1. Money as a Medium of Exchange

This is probably the aspect of money that most of us are familiar with. If I want something, I buy it with money.  Then the store that I patroned pays its employees with money, who in turn go and spend the money on other things.  And the cycle continues.  For example, if I want a mechanic to fix my car I pay him with money, which he can then use to go buy food.  I don’t have to barter three chickens and a jar of oregano for an oil change and a tuneup.

Being able to trade money for goods and services has tremendous advantages.  It allows for the specialization of labor and for products of ever increasing quality and complexity to enter into the market and make our lives better.  Capitalism is pretty awesome like that.

2. Money as Labor

Remember how I paid the mechanic to fix my car in the above example?  Basically, I turned money into labor.  By paying him to fix my car, I didn’t have to waste my time doing it.  Which is probably a good thing, because given my mechanical aptitude the car probably would have wound up exploding had I tried.

3. Money as Employees

But I’m not the only one who can use money to buy labor.  Let’s say I took my car to a big garage to be repaired.  I didn’t pay the mechanic to do the work, rather I paid the garage company.  The company paid the mechanic.  And I assure you that the garage skimmed a bit off the top of my payment and kept it back as profit for the owners.

The owners of the garage turn their money into employees by paying them to fix cars.  The labor of these employees in turn brings in more money and the garage skims some profit off the top.  This process, assuming that the garage is well managed, is a self perpetuating cycle.  It’s entirely possible that the owners of the garage don’t even fix cars.  They may just sit around all day in a beach villa sucking back mai tais while a general manager handles all the operations. Through the power of investing in their garage, the owners used their money to produce even more money.

That is a sweet gig.  You’d have to be stupid not to want in on some of that beach villa lounging mai tai imbibing action.

But what if you don’t have enough money to buy an auto repair shop?  Or lack the connections to find a good general manager?  Or what if you could buy an auto repair shop, but were afraid that the business was risky and that you might wind up losing money?

It wasn’t until sometime around the 17th century when people finally figured out how to surmount these hurdles with the creation of the progenitors to the modern corporation, known back then as chartered companies.  The idea was simple, pool investments from a bunch of people to make inroads into the exceedingly lucrative spice trade.  Seriously, spices were where it was at in the 16th and 17th centuries.  If the adventure went bust, everyone lost some money, but not enough to send them begging in the streets.  If the endeavor was successful, the investors would be the ballers of the mercantilist era.

Corporations evolved over time, as did the markets in which one could buy or sell stock in a corporation.  Today, shares of the biggest and most powerful companies on the planet can be bought and sold any Suzi Homemaker or Joe Sixpack with a few mouse clicks and a couple of bucks to spare.

It is a shame that most people never make it past thinking about money as a medium of exchange.  They bring in money from their day job and immediately trade it in for whatever they fancy at the moment. If they opted instead to save and invest their money through the purchase of stock or other investments, they would be well on their way to unlocking the true potential of money.

As I hope I’ve illustrated above, investments are incredible inventions that allow money to produce more money.  Money that can either be used to purchase further investments or traded for whatever goods or services the investor’s little heart desires.

4. Money as Security

The only reason most of us have a roof over our heads or food to eat is because we pay for it.  If we stopped paying for these basic necessities of life, they would dry up.  Money is security for us.  It allows us to fulfill our needs and acquire our wants.

The personal finance world is obsessed, for good reason, with reminding us about the importance of having an emergency fund.  What if your car dies?  What if you lose your job?  What if you have some unplanned medical expense?

Why does the personal finance community stop short at just covering six months or so worth of expenses.  The ultimate emergency fund would provide for all of your basic needs and probably even some of your more important wants.  Not just for a few months, or until you found another job, but until the end of history!

And that ultimate emergency fund is buildable by anyone willing and able to make saving and investing a priority.  I’m working on building my ultimate emergency fund by saving at least 50% of my income and investing in solid dividend producing stocks.

5. Money as Power

Many people believe that Social Security will provide for them in retirement. And given America’s pathetic savings rate, Social Security is all that they’re going to have in retirement.  Unfortunately, this means that retirement for most people is not going to consist of exotic vacations to the French Riviera or annual memberships to Che Expensive Country Club.  No.  Their retirement will consist of sitting around in a small apartment watching daytime talk shows.  I think this is actually one of the nine levels of hell – let me check  my Dante.

People often equate money with power, but only if that money is being wielded by some obscenely rich caricatured movie villain.  This is short sighted.  All money represents power.  Money is the closest thing that we currently have to pure potential.  Every time I pick up a penny off the ground, I think to myself that I just acquired another small shard of potentiality.  Mario had the right idea! 

The more money you accumulate and put to work generating additional income, the more power that you will have.  If cartoon villain power is off the table, then what kind of power is left?  The power to buy what you want.  The power to do what you want.  The power to be who you want.  The power to do the kind of work that you want.  The power to do no work whatsoever, if that’s what you want.

If your have enough income from your investments, then you get to call all the shots in your life.  Not your credit card company, not your boss, and not the bank holding your student loans.

6. Money as Time

Every day most of us go to work and trade our time and talent for money.  But few of us realize that the trade off works the other way to.  Income from investments can be used to buy back hours of our time from the workplace since we will no longer need as much of their money to support us.  In the best case scenario, we won’t need any of their money to support us and work becomes entirely optional.

