Opportunity Cost discussion

[dwoychuk]

This is a continuation from this topic: http://myreinspace.com/public_forums/Real_Estate_Discussion/62-16873-Why_Wont_It_Cash_Flow.html that got a little hijacked, but I found it interesting as it is something that I have recently come up against in a JV meeting. Read the discussion starting at invst4profit.



I was talking with a possible JV partner to go in on a deal with me. He is open to since he has (casually) been looking for a rental property on his own. He has personally been holding off because the money he would be using for the DP is currently invested in something that is making him 15% (no idea what he is invested in we didn't get into it). When discussing what the profit split would be on a property and how much he would get out of it he wanted to calculate the "loss" of 15% since he would have to pull the money out of that investment and have it added to his side of profit effectively making a deal with him a 65/35 split.



Now, I understand the logic to an extent from his point of view, but the reality of it is, he has to make a choice. Why should I personally be paying his current 15% interest because he chose to move his money out of one investment to another?



Comments/discussion welcome.

 

[DaveRhydderch]

That would seem to be up to you. If that`s what he wants, you have to consider if its a good deal to you. If you don`t think its worth your time, so be it.

In terms of maybe making him ease that criteria, you could discuss safety of the investment, possible liquidity (may be tough), and what you can provide that they aren`t. 15% is quite a good rate of return, which leads me to believe there`s some risk there. So perphaps instead of trying to convince him not to consider that, make him see how good an investment is with you.

Good luck

 

[Thomas Beyer]

QUOTE (dwoychuk @ May 30 2010, 03:19 PM) I was talking with a possible JV partner to go in on a deal with me ... with him a 65/35 split.

Comments/discussion welcome.
65/35 is OK if it works for you !

15% is a VERY VERY good return in today`s market .. The key question is how risky is it ? Many investments can deliver that with very high probability of loss of (some or all) capital like syndicated 2nd mortgages or construction mortgages or publicly tradedbonds on weak firms !

Discuss risk and reward with him !!

Also be close enough to him so he can freely share what investment earns him 15% so you can compare it`s risk to your proposed JV !

 

[ChrisDavies]

If I had a solid 15%, I`d leave it there and try to find some other cash to put into real estate.

To me, it`s part of the takeaway close. Yes we can do very well, potentially much better than your 15% with less risk. No, I`m not going to deal with what might have been. There are other people waiting.

And see what you get.

 

[JimWhitelaw]

Hi Dan,

Sounds a bit like your potential partner is trying to take advantage - perhaps he perceives that you need him more than he needs you. Sure, any split you agree on is OK if you`re OK with it, but I`d be challenging him on the proposal you outline. I`d likely advise that if he`s getting 15% in something he`s comfortable with, he should leave it. If he`s only talking to you because he sees an opportunity to leverage your need for a partner to get 15% plus a high return on your deal, I think you might want to question whether this is a person you can stay in business with for a long time.

 

[JohnS]

QUOTE (dwoychuk @ May 30 2010, 05:19 PM) When discussing what the profit split would be on a property and how much he would get out of it he wanted to calculate the "loss" of 15% since he would have to pull the money out of that investment and have it added to his side of profit effectively making a deal with him a 65/35 split.

Now, I understand the logic to an extent from his point of view, but the reality of it is,

In general, I agree with the other respondents, but I`ve had one question running through my head: Isn`t he mixing up the 2 forms of 15% ? A 15% ROI is not to be confused with the split in a JV partnership. A 50/50 JV could give him an ROI of 2%, 15%, or 200%, depending on how well the investment itself does. For him to say that he`s giving up a 15% ROI means that he gets an additional 15% of all the total returns....To my mind, he`s confusing apples and wombats!

Unless I`m missing something obvious here....

Have a good one!

JohnS

 

[Mecheng]

QUOTE (JohnS @ May 31 2010, 03:25 PM) In general, I agree with the other respondents, but I`ve had one question running through my head: Isn`t he mixing up the 2 forms of 15% ? A 15% ROI is not to be confused with the split in a JV partnership. A 50/50 JV could give him an ROI of 2%, 15%, or 200%, depending on how well the investment itself does. For him to say that he`s giving up a 15% ROI means that he gets an additional 15% of all the total returns....To my mind, he`s confusing apples and wombats!
This is correct, he is asking for an additional 15% of the total profit. That could be anything and likely does not equal his current 15%.

QUOTE (dwoychuk @ May 30 2010, 03:19 PM) Why should I personally be paying his current 15% interest because he chose to move his money out of one investment to another?

You hit the nail on the head here. It is his choice where he puts his money and that should be weighed as investment 1 vs. investment 2. Not (investment 2 - investment 1)) vs. investment 1
If you chose to subtract one investment ROI as an expense against the other then shouldn`t you also apply the reverse logic.
If he is currently making 15% and you are offering 30% (as an example). Then 30-15 would be a 15% ROI.
But reversed (his 15%) - (your 30%) would be a -15% ROI. So he is losing 15% by not investing with you.

