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Dancing on the Margins

February 2015 Insight

Thankfully February was not nearly the month of international commotion as was January. Sure, there were still interesting and alarming events, but overall the activity was much more normal in scope. Of special note is that Sweden joined the race to the bottom of currency devaluation and Greece kicked the can down the road four more months. Greece is still a problem, but at least for the time being the stock market can continue its upward climb without having to deal with the repercussions of a Greek default on the world economy. As Americans we shouldn’t look down our nose at the Greeks for not dealing with their problems now. With the unfunded liabilities in Social Security and Medicare we are a far larger problem to the world economy that little Greece will be. We just have a bigger can and a much longer road, and maybe enough time to make changes now to avoid paying the piper. It is just hard to contemplate Washington having the political backbone to deal with the issue in advance of it becoming a crisis.

With the time available, much of the problem could be mitigated with marginal changes. It can be easy to confuse marginal/incremental improvement with the law of diminishing returns. This is especially true within all levels of government where additional laws/regulations continue to be passed but with a smaller and smaller return in exchange for a larger and larger burden on society. We have covered this topic with over-regulation many times in the past. Some regulation isn’t bad and most regulation is put in place for a good reason (at least in someone’s mind) but the sum of that regulation becomes overly oppressive and ends up hurting the very population it is supposed to help. California is a great example of this. Two different studies (here and here) and a Yahoo! article on the shrinking middle class (here) I read this past week illustrate this perfectly. California is the most regulated state in the union. It is also the state in which the middle class is shrinking the fastest. I believe this is more causation than correlation.

Focusing on margins/increments is a different beast all together. This is where profit lies, and as business owners and investors if we can focus on making incremental improvements; improving at the margins, we can outperform our competitors and greatly increase the return on our investments. Examples from both an apartment and a business we have an investment in are great illustrations:

Apartment Complex

Purchase Price: $4.6 M
Net Operating Income at Purchase: $360,000
Cap Rate at Purchase: 7.8%

As leases roll over we believe we can raise rents roughly $50 per month per unit. The complex has 124 units. This works out to an increase in revenue of $74,400 per year which of course needs to be reduced by vacancy, which for the ease of calculation we will assume is 10%. That means there is an additional $67,000 of Net Revenue each year. Since there is no real increase to operating cost to achieve that increase in rents the Net Revenue flows through to become $67,000 of added NOI.

Adjusted Net Operating Income: $427,000
Market Cap Rate: 8%
Adjusted Market Value: $5.3 M

Assuming a 25% down payment at purchase:

Original Purchase: $4.6 M
Sale: $5.3 M
Gain: $700,000
Original Investment: $1,200,000
Return on Investment from Rent Increase: 58%

In this example a $50 per month increase in rent, roughly 7% of the monthly rent, turns into a 58% return on investment.

Retail Business

Gross Revenue: $350,000
Fixed Costs: $120,000
Gross Margin: 65%
Average Order Size: $8.00

In this example 22,800 orders much be received each year to break even (including Cost of Goods Sold). This works out to 63 orders per day, or roughly 6 per hour. The current gross revenue, producing $108,000 in yearly NOI,  breaks down to 43,750 orders per year, 119 orders per day, and 12 orders per hour. Assuming the business is valued at four times earnings what happens if we can increase the number of orders by 5% while also increasing our average order size by 5%? Neither one of these goals is audacious.

$8 per order increases to $8.40 per order

43,750 orders per year increases to 46,000 orders per year
$350,000 in annual revenue increases to $386,000 in annual revenue
$108,000 in NOI increases to $132,000.
Not only does this result in an increase in a 22% increase in NOI to put in the owners’ pocket, it increases the value of the business by $96,000. Not bad for a measly 5% increase in sales units and 5% increase in sales size.
The take away is that when it comes to maximizing our business profitability, or increasing return on investment, little things matter. It isn’t just $50 per month in rent, it is $700,000 in gains. It isn’t just 5% increases in sales, it is a 22% increase in NOI and $96,000 in gains. Big things matter too, and it is easy to become fixated on the big things, the shiny things, but we can all most likely see substantial improvements to our business or investments by spending time some focusing on the little things. Usually the things that are even low hanging fruit.

Happy Investing.

About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at fjinks@altusequity.com.