The harder you work now to increase your income and direct it towards investments, the faster that you will be able to escape the proverbial rat race.  What would you do if you never had to work again?

7. Money as Legacy

The unfortunate reality is that we are all going to die sometime.  Unless Ray Kurzweil is right about the Singularity.  But there are a few things that will transcend your inevitable demise.  Your children, and your money.  Go to any major museum or university and you’ll see the names of their donors, usually big recognizable names like Vanderbilt or Rockefeller.  Or think about those major philanthropic foundations created by the captains of industry, the Ford Foundation, the Pew Charitable Trusts, the Welcome Trust to name a few.  These institutions and organizations are the legacies of their founders.  Through them, the ideas and values of their founders have lived on decades after their death, and will continue to live on for decades more.

It is, I suppose, unlikely that any of us will be the next Henry Ford.  But if you have goals, ideals, or passions you can support them long after you die by directing your accumulated money and investments towards them.  You could set up a scholarship for local students, or fund a home for orphan kittens, or direct your money towards supporting biomedical research grants.  The sky’s the limit, constrained only by your imagination.  If you could support a cause for the rest of eternity, what would it be?

Readers:  How do you use your money?  What’s your motivation for achieving financial independence? Security? Power? Time? A legacy?

Dividend Growth or High Yield

The first choice that you’ll need to make when evaluating REITs is whether to focus on only those REITs that have demonstrated consistent dividend growth (10+ years), or to consider REITs with higher, but more labile dividend yields.  The “right” answer is the one that aligns with your investment philosophy, risk tolerance, and desired asset allocation.

At present, I am employing both strategies.  Those REITs with consistent dividend growth are strong candidates for inclusion into my dividend growth portfolio.  Those with higher, but less predictable, yields are candidates for my high yield stock portfolio.  For those with less predictable yields, I look at the lowest dividend paid over the last several years as well as the average dividend payments over that time.  I try to limit my yield chasing to a maximum of 10% of my portfolio (see my previous post on my portfolio’s asset allocation).

Take note of how a REIT makes it’s money

If you recall there are two main flavors of REITs. Equity REITs which make their money from rents.  And mortgage REITs that make their money from mortgage interest.  Different local real estate markets and different macroeconomic situations affect a REIT’s income and thus it’s ability to pay out dividends.

In markets where rents have room to grow, equity REITs will be more likely to maintain and even increase their dividends as their rental income grows.  Mortgage REIT income depends on the spread between short and long-term interest rates.  As these two rates move farther apart, mortgage REITs will do well.

Earnings Per Share - not particularly useful for REITs

Earnings Per Share (EPS) and metrics derived from it, including price/earnings (P/E) ratio and payout ratio (Dividends per share / EPS) are usually skewed and not particularly useful when evaluating a REIT.  For example, it’s not uncommon to see P/E ratios 30s, 40s, or 50s.

Instead, FFO is used in place of EPS.

Funds from operations (FFO)

The REIT world prefers FFO, rather than EPS, as a measure of cash flow.  FFO begins with net income, adds depreciation and amortization expenses back in, and subtracts gains and losses from property sales. Depreciation is added back in because real estate rarely depreciates in value and often appreciates.

If you’re lucky, you can find FFO quoted on a per share basis.  Otherwise, you’ll have to calculate it.  No, you don’t get to be lazy and not calculate FFO/share.  REITs regularly fund their expansion by issuing new shares.  The more shares issued, the lower that FFO/share ratio goes.  Low is bad.

FFO per Share Growth Rate

Similar to how EPS should grow over time for a dividend stock, FFO per share should grow over time for a REIT.  A falling FFO per share may indicate either a decline in income over time, or that the number of outstanding shares is increasing.  One of the main ways in which REITs raise capital for expansion is by issuing new shares.  Either way, it suggests that the value of of the stock may stay flat or decline over time.

Calculating a Payout Ratio and P/E for a REIT

Now that we have the FFO/share value we can calculate the payout ratio of a REIT.  If you are seeing payout ratios consistently above 90%, that’s an indication that the dividend may not be sustainable.

REIT Payout Ratio = Dividend per share / FFO per share

You can also calculate something similar to a P/E ratio for a REIT by using price per share/ FFO per share.

Adjusted Funds from operations (AFFO)

AFFO is often used in place of FFO when evaluating REITs.  The problem with FFO is that it does not subtract capital expenses undertaken to maintain property.  AFFO corrects for that.  However, AFFO is not a standardized measure and may or may not be reported.

Conclusions

My hope is that this post will enable you to get started evaluating REITs.  Like stocks, evaluating REITs can be complex, especially since you have to familiarize yourself with some new terms.  But once you’ve gotten a handle on the basics, you can start adding additional metrics to your REIT analysis arsenal.

Readers: What other metrics do you use in evaluating REITs?  What REITs are your favorites?

CVX Basic Company Stats

• Ticker Symbol: CVX
• PE Ratio: 9.17
• Yield: 3.3%
• % above 52 week low: 99%
• Beta: 1.18
• Market cap: $235.69 B
• Website: www.chevron.com

CVX vs the S&P500 over 10 years

CVX has been crushing the S&P500.  After 10 years, an investment in the S&P500 would have grown by 78% compared to the 283% that an equivalent investment in Safeway would have grown.  Strong work CVX, strong work.

