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Is South Korea going to be attacked? Well, we can get a sense for market opinion by analogy with World War II.
Back in 2004, Financial History Review published an article correlating market events with World War II events. In particular, they looked at the prices of Nazi German bonds and Belgian bonds. Below is an example of Belgian bonds traded in Zurich. Before the invasion, starting in about 1936-37, the market slowly started demanding lower and lower prices (higher and higher yields) for taking the risk of buying bonds from Belgium. When Poland was invaded in 1939, Belgian bond prices dropped sharply. When Belgium itself was invaded, trading was briefly suspended (break in data), but then resumed at far lower prices (higher yields):
You can read the full article here.
So what’s going on with South Korea’s borrowing? Are investors demanding a high risk premium for buying South Korean debt? The answer is basically “no.” Here’s a graph of yield for South Korean bonds (you’ll have to mentally invert it to compare it to the graph above, which shows prices):
Over the last two years, buyers of South Korean bonds have been accepting lower and lower yields (higher and higher prices). There’s a slight uptick at the very end there, but overall, investors in aggregate seem to be saying that South Korea will be just fine.
But it’s hard to say, especially with menacing North Korean displays like this.
This recently blew my mind, so I thought I’d share some simple math with you.
Imagine an investor wants to invest in your startup. He says it’s worth $1 million and he wants to invest $500,000. He’s going to take half your company, right? Wrong. He’s going to take one third. At least, that’s the usual math.
In publicly traded stocks, it works the way I’d expect. If I buy $500,000 worth of stock in a company with a capitalization of $1 million, I’ll own half the company. That’s because my stock came from other stockholders. My money went to pay out existing owners.
In the startup world, that’s very unusual. All the old money has to stay to keep the business alive. There’s no “capitalization” yet, not in the sense of capital sitting there doing its job. So when someone invests in your startup, they don’t buy shares from existing owners. They add to its value.
So in the example above,
Don’t believe me? Think about it in terms of share price. Say you have 1 million shares. A $1 million valuation divided by 1 million shares = $1/share. The new investor buys 500,000 shares in your company at $1/share, equaling his $500,000 investment. You create those shares by issuing new shares, rather than by selling him existing shares. Now there are 1.5 million shares out there, and he owns 500,000. So what does the investor own? One third.
Here’s a neat concept that everyone can use, from professional poker players to Warren Buffett. In Alice Schroeder’s biography, The Snowball, she describes how in his youth, Warren was good at assigning odds to each horse in a race. This is called “handicapping.” Schroeder uses this as an analogy to explain how Buffett calculates investment probabilities.
It’s also the same concept underlying my previous post, How much is my startup worth?
Here it is in simple terms:
Your roof is leaking somewhere. The roofer offers a complete replacement of the roof for $10,000. He offers a 100% guarantee that your roof will be leak-free for three years, or else he’ll come back and completely replace it again for free. He gives you an alternative, as well: he can patch this one mossy spot for $2,000. He estimates that there’s a 25% chance this patch will fix the leak.
If you choose the patch, you have a 25% chance of saving yourself a $10,000 replacement. That’s kinda like saving 25% of $10,000, or $2,500. To get this chance, you have to spend $2,000 for the patch. In mathematical terms,
Value of Patch = -$2,000 + 0.25*$10,000 = $500
The $500 is what I’m calling Sklansky dollars, and it represents the increased economy of trying the repair first.
Crucially, these 500 Sklanksy dollars were still there even if you elect the repair and it doesn’t work. Now you’re in for the cost of the patch, $2,500, plus the cost of the replacement, $10,000, or $12,500 total. It hurts. But it was justifiably the right call to try the patch first because you had positive Sklansky dollars for that decision.
For further reading, read it in poker terms.
People usually say there are three important things: “Location, location, location!” But in rental real estate, it’s mostly just price.
The Economics of Real Estate
In any decision to purchase — any decision to invest — you always look at “what you get and when you get it” vs. “what you pay.” But there are a few things you should keep in mind about real estate as an investment class, regardless of the rents you get.
The majority of costs for a rental property are related to the property as an asset. They’re things that even brilliant management can do very little about once the property has been purchased. They all scale with purchase price:
- real estate taxes
- insurance premiums
- base depreciation
Let’s take a typical property as an example. The purchase price was $250,000. Twenty percent was put down at time of sale, so the interest payment at 4% is about $8,000/year, or $667/mo. Real estate taxes might be, say, as high as 2% of asset value per year, or $417/mo. Insurance for replacement value might run you, say, $170/mo. Base depreciation as a residential property, per the 2012 IRS tables, might be $5,000/yr, or another $417/mo.
Now here you might object, saying that depreciation is not cash out the door, so it shouldn’t count. But it does represent a real long-term expense, namely, what you’ll need to keep putting into the place to keep it from falling apart. Pricier properties generally need bigger budgets.
Add up all those expenses and you find that $1,671/mo of expenses have nothing to do with how well you manage the building as a rental property. They’re just tied to the purchase price.
So you can see that if you buy the wrong property, a management strategy to reduce utility costs, avoid lawsuits, and get the best tenants will matter comparatively little at the beginning. It can take long time for this cost avoidance to show itself on an income statement.
The moral is “shop around before you buy.”