Capital can be invested in one project at a time; you can`t assume it could be in both any more than you could work two jobs.
If you where choosing between two jobs, you would weight all the information and pick one or the other.
When you send your money off to work for you, you also have to pick one or the other.

If he was saying he is looking for X% above his current investment and any new investment ROI - 15% mush be higher than X% that would at least be logical. But as JohnS pointed out it looks like he is just trying to capture an exrta 15% of the profit.

 

[RedlineBrett]

QUOTE (dwoychuk @ May 30 2010, 03:19 PM) Now, I understand the logic to an extent from his point of view, but the reality of it is, he has to make a choice. Why should I personally be paying his current 15% interest because he chose to move his money out of one investment to another?

Comments/discussion welcome.

If he is earning 15% right now then the `opportunity cost` to your investment is that 15% return and the risk associated with it.

So for it to make sense for him to move his money over to you your investment has to return better than 15% with the same risk for your JV partner to be better off. That`s all that `opportunity cost` means.

You need to tell your partner that he is doing the math wrong. Your investment will have a total annualized return number that you will be splitting up according to your agreement. He`s asking you for an extra 15% of the partnership. For him to ask you for an extra 15% of the partnership doesn`t necessarily get him an extra 15% per year.

What you need to show him is that with a 50% interest in your investment he is getting at least 15%/year with the same risk all things considered. If that`s the case then there is no opportunity cost to your investment relative to where his $$ currently is. If you can show his $$ going further with you at 50/50 (as in he`s getting better than 15%/year) then you don`t need to give him a bigger slice of the pie.

 

[gwasser]

QUOTE (RedlineBrett @ Jun 1 2010, 10:57 AM) If he is earning 15% right now then the `opportunity cost` to your investment is that 15% return and the risk associated with it.

So for it to make sense for him to move his money over to you your investment has to return better than 15% with the same risk for your JV partner to be better off. That`s all that `opportunity cost` means.

You need to tell your partner that he is doing the math wrong. Your investment will have a total annualized return number that you will be splitting up according to your agreement. He`s asking you for an extra 15% of the partnership. For him to ask you for an extra 15% of the partnership doesn`t necessarily get him an extra 15% per year.

What you need to show him is that with a 50% interest in your investment he is getting at least 15%/year with the same risk all things considered. If that`s the case then there is no opportunity cost to your investment relative to where his $$ currently is. If you can show his $$ going further with you at 50/50 (as in he`s getting better than 15%/year) then you don`t need to give him a bigger slice of the pie.

I did once a rough estimate (you could do the same for your JV investor) based on a 50/50 split and the following assumptions: Cap Rate 6.5% plus annual appreciation of 6%; LTV 75% and an interest rate of 2.25% over a five year period an investment overall can have a compound rate of return of 25%. With the investor providing the downpayment his/her rate of return would be 15% while yours is infinite (but that is because you do the work and your compensation should be seen in terms of absolute dollars and how it compares with your (normal) salary and time spend on the project).

So now it is just a matter for your investor to decide whether he likes his current investment and its risk level or whether yours is better. Opportunity costs does not come into this equation because either way he`ll make 15%.

Hope this helps,

You can create a similar spreadsheet to evaluate your project (if you have not already done so) to show your investor. This beats arguing about opportunity costs any day of the month. Hope this helps.

 

[dwoychuk]

Thank you all for the insights. Definately a few things to talk with him about and discuss further of what his expectations would be. This person is family and their is no pressure on either side to make a deal happen, it would just be nice if we find a good middle ground so my family can benefit from these ventures as much as I will.

Cheers,

 

[Thomas Beyer]

QUOTE (dwoychuk @ Jun 1 2010, 07:10 PM) Thank you all for the insights. Definately a few things to talk with him about and discuss further of what his expectations would be. This person is family and their is no pressure on either side to make a deal happen, it would just be nice if we find a good middle ground so my family can benefit from these ventures as much as I will.

Cheers,
why not share this "guaranteed 15%" investment here .. I would love to know ..

 

[Nir]

Dan,

your "potential partner" either does not understand the math/logic behind the term ROI or thinks you don`t and tries to take advantage of that.
As other investors mentioned above, how in the world can someone making 15% ROI think if you split 35/65 he is compensated appropriately!?
There is no connection between the 2. Anyway, although very limited info was provided, something already just doesn`t sound right about
working on this.

GL!

 

[invst4profit]

In JV partnerships is it unheard of for the money man to ask for a larger percentage.
What about the guy with the gold making the rules.

I think this guy is simply not that interested in the deal and is asking for something unacceptable simply to make you go away.

 

[Pheenix]

Hi
Just to put in my two cents. Some very good comments already.

Your prospective partner should be clear on the pre-tax and post tax implications. Is that cash on cash or inclusive of capital gains? Is this leveraged or unleveraged? Is he is able to compound on the 15%? Is that year on year for many years, or a relatievely short term result? Does he have to find cash from other sources to pay the imputed tax each year, or can it be deferred, off-set or sheltered?

Need to compare the results and implications from many aspects. Not quite apples to apples but . . .