CVX Earnings Per Share (EPS) & Dividend Growth

• 1 year EPS growth: -0.9%
• 3 year EPS growth: 18.5%
• 5 year EPS growth: 3.4%
• 10 year EPS growth: 15.8%

EPS growth for CVX has been pretty solid over the last 10 years with some exceptions.  The most obvious one is 2009, during the Great Recession.  The less obvious one is 2012, where EPS actually slipped a bit compared to 2011.  I’m not too worried a this point, but hope that EPS will resume solid growth in 2013.

• 1 year dividend growth: 13.6%
• 3 year dividend growth: 11.2%
• 5 year dividend growth: 8.5%
• 10 year dividend growth: 10.5%

Dividend growth for CVX has been moving at a nice clip of 10% or so over the last 10 years.  Judging from the last 5 years of dividend growth, it’s possible that CVX’s dividends are entering an accelerated growth stage.  CVX certainly has a low enough payout ratio to pull that off (see below).

With a starting yield of 3.3% and a growth rate of about 10%, CVX’s yield on cost will grow to well in excess of 9% in 10 years.  In order to double the dividend, using the rule of 72, it will take approximately 7.2 years.

CVX Payout Ratio

CVX’s payout ratio has been crazy low, staying below 30% for most the last decade.  Even during the Great Recession in 2009, the payout ratio just barely broke 50%.  The average payout ratio over the last 10 years has been 30%.  I love the low payout ratio as it gives CVX great room to continue growing its dividends.

CVX Cash Flow & Revenue Growth

• 1 year revenue growth: -4.6%
• 3 year revenue growth: 8.6%
• 5 year revenue growth: -2.2%
• 10 year revenue growth: 8.1%

CVX’s revenue growth is probably the most disappointing thing about it.  I was really hoping to see higher revenue growth from 2011 to 2012.  On the other hand, cash flow has been moving in a nicely positive direction.

CVX Balance Sheet

The current debt to equity ratio for CVX about 9%, which is a lot lower than most other equities.  The debt to equity ratio has been decreasing over the last ten years.  The absolute amount of debt has remained about the same, however the total equity of the company has increased over time, thus driving down the ratio.

CVX Risks

Chevron’s profits are susceptible to the price of oil.  Should the price drop again, perhaps during another recession, Chevron’s profits would take a hit.

As an oil company, some amount of environmental damage is going to be a result from Chevron’s activities.  As a result, the company is being sued by some government at just about all times.  Currently Brazil and Ecuador are suing Chevron.  This sounds bad, but I would consider it the cost of doing business in this industry.

Then of course there is the possibility of a big black swan event like the BP deepwater horizon accident.  If you recall after the accident, BP temporarily suspended its dividend (now reinstated) and it’s share price dropped and has not yet recovered after nearly 3 years.

CVX Valuation Panel

Graham Number

The Graham number represents one very simple way to value a stock.  The Graham number for CVX is $144.49.  The current stock price is below that, suggesting that CVX may be undervalued at the moment.

Two Stage Dividend Discount Model

Using a risk free rate of 2%, an expected return of 10% and the beta of 1.18, the CAPM model provides a discount rate of 19.4%.  Using a growth rate of 12% for 5 years and a slower growth rate of 7%, the two stage model produced a value of $45.50.  I also tried this model with a discount rate of 10% and got $181.23.

Valuation Conclusion

Of the three different models tested, two of the three seem to agree that CVX is very undervalued.

CVX Cash Secured Puts

I really like CVX so I wouldn’t mind selling puts against it at the moment.  However, it should be noted that both the market as a whole and CVX are at all time highs, so there is always the possibility of assignment should the market as a whole dip.

Conclusions

Even though CVX is trading at all time highs, I really like the company.  The payout ratio and debt load are ridiculously low and the company is currently yielding over 3%.  Of course, I’d love to jump in at a lower price, but even at its current price CVX represents one of the only islands of value in the current overheated market.

Disclosure: I am long Chevron and trying to add to my current position.

Readers:  What are your opinions about Chevron?

1. Dividend Paying Stocks - This is by far my favorite method of pursuing passive income.  Regular investments in companies that have a consistent track record of increasing dividend payments year after year.  This strategy allows me to achieve capital appreciation in line with the S&P500 index, but also produces regular dividends.

2. P2P Lending - Many times, people need a loan, but can’t or don’t want to get one from a bank.  Enter, peer to peer (P2P) lending.  The system works roughly as follows.  Individuals apply for loans (for cars, new furniture, starting a business, paying off high interest credit card debt, whatever).  The P2P lending company does the heavy lifting of screening the loan application and checking the applicant’s credit. Next, the loan is split into pieces and sold to individual investors, with each investor financing a small portion of the loan.  As the loan is paid back, each investor gets back a piece of their principal and some interest to boot.  The two big names in this arena are Lending Club and Prosper.  Unfortunately, only certain States allow P2P lending.

