be easier than a boots on the ground seasoned fix/flip/ttee buyer/land developer.

Let's see the portfolio risk equation Jason. I'm an engineer by training so numbers and equations are always something that interests me.

Another thing to consider is that risk comes in different forms. Investing in cash carries a very high inflation risk that is hedged to a large extent by investing in real materials.

I think that really depends largely on one's age and goals Cheryl. We keep around 10% of our long-term debt in cash right now primarily because:

1. It allows us to keep borrowing money from small regionals
2. I think inflation will erode the value of long-term debt and is basically free money in real terms

For those with shorter time horizons and a greater need for capital preservation a much larger quantity of cash is a good idea.

I'm torn right now Bryan. On the one hand, I want my properties paid off (peace of mind but "dead equity"). On the other hand, I want as much of this cheap money as I can get my hands on. For me it comes down to stage of life and not really wanting to expand my portfolio.

I,too, maintain a decent balance with the small regional that funds my purchases (now just flips).

Originally posted by Bryan Hancock:
Let's see the portfolio risk equation Jason.

An equation like that would have many elements including the underlying market risk of each invested asset, the way that asst performs in relation to the underlying market, and many other factors.

I was considering writing it out and graphing the true risk of investments given different LTV's in order to justify precisely calculate the theories that are espoused on this forum and then comparing them to different sliding scale stress tests in order to see how we could deviate without increasing true risk. But then I determined it is easier to make an appeal to logic given the markets in which I invest and that most people that I seek funding from would not care.

Though it could be useful in obtaining funds from larger hedge funds..... anyway its a pretty nerdy task and I do not have the time because I am not certain I will find capital that will invest based on the equation at least not any capital that would not already be persuaded with an understanding of the market.

That is the trouble Jason...by the time you do all of that you have made tens of other assumptions. It is arguable whether or not these could really be defined precisely in the real world.

Cash sitting around idly is sub-optimal from a risk-adjusted perspective when compared with spreading the investment out across a number of good projects. Do you think this is something informed investors would generally agree with? Or are you claiming they would rather wait on the home run to somehow minimize the general risk of having funds spread across a number of "inferior" projects?

Bryan,

At the risk of participating in a topic more sophisticated than my current station; it seems to me that if you have the money to invest at any given moment and enough to do it in regular and small time intervals, you should find something to invest in, even if it's not an awesome deal, as long as it's a good deal. I would agree with this philosophy, although only from a spectator's vantage point.

If you are a smaller investor and have limited funds and are constrained by outside limits such as needing time to accumulate more funds to act on the next deal, then the considerations are different (at least I think they would be). If I have to wait two years between deals because my access to funds is limited, it might be better to wait another 6 months to find a better than good deal, would it not?

Well...at the risk of over complicating things the general answer is maybe Brian. The best investments I see are those that are too big for small investors and too small for big investors like REITS or other institutional money sources. If you are capital-constrained and need to place your money on the absolute best horse running you probably can't play ball in the best investments. Sponsors for these types of investments also should not take all of your money even if you were willing to invest all of it.

What strikes me as very odd behavior is seeing people hoard money and try to cherry pick the deal of the century instead of placing smaller (but still big) bets in very good deals. This would seem to diversify risk some and make for a better overall return.

My sense is that a lot of this has to do with trying to negotiate the best deal. Some of it has to do with wanting to control things as has been mentioned a bit. I find it hard to believe that these items alone are a good enough tradeoff for keeping the money in service in good projects longer though. I wanted to start a thread to see if I was missing something of consequence in this simple analysis though.

I too share Brian's fear...

But something to consider... from what I've heard, if you've found a home run, the money will find you. Seems like you're best keeping your money constantly working by taking the singles and doubles that are constantly present. If you happen to trip over a home run at a lull in your personal finances, money will be available through other sources to capitalize.

That's my plan. When the money is there, make a good buy... but always have my eyes open for great deals and if found, figure out a way to capture.

Originally posted by Bryan Hancock:

What strikes me as very odd behavior is seeing people hoard money and try to cherry pick the deal of the century instead of placing smaller (but still big) bets in very good deals. This would seem to diversify risk some and make for a better overall return.

Well, I do have an oblique perspective on this. I work as a geotechnical engineer. So, although my personal real estate experience is VERY limited, I do work with land developers, builders both large and small (commercial and residential)and many other characters in the real estate investing/business spectrum.

What we notice today is that the deals (projects that we provide testing for)are generally much smaller in scope than before the economic down turn. New developments have been divided into smaller phases and sub phases, large commercial projects have been reduced in scope. However, our total number of jobs has remained about the same.

So, maybe there are more people subscribing to your ideas than you think. For us, there are several parts of our team that remain the same in size despite the size of the project. What I mean is that the relative cost to do 100 smaller jobs is more than the relative cost to do 100 similar jobs that are larger in scope. But, we will take what we can get and it appears that our clients, pushing and shoving as they do, feel largely the same way. Maybe your observations are a condition of your client base rather than what is happening at large.

We have a pretty diverse client base ranging from the super high end, highrise whatever all the way down to the small home builder that does two or three homes a year. Most clients have niches that they are comfortable with. Some stay withing certain scopes and will have broad ranges of project types within that scope. Others are so specialized as to only participate in, say, medium end nursing facilities - only.

My observation is that people tend to stick with the business model they know until they are forced to change it or die. Otherwise they fear loosing money through mistakes in areas of less competency.

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