Saturday, June 23, 2012

Yields and capital gain explained

Battle of the yields

by Phil Champagne of Wren Investment Group, LLC

A yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value. The type of investment the market will favor and the yield priced into those instruments is highly dependent on the inflation expectation. But when someone want to invest, several strategies are available:
  1. Investing for Cash flow
  2. Investing for Capital Gain
  3. A combination of both cash flow and capital gain.
In addition to this, the investor will choose a risk level, from low to high, according to what this investor is perceiving for the risk level. Interestingly, not everyone will give the same risk level to any given investment, but the market will set the price based on the aggregate risk level perceived by all investors.
The types of investment that are strictly cash flow base are corporate and government bonds and notes - annuities - which pay a define amount (interest) for the money loaned. They are not an hedge against inflation. Those that are capital gain only are company stocks that do not pay any dividends, only the increase in the company's value can translate into a gain for the investor. Another example of capital gain is also gold and silver as well as other commodities. The following picture illustrate them:

In all cases, the price of ANY of those investments reflects the yield they produce along with their risk level. Accordingly, those investment instruments the market consider having a low risk will cost more than those considered with a higher risk, effectively a premium is added to the value of the instrument when it is safer, lowering their yield.
Pricing for capital gain only instrument is based on the perceived current value as well as the future expectation of capital gain combined with the risk involved. Those for example investing in oil or other commodities are doing so because of the expected increase in value based on current and future supply and demand. As for gold and in some cases silver, it also can be based on future demand but also sometimes as a safe heaven - low risk. Gold essentially compete with a 10 year treasury bond with a 0% yield or perhaps negative to account for the storage cost. What is the difference in investing in a Treasury bonds versus gold when the treasury bond real rate of return (the interest rate the bond returns subtracted with the inflation rate) is lower than or same as gold. Some will consider the safety and security of the T bill versus gold as more valuable while others will find gold much safer, but they are essentially competing instrument.

Finally, those instruments that combine both a capital gain component as well as a cash flow component - such as dividend yielding stock and real estate - are priced on both their capital appreciation expectation as well as their yield while still considering their risk level.

A typical example of a high yield low growth investment would be a real estate investment property located in an area with lots of available land and few government restrictions on construction. In such a case, the capital gain will roughly match the inflation rate (devaluation of the dollar) assuming the property is maintained properly. On the other hand, an example of a low yield high growth expectation would be a property in an area where land is restricted and/or construction heavily regulated such as coastal areas of California.

The combination of both the yield returned in cash flow and the capital gain is what is called internal rate of return. It is effectively a way to evaluate all types of instrument to compare them against each other in terms of returns. For example,one might purchase an income property for $10,000,000 and resell it for $12,000,000 some 3 years later, giving a capital gain of $2,000,000. But in addition, during those 3 years, the mortgage was paid down and cash flow was returned on a monthly bases, say $1,000,000 per year (with a property with no mortgage), increasing 5%, for a total of $3,152,500 in cash flow - hence a total gain of $5,152,500. If this whole gain was evaluated per year, it would provide the Internal rate of return. Several methods are used to evaluate the IRR and such can be the subject of another article, but beyond the scope of this article. Any financial instruments will be priced by considering both their internal rate of return and their risk level expectation.
But all those are very influenced by a major factor: interest rate set by the Federal Reserve and the inflation rate. What is a return of say 3% if the inflate is 5% or even more. What the government CPI index says and the reality are 2 different things. elaborate greatly on this subject. Right now, the federal reserve is pushing yields lower on treasury bonds which push prices higher automatically on any financial instrument, therefore essentially slowly pushing the yields down across the board.
We still see good returns to be made in many real estate market, although the attractiveness of those market will eventually increase their value and pushing their return lower eventually. Everyone is looking for high yields in this low interest rate environment! In all cases, focusing on our ability to create value with forced appreciation will give us higher return than what we would have otherwise have.

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