3. Article Residuals - Writing can be a great way to earn a bit of money.  You can write for websites or you could write for print magazines.  Oftentimes, you are paid an upfront fee for your content and then offered additional payments (called residuals) based on how popular your article is.  The more views or reprints, the more residuals.  While the initial act of writing takes effort, collecting the residuals is entirely passive.

4. Book Royalties - Basically the grown up version of collecting article residuals.  If you write a book, you get to collect royalties for every copy of the book sold.  Writing the actual book is a very long and effort consuming task.  But thankfully, in today’s world, there are plenty of ways to publish the book.  You can go through the traditional route of finding an agent or you can go the self publishing route with services such as LuLu or Amazon self publishing.

6. Rental Properties - I really hesitate to add this one to the passive income list.  But if you’re just the owner and have all the management tasks taken care of by someone else, then this is actually passive income.  You can be a small time landlord, who rents out a room in your house, or you can go for the big time and invest in single family homes or 2, 3, and 4-plexes.  Rental property generally appreciates over time and produces regular monthly income from the rents.  Once the mortgage is paid off, that monthly income becomes much larger.  The downside is that you need to keep renters in your units.  No renter, no rent, but you’re still on the hook for the bills and property taxes.

7. Stock Photography - Another version of royalty based income.  Basically, you sell access to your photographs through a stock photography company like Shutterstock.  One could argue that this isn’t particularly passive.  I would say that the naysayers are correct.  Except for people who take tons of photos anyway.  I love to go hiking, camping, sightseeing, and generally being a tourist.  Especially in summertime.  I also take a metric crap ton of photos.  Most are mediocre at best, but some are actually descent.  If you’re like me, but maybe with a better ratio of awesome to crappy photos, you might wish to look into adding your better photos to the stock photography universe.  Making a few extra bucks off a hobby isn’t a bad idea.

8. Patent Royalties - If you invent something new and patent it, you own the rights to produce and sell that product for the duration of the patent; 20 years in the US.  But maybe you aren’t interested in making or marketing your invention.  In that case you can license (or sell outright) the patent to another party.  Oftentimes licensing agreements are made that allow you to get a share of the profit.

9. Silent Partnerships - These are a kind of business partnership where you bring money to the table, but you aren’t expected to do anything.  In exchange for helping someone get their business off the ground, you have an ownership stake and are entitled to some share of the profits as worked out between yourself and the other partners.  As you can probably imagine, there are all kinds of potential problems that can arise with these kinds of arrangements, especially if the managing partner(s) are running the business into the ground.

10. Hobbies – Hobbies aren’t really passive income.  But you may be one of the lucky people out there who happens to have a hobby that can somehow translate into income.  Photography comes to mind.  As do certain online ventures like running a website about some passion of yours. What makes the income from these “passive” is that you would be doing the activity anyway, even if you weren’t paid for it.

11. Business Owner - Just like in the real estate example above, the focus here is on the act of owning the business.  Not the act of actually doing any work.  If you own a thriving business and have a trustworthy manager who can  handle all the day to day operations, then congratulations, you’ve got yourself a nice chunk of passive income.  Just make sure that you keep that manager happy and working for you.  If he or she quits, the passivity of your enterprise may evaporate when you have to get in the trenches and start doing work.

Some general thoughts

The personal finance community favors investment income and real estate. I don’t think that one is particularly better than the other.  Real estate is essentially a business and appeals to people who have a bit more of an entrepreneurial bent.  Investments appeal to those of us who don’t mind continually researching new and old investments and aren’t particularly interested in running a company.  Investment income also has a much lower entry point.  Got $1000 laying around?  Rock on, you’ve got dividends!  Want to get into rental properties?  Better start saving for that 20+% down payment.

One of the problems with any of the royalty or residual based income is that the income will probably decrease over time. New things come out and older books and photos get pushed to the back.  The world changes and your work slowly goes out of date.  Unless my name was J.K. Rowling or E.L. James, I wouldn’t plan on retiring comfortably off of royalties.

NOT Passive Income (bonus section)

The below are a few things that I often see conflated with passive income in the personal finance world.  They aren’t bad sources of income, but they aren’t passive.

Anything Online - I’ve been blogging for fun for a little while now.  There is nothing passive about this.  There’s a whole community out there who will happily sell you an ebook explaining how you can quit your day job and then make a good living by blogging, setting up affiliate marketing programs, and hocking eBooks.  And somehow this will all be done in 4 hours a week or less.  Of course, you’ll be spending the rest of your time relaxing on a beach in Thailand.  The reality is that you’ll be spending way less time than you expect chasing Asian hotties, and way more time than you expect trying to grind out content and freaking out every time Google updates its search algorithms.  Online income can be very real and online activities can be very rewarding, they just aren’t passive.

Side Hustles - A wonderful catch all term for all kinds of hobby-jobs ranging from coaching Little League to buying and selling rare books.

Part Time Jobs - If it has the word job in the title, it’s not passive.

Selling Your Crap - Selling your crap can be a great way to generate passive income.  Except for the fact that you will eventually run out of crap to sell.  And the annoying realization that you’re probably selling stuff for way less than you bought it for originally.

Readers:  What kinds of passive income are you pursuing at the moment?  What kinds of passive income do you hope to develop in the future?  What draws you to one particular style of passive income?  What drives you away?

