Because it is not good enough to measure in dollars
The original definition of a meter was 1/10,000,000th the distance from the Earth’s equator to Santa’s house at the North Pole, today it is less interestingly defined as the length of the path traveled by light in vacuum during a time interval of 1/299,792,458 of a second, while a second is defined as the time that elapses during 9,192,631,770 cycles of the radiation produced by the transition between two levels of the cesium 133 atom.
Got to hand it to the scientists, they leave nothing to chance. Luckily for all of us, the official unit of measurement for length, the meter, is not a variable.
In contrast, the dollar is defined as, well, the dollar. The amount of wealth a dollar stores and transfers is a variable, constantly changing from day to day, year to year, gradually decreasing in the long run.
While making dollars feels good and subjects one to taxes, the preferred goal of investing is to make wealth. But how does one know if you are generating positive wealth flow, given that our unit of financial measurement, the dollar, is a variable?
It is possible to know, one just needs to think in terms of wealth, not units of dollar. Let us see how this is done for a simple real estate example.
In year 2020 you purchase a condo for $100K that you proceed to rent for $800 per month. After deducting all expenses (property tax, maintenance, etc.) you net $7,000 per year. For the duration of this investing the rent is fixed, and you enjoy a 100% occupancy rate.
Thanks to an overall increase in real estate prices where the condo happens to be, ten years later in year 2030, you sell the condo for $150,000.
Ignoring the rent for now, it appears that you made a profit of $50,000, a 50% dollar ROI on your original investment of $100,000.
But how much wealth did you make? Was the wealth flow positive or negative? What is the wealth ROI?
To analyze create a spreadsheet like this:
Will assume that the annual rate of inflation is fixed at 3%.
The “principle” column represents the fixed amount of principle wealth as represented in the dollars for each year. $100,000 in year 2020 stores the same amount of wealth as $134,390 in year 2030.
The amount of wealth required to purchase the condo in 2020 is represented in “variable dollar math” notation as:
which is defined as the wealth stored in 100,000 dollars in the year 2020.
Thanks to inflation, in year 2030 this same amount of wealth will be stored in 134,390 dollars, represented as $(2030)134,390.
Starting to make sense? This allows us to state that, that in terms of stored wealth:
$(2020)100,000 = $(2030)134,390
The amount of wealth earned by the sale of the condo can now be represented as:
$(2030)150,000 — $(2030)134,390 = $(2030)15,610
Good news, the wealth flow appears to be positive!
The table provides us with the conversion factor from one year to another. Converting 2030 dollars to 2020 dollars uses the ratio 100,000/134,390 = 0.744
Since 11,615 = 15,610 x 0.744, it can be stated that:
$(2020)11,615 = $(2030) 15,610
Allowing us to finally compute the ten-year wealth ROI as:
$(2020)11,615/$(2020)100,000 = 11.6%
Which is quite a bit less than the 50% dollar ROI…
To be complete, let us compute the wealth ROI in 2030 dollars, that would be:
$(2030)15,610/$(2030)134,390 = 11.6%,
Same as before, demonstrating that while the dollar is a variable, measured wealth is constant.
This was before tax. Earning $50,000 on the sale of an asset in any year is usually a taxable event, so assuming no deductions and a 25% income tax on your dollar gain, the income from the sale will be reduced by $12,500.
Which means that the amount of wealth earned from the sale of the condo is:
$(2030)150,000 — $(2030)12,500 — $(2030)134,390 = $(2030)3,110.
That’s right, just $3,110, almost break even in terms of wealth flow, with the wealth ROI approaching zero. With a slight lower sales price, or a slightly higher tax rate, you would have lost wealth on the deal, which is generally an undesirable outcome.
Luckily, you were charging rent, which brings us to the second table.
Where the values in the “rent” column have been all converted to “2020 dollars”, reflecting that each year less wealth is collected as the dollar loses value, $7,000 collected in year 2020 will store less wealth than the $7,000 collected in all future years.
The total amount of rent collected will be the sum of the rent column, which is $(2020)66,711, which is equal to $(2030)89,653.
Will also assume that the rent is subject to a 25% tax, so realized rental income is $(2030)67,240
Which means that the total amount of wealth earned from the $150,000 sale of the condo is:
$(2030)150,000 — $(2030)12,500 — $(2030)134,390 + $(2030)67,240 = $(2030)70,350
Thanks to collected rent, the wealth ROI = $(2030)70,350/$(2030)134,390 = 52.35%, which is a heck of lot better than breakeven.
What happens if the housing market tanked and you had to sell the condo for $(2030)80,000?
$(2030)80,000 — $(2030)134,390 + $(2030)67,240 = $(2030)12,850
Even after selling the condo for loss, thanks to the rent you still generated positive wealth flow.
What did we learn? Dollar profits can be deceiving, and rent is good!
Given this result, how much sense does it make to rent the condo at “break even”, charging just enough rent to cover the expenses, hoping that your risk will be rewarded by selling the condo in the future for a higher price? High enough to overcome inflation and generate positive wealth flow?
And what if there is also a “catastrophic end-of-life event”, where somewhere between 20–30 years the condo will disappear into a crevice in the earth. Yes, this is a stupid assumption, but will become more relevant when analyzing the wealth flow of investing in stocks.
In my next blog.
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