Using housing to learn key investing terms

In Episode 52 of the podcast (listen here), Andrew Brown used the analogy of owning and renting a house to better understand some key investing terms. We thought it was a useful explanation, so we put it in a blog post for you to use and refer back to, to help you understand there terms.

This post is a bit numbers and jargon heavy, but give it a couple of reads if need be. Understanding these terms and their different meanings is important when reading company reports and announcements.

 

So, you’ve finally done it. You’ve bought a house…

Let’s assume you’ve just purchased a house for $1 million. To afford the $1 million, you put $300,000 of your own money and took out a $700,000 mortgage at 5% from the bank.

  • In investing terms, you would say you have $300,000 in shareholder equity (the amount of money put in by shareholders, as part owners of the business, to start the business).
  • You have $700,000 in debt, and have an interest rate of 5% p.a
  • This would make the total enterprise value of the business – where you add shareholder equity and debt and subtract any cash – $1 million).

Let’s assume there is $70,00 worth of fittings in the house.

  • These are the Tangible Assets of the business. They are the physical items that a business owns and holds on its balance sheet.

You rent the house out for $40,000 per year, earning a rental yield of 4% off the $1 million value. The real estate agent takes a 6% property management fee ($2,400). Meaning you are left with $37,600 in your pocket.

  • In an investing sense, this $37,600 it is often referred to as EBITDA (Earnings before interest, taxes, depreciation and amortisation). It shows how much the business is making from operations.

Now, all assets lose value over time. So let’s say the $70,000 worth of fittings depreciate at 10% per year. This means every year, you’re incurring $7,000 in depreciation costs. Now you are left with $30,600 in profit.

  • This $30,600 is often referred to as EBIT (Earnings before interest and tax).

You had to borrow the $700,000 to buy this house, and you’ve got to pay interest on your mortgage. Given your interest rate is 5%, you owe the bank $35,000 in interest (5% of $700k).

  • So you subtract the $35,000 interest payment) from your EBIT of $30,600. Turns out, you’re going to make a pre-tax loss of $4,400.
  • Unfortunately, your company has made a loss this year and you will be reporting negative earnings or negative profit.

Hold on, when we think about the $7,000 depreciation cost – it doesn’t actually affect the cash you have in your hand. For example, think of all the assets in your home – your fridge, TV, computer etc. They lose value over time (depreciate) but it doesn’t cost you anything until you have to replace them.

So while your $7,000 depreciation expense has to be reported, it doesn’t actually affect your cash flow.

Instead, to calculate your cash flow take your rental income ($40,000) less management fees ($2,400) – to get your EBITDA of $37,600. Now subtract the interest payment of $35,000, because that is cash you actually have to pay out to the bank.

  • This leaves you with $2,600.
  • So while your house/business reported an operating loss this year, you are actually cash flow positive. Meaning you have cash in your hand left over at the end of the year.

Understanding these concepts will help you make sense of financial reports and investor announcements and presentations.

If you haven’t listened to our interview with Andrew Brown where he works through this scenario, check it out here.

So let’s review, if our house was a business:

Housing Term Investing Business Dollar Amount
Balance Sheet
Deposit Shareholder Equity $300,000
Mortgage Debt $700,000
Property Value Enterprise Value $1,000,000
Earnings from Operations
Rental Income Revenue +$40,000
Property Management Costs Operating Costs – $2,400
EBITDA $37,600
Depreciation of fittings Depreciation -$7,000
EBIT $30,700
Mortgage Repayment Interest Payment -$35,000
Profit Earnings ($4,400)
Cash Flow Statement
Rental Income Revenue +$40,000
Property Management Costs Operating Costs – $2,400
EBITDA $37,600
Mortgage Repayment Interest Payment -$35,000
Cash Flow $2,600

 

Comments

  1. Hi guys,

    The links are wrong to the podcast page – just letting you know 🙂

    Keep up the great work, what you are doing is exactly what I’ve been looking for. I’m totally new to investing and so far haven’t invested anything, as I’m still learning about it. I started out listening to the Motley Fool podcasts, but then I realised that I was never going to own any of the shares they were talking about, partly because it’s all American, but also because they all seem to be flavour of the month stuff.

    Anyway, I’m rambling – great work 🙂

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