Today we’re going to the other side of the planet.  Specifically Japan.  If you pay attention to more of the news than whatever the hell that Kardashian woman is doing to embarrass the species you are likely aware that Japan’s economy has been in the shit hole for a while.  You are also likely aware that Japan has a new Prime Minister, Shinzo Abe, who is doing quite a bit to shake things up.  His reforms are referred to as Abenomics.  I’m not going to get into those reforms in this post because that would take more effort than I’m willing to expend at the moment and wouldn’t be nearly as hilarious as what follows.

You are also probably aware of the old wives tale that you can tell how well the economy is doing by the length of women’s skirts.  The greater the bull market, the more women end to dress like hoochies.

Because Japan is a strange place, one new Jpop group called Machikado Keiki has decided to take it one step further and actually vary the length of their skirts based on the Nikkei index.  They have a video (below).  It’s not that great.  I say this as someone who loves Asian pop music, but the song is about economics and I would love to read a translation.  If you find one, post a link in the comments.

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Here’s the article from Marginal Revolution if you’d like to read more.

Here’s a collection of pictures detailing how their skirt length has varied with the Nikkei index.

Here’s me wishing that the Koreans would do this because the girls would be cuter and the music would be better.

Bonus:  Here’s a bra based on Abenomics, because Japan is a strange place.

Readers:  What do you think?

A short history of REITs

In 1960, Congress created REITs as a way for individual investors (people like you and me) to directly invest in large scale commercial properties (things like shopping malls, or massive apartment complexes).  Currently, there are about 150 publicly traded REITs in the US, with a combined worth of around $400 billion.  In the old days, you would have had to save millions of dollars (and probably partner with other investors) in order to be able to invest in a shopping mall or giant apartment complex.  Now you can buy shares of a REIT on a stock exchange, just like you would any other stock.

Flavors of REITs

REITs can make money through two primary means, and come in three main flavors depending on the nature of their income.

• Equity REITs - Invests in and owns physical properties like shopping malls, apartments, commercial property, industrial property, health care property, etc.  If a property investment class exists, there is a REIT investing in it.  Their profits come from collecting rents.
• Mortgage REITs - Invests in and owns mortgages.  They may directly loan money to a property buyer for a mortgage or they may purchase mortgage backed securities.  Mortgage REITs borrow money at lower short-term interest rates and then loan it back (in the form of a mortgage) at a higher interest rate.  They make money on the spread between these two interest rates.  The bigger this spread the more money they can make.
• Hybrid REITs - These use both both of the above strategies.

Within the world of mortgage REITs, there are two more investment styles that you need to be familiar with, agency and non-agency. “Agency,” when used in the world of REITs, refers to government backed or supported agencies that gaurantee repayment of the mortgage principal, such as Ginnie Mae, Freddie Mac, and Fannie Mae.

• Agency REITs - Invest in mortgages backed by government supported agencies.  Because their investments are government supported, these REITs have less risk associated with them.
• Non-Agency REITs - Invest in mortgages NOT backed by government supported agencies.  These have more risk associated with them.

Characteristics of a REIT (the short version)

To make a long story short and simple, REITs are corporations that invest almost entirely in real estate with shares that can be publicly traded on stock markets.  REITs have access to corporate level debt and equity, which puts them in a much more favorable borrowing situation than you or I would be as individual real estate investors.  By law, REITs must pay out at least 90% of their taxable earnings to shareholders.  Because REITs must distribute almost all of their earnings, they tend to provide much higher dividend yields than traditional stocks.  The REIT does not pay taxes on these earnings, instead the dividends are considered “ordinary” and the investor pays pays taxes at the higher “ordinary dividend” rate.

Characteristics of a REIT (the long version)

REITs aren’t just glorified landlords.  According to US tax laws, in order to qualify as a REIT, a company must (*):

• Be structured as a corporation, trust, or association
• Be managed by a board of directors or trustees
• Have transferable shares
• Be taxable as a domestic corporation
• Not be a financial institution or an insurance company – Bank of America can’t be a REIT just because it owns a lot of foreclosed properties.
• Be jointly owned by 100 persons or more – If you and your friend Bob buy a 4-plex together, you can’t claim to be a REIT.
• Have 95% of its income derived from dividends, interest, and property income.  Basically, REITs must specialize in real estate.
• Pay dividends of at least 90% of the REIT’s taxable income
• Have no more than 50% of the shares held by five or fewer individuals during the last half of each taxable year (5/50 rule)
• Have at least 75% of its total assets invested in real estate
• Derive at least 75% of its gross income from rents or mortgage interest
• Have no more than 25% of its assets invested in taxable REIT subsidiaries (a fancy tax term for subsidiary companies that provide services to tenants such as cleaning, landscaping, concierge, etc.).

How do REITs compare with being an individual real estate owner?

Many financial independence hopefuls (myself included) are either considering investing in real estate, or have already committed to investing in real estate.  This begs the question – Should you direct your money towards buying property or investing in REITs?  The “correct” answer depends on the investor.  But here are a few things to consider.

