I believe you can absolutely beat the market’s returns. It takes hustle, and works better if you control more than your own capital.
I don’t think it’s likely you’ll outperform in a passive form of investing. Meaning, you won’t likely do so by: investing in public companies, mutual funds, simple market timing, technical analysis, or through a typical advisor.
So can you really beat the market?
Yes. Ben Graham became famous for beating the market. He literally wrote the book on value investing in Security Analysis, providing insights on how to find undervalued public companies. He described that an “enterprising investor” could study, work, and learn to pinpoint these undervalued opportunities. Old fashioned work. “Hustle” as J Money usually terms it.
These enterprising investors many times find their ways to hedge funds, family offices, real estate development, or private equity. Why do they end up at hedge funds, etc? Because fundamental analysis of markets and companies can produce returns in excess of the market, but it takes a lot of work and is hard to keep up over time.
If you give the effort, then might as well scale this effort using additional capital.
Successful entrepreneurs, RE developers, CEOs, and fund managers all work to control large amounts of capital. When successful, they take a slice of profit from an inflated pie. A 20% outperformance on $1,000 is only $200. Scale this up by 10,000x, and now we’re talking.
Below, I’ll run through some ways to employ this concept. I’ll use real estate as the running example, since this is most familiar to me. But the general topics hold for other lines of business as well.
Four ways to benefit from higher capital
- Tax Shelters
- Fee based management
- Promoted interests
Leverage is the fancy word for debt. Using debt in your purchase allows you to “leverage” up your equity position. It magnifies gains (or losses) in both cash flows and asset value changes. Leverage adds risk to a deal, so beware. Risk increases as debt yield approaches return yield, and also as Loan-to-Value (LTV) ratio increases.
Debt is used heavily in real estate, as values of assets are typically pretty clear. It is also used in most businesses, but usually at a lower LTV.
Single Family Rental Houses are a way that people use leverage in controlling assets on a small scale. Below is a case study showing the power of leverage.
- Un-leveraged: Many use the 1% rule in real estate in purchasing real estate – meaning that the monthly rental amount is 1% of purchase price. Assuming vacancy & expenses are 50% of income, that leaves you with a 6% return or yield (1%*12 months *50% profit). Meaning for $100,000 invested, you will receive cash flow of $6,000 un-leveraged annually.
- Leveraged: By holding 50% loan-to-value debt at rate of 4% (assume interest only – for simplicity), you could buy a $200,000 property. Assuming that same 6% yield, the property would cash flow $12,000 per year. Then there would be $4,000 in interest payments due ($100,000 * 4%), leaving cash flow of $8,000 leveraged annually. A leveraged return of 8%.
The examples above would be further helped by effects of depreciation on the after-tax cash flow, but that would get too complicated for this example.
The ultimate goal of having investment assets is to produce cash flow. Given the structure of the tax code, it is to your benefit if you can delay paying taxes as long as possible on the asset appreciation. Especially when taxes and leverage are combined.
Tax Shelters conjure up fear of hiding from the IRS, and ultimately getting raided and left with nothing. But really, there are plenty of legitimate and legal tax shelters available to most investors. Several of the most straightforward are: 401(k) accounts, IRA accounts, and 1031 exchanges (in real estate).
1031 Exchanges provide real estate investors with the ability to defer taxes on asset sales as long as the money is quickly re-invested in a similar type of asset. The spirit of the law being that liquidity would be hurt if investors were penalized for switching in and out of similar assets. Here is an example of why 1031s are a huge benefit to real estate investors.
Let’s assume you have owned the same investment property from the leverage example (worth $200,000) for decades and it’s fully depreciated (Your tax basis is zero) from your $100,000 purchase. You have $100,000 of debt on it. It yields 6% un-leveraged, 8% leveraged.
Let’s play out the scenarios if you sold it to buy another property with a better yield of 10% un-leveraged.
