Chingo De Dinero

A lot of people talk about options and know the power in the amount of leverage you can get with them.  The one area where most of the people I talk to lack knowledge is how to price stock options.  If I ask if the option is cheap or expensive, the give me the blank look.  If I ask about implied volatility I get an even funnier look.

In short, the price of stock options boils down to implied volatility, which is more or less the probabilities of wide variations in the underlying stocks price.  Using Black-Scholes which is more or less the space under the normal distribution curve that shows the probability at different prices for the underlying stock.  Less volital, the taller, thinner the curve is.  As volitility increases the wider the curve is.  So, as you get an option away from the current stock price, the area under the curve is larger when the volatility is higher.

If you are not familiar with this, I doubt my short explaination will help much, but it should plant some seeds which will make more sense as you research.

I started investing in rental property about 3.5 years ago, and now need to do a recap/lessons learned. When I originally did my calculation, I was looking at around 25% yearly return. I used a basic IRR calculation in excel. My key variables were rental rate growth, home appreciation, and repair expenses. The current rent rate and home value was given.

The first variable rental rate growth, I actually underestimated. I used 3%, but it actually grow around 10% each year. I don’t think that can happen forever, but I guess I just got lucky and bought in at the low.

For home appreciation, I used 3% as well, but in reality it was around 12% per year. There is probably a relation between the rental rate and home value.

The last variable, repair cost I used 50, but in reality, it should be around 125. For a few of the condos, it was very low, mainly due to who is living there. But, you get on AC out, or a few appliances and the repair budget is gone. I have two properties that have expended their budget for the next few years, but all in all, it should probably be around 125, not the 50 I used. Also, it is important to note that I do the majority of repairs myself. If you hire someone for everything, you are looking at 200 per month.

One thing I did not factor right was % of time rented. I worked very hard to have little down time. For 7 units, I would have less than 7 days of a unit not being rented (average 1 per unit). This was not factored in, but was very small. It is easy to have 15 or so unrented days a year per unit if you do not manage the unit tightly. This makes a very big difference in return.

After all of this, I would say my return on investment was over 100% per year. I think I had very good timing, and it is time to take the exit. Plus, with travel, the repair cost increase even higher.

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It is always interesting, to me, why external auditors must be used by all publicly traded companies. It all began back in the early 1930s. If you are at all familiar with American history, for the time, this is during the great depression. If you are not familiar, basically the late 1920s were high times, then everything came crashing down, the stock market, banking system, basically the economy in general. I do not want to get too much into the cause of this, but will discuss the government’s reaction.

One of the first things the government did was set up the FDIC, to insure bank deposit, thus improve trust in the banking system. Also, the wonderful Social Security program came along, to ensure our elderly are financially secure. Many other actions were taken, but to stay on track, laws were passed in 1933 and 1934 to regulate public companies (created SEC). The laws in 1933 apply to become public, what papers to file, how it must be advertised, what information must be communicated to purchasers, having the financial statements audited, etc. The laws in 1934 apply to ongoing reporting, 10k, 10q, etc. Getting back to my purpose here, the laws in the early 1930s required companies to have audited financial statements to become public, and to have their annual financial statements audited. Thus, guaranteeing business for external auditors.

This is where it began, but now the government has created Sarbanes-Oxley which requires external auditors to give their opinion on a company’s internal controls. So, basically, the external auditors require the company to prepare a ton of paper, and sign off if it is correct or not (not totally true).

The two services I described above are called attests services, which means the external auditors give their opinion, e.g.Financial Statements are correct, Internal Controls are sufficient. There are many other services, tax advise, financial system consulting, management consulting, etc. But, if the attest services, which are required by law, go away, all of the other services which the majority of money if made from is disappear quickly, or at least will be disbursed to different companies (my opinion).

So, if you couldn’t tell, I am not to fond of external auditors (even though I am an Accountant myself). The main reason is because it is government controlled. The only economic argument for them is that the borrowing cost for an audited company will be less, because they will be viewed as less risky. Maybe this is true, but the only way to see is to remove the government requirement, and let the market do its thing.

To recap, external auditors service the purpose of giving their opinion on the accuracy of a company’s financial statements.

All of that sub-prime mess going on is a joke.  The banks were loaning money to people who couldn’t pay the loan.  I treat the previous statement as a fact, if these people could pay it back, the would not get sub-prime loans, they would get regular loans and avoid the higher rates. 

 Why would banks do this?  Two reasons, the default projections they were using were not good predictors of the future, they underestimated the true number of people that would default.  The second, is the downside risk….when you stop paying your loan, the bank forecloses on you.  So they sell your home, keep what you own them, and return the rest to you.  The only way to lose is if the value of the home is less that what is owed.  If you have a strong housing market, with prices rising rapidly, this does not happen often.  But, if prices start to drop, this can easily happen, thus why housing prices are so important to the sub-prime issue.  So going back to my first asset pricing model, the banks used a discount rate that was too low, it did not factor in the true size of default risk.  If the banks would have charged more for the loans, and set aside a higher reserve, we would not be seeing the headlines we are seeing right now.

 Back to my first statements, I think the banks got a little too optimistic, not that they are stupid, just a little too excited.  Now…they are paying for it, which they should.  Letting them suffer will result in them changing their models, and correcting the market.  That should be the end of it…the government does not need to come in and be a hero.  The banks agreed to lend money, and people agreed to borrow.  The people did not pay back, the banks lost money, so the banks will stop lending money to this sect of people.  All problems solved, the market working at its best.

As a side note, I like sub-prime loans, I actually have two for some condos I own.   One weird thing, the interest rate is less on my sub-prime, where I was viewed as risky and put very little down, than the prime ones, where I put more money down and was viewed as safer.  I guess mess like that is why the banks are having these record write-offs.