Rental property is a business.  Rental property is not a passive investment, it’s a business.  You (the owner) are in charge of buying the property, selecting tenants, collecting rents, ensuring that maintenance and renovations are done, etc.  You can outsource some or all of these tasks to a management company (for a fee), but you are still responsible for ensuring that they get done.

REITs are just like stocks – passive income.  You don’t have to actively manage a REIT.  In fact, you don’t have do much of anything except check in on your stock periodically and collect your dividend checks.  The tradeoff is that someone else is making all the decisions about how the company is being run.

Liquidity.  You can sell your REIT holdings in an instant.  It takes several months at a minimum to sell a rental property.  Depending on your situation and personality, this may or may not be an issue for you.

Returns are roughly equal.  I’ve been scouring the internet trying to see what a landlord can expect in terms of return on investment.  People have reported numbers ranging from the negatives (yes, people lose money on investment properties all the time) to the double digits.  On average, people seem to report around a 7% yield on rental property.  All real estate markets are different, so the expected yield for property near you might be higher or lower.  On the other hand, it’s not very hard to select a REIT, or a basket of REITs, yielding around 7%.  In the long run, as the mortgage is paid off and the property value rises over time, I suspect that you’ll do better buying property, but I don’t have any solid information yet on how much better.  Like all things in real estate, it’s probably local.

Why invest in REITs?

1. Diversification into real estate - REITs allow diversification into real estate, something which would normally only  be available to you if you were willing to become a landlord.

2. High yields - Because REITs must pay out at least 90% of their taxable income to shareholders, they tend to have much higher yields than more traditional stocks. Usually between 4%-10%, with some REITs even moving into double digit yields.  Many REITs do not consistently raise their dividends, like traditional dividend growth stocks do, because their payout ratios are so high that they do not have a buffer against income fluctuations.

3. REITs can show solid dividend growth - Some REITs do have characteristics of good dividend growth stocks – a minimum of a 10 year history of increasing dividend payments.  Here’s a short list of some REITs with a consistent history of increasing dividend payments pulled from the dividend champions and contenders lists.

• HCP Inc. (HCP – 27 years of consistent increases)
• Universal Health Realty Trust (UHT – 26 years of consistent increases)
• Federal Realty Investment Trust (FRT – 44 years of consistent increases)
• Essex Property Trust (ESS – 18 years of consistent increases)
• National Health Investors (NHI – 10 years of consistent increases)
• Omega Healthcare Investors (OHI – 10 years of consistent increases)
• Tanger Factory Outlet Centers (SKT – 19 years of consistent increases)
• National Retail Properties (NNN – 23 years of consistent increases)
• Realty Income Corp. (O – 18 years of consistent increases)
• Urstadt Biddle Properties (UBA – 18 years of consistent increases)

4. Liquidity. REITs are traded just like stocks and as such are very liquid investments.  You can dump your REITs any time with the push of a button.

Conclusions

REITs can be a valuable addition to your dividend portfolio, giving you exposure to the real estate market.  REITs tend to produce high yields, and some companies exhibit all the characteristics of dividend growth stocks.  REITs can also substitute for owning rental property and being a landlord if you are not interested in the hassles of running a business.

(*) List adapted from Wikipedia

Disclosure: I have nothing to disclose.

Readers:  What do you think about REITs?  Do you currently invest in them?

SWY Basic Company Stats

• Ticker Symbol: SWY
• PE Ratio: 9.71
• Yield: 2.5%
• % above 52 week low: 62.7%
• Beta: 1.1
• Market cap: $5.73 B
• Website: www.safeway.com

SWY vs the S&P500 over 10 years

SWY appears to be matching the S&P500.  After 10 years an investment in the S&P500 would have grown by 76% compared to the 40% that an equivalent investment in Safeway would have grown.  This seems low, but if you look at the graph you can see that SWY tends to both slightly over and slightly under perform the S&P500.  So I’m going to call it a tie.

SWY Earnings Per Share (EPS) & Dividend Growth

• 1 year EPS growth: 52.3%
• 3 year EPS growth: 21.0%
• 5 year EPS growth: 0.7%

EPS growth for SWY has been spotty over the last 10 years.  It was negative in 2003 and 2009, both of which were recessions, so I can understand.  EPS in 2012 finally beat EPS in 2008.  And just in case you were wondering, earnings in the first quarter of 2013 was lower than expected.  But overall, it looks like EPS has finally returned to pre-Great Recession levels.

• 1 year dividend growth: 26.4%
• 3 year dividend growth: 23.4%
• 5 year dividend growth: 20.3%

Dividend growth for SWY has been on a tear since 2005.  Just in case you were wondering, 2005 was the year that SWY started paying dividends in.  The 7 year dividend growth rate was 28.3%.  It is likely that SWY is in a phase of accelerating dividend growth.

With a starting yield of 2.5% and a growth rate of about 20%, SWY’s yield on cost will grow to well in excess of 12.5% in 10 years.  In order to double the dividend, using the rule of 72, it will take approximately 3.5 years.

It’s not clear to me how long SWY will be able to maintain this rate of dividend growth.  On the plus side, the payout ratio is low (see below).  But if the EPS doesn’t start growing again SWY will have to slow its dividend growth sooner rather than later.