- Non-sheltered scenario: You sell the property, and owe taxes on the depreciated $100,000 at 25% maximum rate, the rest lets assume at 20% (rates can vary based on your tax bracket). So $25,000 + $20,000 = $45,000 tax bill. So your disposition looks like $200,000 sale – $100,000 debt – $45,000 taxes = $55,000 remaining equity. Assuming you again put 50% LTV debt on a new purchase, then you would buy an asset for $110,000. A 10% yield = $11,000 – $2,200 interest = $8,800 Unsheltered Cash Flow. Still worth the sale, but barely.
- 1031 Shelter scenario: You are allowed to exchange into a property of equal or greater value with no taxes, if you follow the rules in IRS code section 1031. Without any tax burden upon sale, you could buy a full $200,000 property with $100,000 debt, thus keeping the same LTV ratio. This property would cash flow $20,000 – $4,000 interest = $16,000 Cash Flow with 1031. Almost double the unsheltered return!
Fee Based Management
Many financial and real estate businesses operate on a fee as a % of assets (or revenue). When you’re providing a service, people can get comfortable with a couple of % points going to the service provider. It is in many cases more palatable than a fixed fee – with an ugly dollar amount staring them in the face each quarter or year. 1% or 2% sounds harmless.
Below is a list of business types that employ this strategy:
- Financial Advisors
- Real Estate Brokers
- Private Equity Funds
- Mutual Funds
- Real Estate Developers & Property Managers
The mechanics of this are pretty straightforward. Let’s take an office leasing broker. They find clients new office space and negotiate the lease with the the landlords. In return they get a fee % on the total revenue produced by the lease – usually around 3%. The crazy thing is that there is not much movement in the % basis for 10,000 square foot leases versus 100,000 square foot leases. The job is basically the same, just that one pays 10x as much. Maybe the fees move around a bit at the extreme high & low ends of the range, but only marginally.
The broker with the larger tenant usually has more experience. But basically, she has just manuevered into a better position over time. She has sourrounded herself with richer/larger clients & people. She has built/sold her brand as someone who is capable of big deals.
This spans many industries. In real estate, brokers, developers, and property managers all use % based fees. Fund managers, financial advisors, some bloggers, and many other professionals monetize their work on the same basis. Those with the biggest deals/clients/sites bring home the biggest checks. And I’ve seen first hand that size does not correlate perfectly with complexity or time spent.
So the key to making more in many business lines is to get yourself playing with the elephants. As a broker or financial advisor, plant yourself among the wealthy or larger companies. Become trusted by them, and find yourself doing the same work but on larger deals. Less of a grind.
Promoted interests are the key to profitability in both real estate and private equity / hedge fund worlds. The basic agreement is that an investor wants to make a certain percentage – let’s say 10% annually, with a decent chance at 20%. They will incentivize the real estate developer at an increasing rate once they have hit thresholds.
The Cash Investor (Limited Partner) will usually put in between 75%-95% of the required equity in a project. Leaving the developer with 5%-25% of the equity. That means with leverage around 70%, the developer runs a project while only contributing 1.5%-7.5% of the total capital.
Thresholds, or hurdle rates, are established so the developer gets a larger share of cash flow as profitability increases. For example, up to the 10% IRR (internal rate of return) level, they might split split cash flow according to the contributed capital ratios (called pari pasu). Above a 10% IRR, the developer might get 20% of all cash flow. Above a 20% IRR, the developer might get 30-40%.
These splits are determined based on many factors, including: developer experience, deal profitability forecasts, fees earned, and amount of capital chasing this type of deal. As you can imagine, extremely outsized returns for the amount of investment are possible. In our deals, we have hit deal IRRs of 40%+…leading to developer returns in the hundreds.
These Principles in Action
The ideal investment to hit it rich might include a combination of any, or probably all of these principles. Starting out as an entrepreneur, you might be limited in direct application of all of these at once. Fees will likely be limited and an investor will want to share in most profits – they are giving you a start after all. The more experience you gain, the more you bring to the table. At least try to consider scaling your efforts through prudent debt and tax efficiency.
Ultimately you should shoot for, and may be able to structure, a tax efficient investment alongside someone else’s money that utilizes a prudent amount of debt and pays you a fee for your work. Then ideally if it’s a home run, you can share an outsized portion of the cash flow once the investor has gotten back capital and secured a fair return. Everyone wins, especially you.