SWY Payout Ratio

Note: Just so that we’re all clear about the chart above, SWY didn’t start paying dividends until 2005.  2009 had a negative EPS, so the payout ratio is meaningless, thus I excluded it from the chart.

SWY’s payout ratio is currently hovering around the 30% range.  If SWY continues to increase it’s dividend aggressively without concomitant increases in earnings the payout ratio will have to increase.  Given the current dividend growth rate, the question is how high will the management let dividend payout go before it slows down dividend growth.  I would guess that dividend growth would slow down around a payout ratio of 50-60%.

SWY Cash Flow & Revenue Growth

• 1 year revenue growth: 1.3%
• 3 year revenue growth: 3.8%
• 5 year revenue growth: 0.1%
• 10 year revenue growth: 2.5%

SWY’s revenue growth hasn’t exactly been stellar.  Admittedly the supermarket business is pretty competitive so this is perhaps to be expected.   As for cash flow, SWY  has keep up a pretty steady trend of increasing cash flow.  But man, they got hit hard in 2009 with the recession.

SWY Balance Sheet

The current debt to equity ratio for SWY about 165%, which is a lot higher than most other equities.  SWY has maintained a pretty high debt to equity ratio over the last 10 years, so I would assume that this is standard operating procedure for them.  This wouldn’t concern me too much except for the fact that SWY doesn’t appear to be a stellar company by any other metric.

SWY Risks

The supermarket business is a low margin business.  Since 2005 SWY has been working to improve it’s stores adding higher quality foods and full service meat counters and bakeries, among other things.  So far, these improvements appear to be working but as almost all the stores have finished their upgrades it remains to be seen just how much additional revenue these renovations can bring in.

I expect profit margins to remain narrow as the wholesale price of food continues to increase and as shoppers shift away from traditional supermarkets towards value oriented stores (Wal-Mart and Aldi) and specialty food stores.

But SWY is a large established chain, so I wouldn’t expect it to fold any time soon.

SWY Valuation Panel

Graham Number

The Graham number represents one very simple way to value a stock.  The Graham number for SWY is $25.82.  The current stock price is slightly below that, suggesting that SWY may be undervalued at the moment.

Two Stage Dividend Discount Model

Using a risk free rate of 2%, an expected return of 10% and the beta of 1.1, the CAPM model provides a discount rate of 18.8%.  Using a growth rate of 20% for 5 years and a slower growth rate of 7%, the two stage model produced a value of $10.98.  I also tried this model with a discount rate of 10% and got $43.85.

Valuation Conclusion

Of the three different models tested, all seem to agree that SWY is undervalued, with the Graham number model suggesting that SWY is more fairly valued than undervalued.

SWY Cash Secured Puts

SWY is likely fair valued or under valued at the moment based on the valuation models and P/E ratio.  SWY is also hovering in the upper half of its 52 week range.  This could make it a good candidate to sell cash secured puts against.  However, the potential profit from put sales must be weighed against the risk of assignment.  So you have to think carefully about whether you want to potentially own SWY or not.

Conclusions

Overall, I have mixed feelings on SWY.  The valuation models suggest that the company is a good buy.  The yield is a bit low for my tastes, but that can be circumvented by put selling or just waiting for a dip in the price.  And the opportunity to get in on the ground floor of company with a 20% dividend growth rate is enticing.  However, after doing this analysis I’m not exactly in love with SWY.  I think that there are better players out there in the supermarket space.

I wouldn’t discourage anyone from buying SWY, but I wouldn’t encourage them either.  I’d say but it if you like but don’t plan on making it a large position in your portfolio.

Disclosure: I have nothing to disclose.

Readers:  What are your opinions about Safeway?

First some blog news:

• My post on whether to buy a new car was featured in the Carnival of Personal Finance, hosted by Wealth Pilgrim.
• My portfolio update was mentioned by Passive Income Pursuit.

Links!

This week I recommend that you check out the following links.  Presented in the order that I came across them.

1. Krantcents introduces us to forex trading.
2. The College Investor provides us with a primer on investing in Canada.
3. Edward Antrobus asks if the SEC should regulate social media.
4. Wealth Informatics hits a double this week.  Suba writes about how social proof may affect your finances. and explains home closing costs.
5. Financial Samurai also hits a double this week.  Check out his articles on the 72(t) rule for early withdrawals from a retirement account and his article on safe withdrawal rate.
6. Good Financial Cents reviews IRS gifting rules for 2013.
7. Freedom 35 provides a detailed FAQ about being a farm landlord.
8. Brick by Brick Investing has started a series on investing lessons from the Art of War.  Check out Part 1 and Part 2 and Part 3.

Stock Analyses:

1. Dividend Monk provides an analysis of Colgate Polmolive (CL).
2. Dividend Growth Investor provides an analysis of Proctor and Gamble (PG).

Readers:  How did your week go?

Under the portfolio tab above is where I am keeping a more or less current list of my positions.  The below is where my portfolio stands as of May 1, 2013.  Also, check out the options page where I am tracking my options activity.

2013 Portfolio Value as of:

• January 1st: $91,567.06
• February 1st: $95,514.53
• March 1st: $99,743.57
• April 1st: $102,160.83
• May 1st: $111,056.49

Between the market run up, my fresh infusions of capital, my dividends, and my options premiums (okay, mostly the market run up) my portfolio value has grown by about $20,000 in four months.  Holy crap, that is amazing. I was pretty busy this month with transactions as I bought stocks, sold options, and then bought more stocks.

I’m sure that a market correction will take place sometime this year since almost everything is ridiculously overvalued.  Then my portfolio will deflate a little bit.  But that’s okay because more great companies will be worth buying.

In terms of dividends, I pulled in $301.76 in April of 2013.

2013 Monthly Dividends:

• January: $164.00
• February: $265.11
• March: $317.44
• April: $301.76

One of my major goals for this year and next year is to substantially increase my emergency fund so that it can cover one full year’s worth of my expenses ($35K).  So let’s track that too:

2013 Emergency Fund Value as of:

• January 1st: $4,753.16
• February 1st: $7,353.16
• March 1st: $8,965.33
• April 1st: $10,560.33
• May 1st: $12,168.49

Portfolio as of May 1st, 2013:

Document your accomplishments

If it’s not on paper, it never happened.  That’s why we need to keep a record of every one of our tasks, responsibilities, and accomplishments.  This is not a pick one of the following style list.  This is a do every single one of them list.  Also, plan on regularly updating these records.  Once a year is usually sufficient.

1. Resume - These are short one page summaries of our education and work history.  The challenge is highlighting our most significant accomplishments in a way that will get hiring managers to contact us for an interview.  I’d actually recommend that everyone write up a CV first and then compress it into a resume.  It’s always easier to cut than to add.
2. Curriculum Vitae (CV) - This is the standard currency for academics as well as people with scientific or technical jobs.  However, it’s probably not a bad idea to write one up regardless of your employment position.  CVs have much more detail than resumes so feel free to expound upon your responsibilities and accomplishments in far more detail.  Keeping this document up to date will be invaluable since you’ll no longer struggle to remember what projects you were working on five years ago.  You can just look at your CV.
3. LinkedIn Profile - Basically this is an online resume or CV combined with professional networking.  LinkedIn is free to use and I recommend setting up a profile there, if you don’t already have one.  The quickest way to build a profile is to copy your CV.  After you’ve gotten your profile updated, build out your professional network.  Keep in mind that LinkedIn is not Facebook.  It’s a professional network.  As such, keep your idiocy, goofballery, cats, whining, and opinions off the site.
4. Company Objectives / Evaluation - Most companies have some kind of a yearly or semiannual evaluation process.  You get assigned objectives and then you work towards meeting those objectives.  As you knock each objective out, make sure it’s documented.

A little self promotion goes a long way

I’m not one to toot my own horn, but I try to make sure that my boss, his boss, and other more senior people know what I’m working on and that I am making progress.  The more people know what you’re doing, the less likely you are to be perceived as “That guy, the one in the office who does something.  What does he do again?” and more like an actual member of the department making meaningful contributions.

There are other benefits to keeping your coworkers and managers in the loop.  First, you’ll always be able to meet your communication objective.  Second, you’ll be in a position to be more quickly informed of important changes or developments.  Third, when you need someone important to back you up (e.g. when working with a troublesome vendor, client, or coworker), you’ll have already built that relationship making air support much more likely and effective.

On making yourself look good

Like everything in life, perception matters.  Therefore, I engage in a rather aggressive program of perception management.  Below are some of the goals that I strive for as part of my perception management program.

• Be likable.  This one can’t be stressed enough.  Go out of your way to be likeable.  Smile more.  Chat with people.  Always be ready and available to help someone.  The more likeable you are, the more likely you are to be scored better on your evaluations and the more resistant you’ll be to layoffs.
• Dress the part.  Whatever the dress code is at work, dress one step above it.  It doesn’t matter if your a suit and tie investment banker or a ‘just rolled out of bed’ tech startup employee.  If you dress better, people will slowly start thinking better of you.  Similarly, work out and eat better.  You’ll look healthier and thus look better, which will increase your likability (yes, people are that shallow).
• Be sincere.  Make a sincere effort in everything you do.  Perfection is usually not required.  Giving-a-damn is.
• Deliver.  Get shit done.  You are at work to produce something, not to stand around and look good while talking about your fantasy football team.  If you get a task, get it done.  And make sure that your work is the best quality that you can deliver.
• Don’t whine.  Work can suck.  Coworkers can suck.  Management can suck.  But keep your whining to a minimum.  No one wants to hear it.  Just get things done, that’s what you’re paid to do.
• Stay positive. You don’t need to be super chipper and skip around the office.  But you do need to stay positive.  People like being around positive people way more than negative people.
• Help people.  Whether you’re a total newbie or you’ve got 25 years under your belt, always do your best to help your boss and your coworkers.  People appreciate being helped and they resent it when you let them twist in the wind.  You can’t solve every problem, but you can at least make an effort.
• Build relationships. Take an interest in all of your coworkers.  Do they have kids?  Do they have hobbies?  How are they feeling?  Get to know everyone around you.  Treat them like they’re your friends.  Even if you don’t particularly care for them, fake it.

This wraps up part 2.  Don’t worry, more career advice will be coming in the future.

Readers: How do you work to document your accomplishments, self promote, and build a positive reputation at work?  How have your efforts paid off?