Unfortunately, before we get to the comedy part of the comedy of errors, we have to understand a wee bit about the math of finance. Don't panic; this won't be on the test. But it is important to any fair analysis of the difference between a strata-titled condo hotel and a more traditional hotel, which is to say the difference between your house and your business, assuming you had both.
The math of finance is all about delayed gratification. One plus one still equals two but if you don't get that two for a while, you have to figure out what it's worth today. Finance math lets you decide how you're going to invest your capital based on what you expect in the way of a return. In short, it's about the future cash flow your investment will yield and your risk-return appetite.
Think of it this way. You've got $100 to invest. You could buy a Government of Canada bond. That's considered riskless because the Canadian government is a stable, if slightly batty, institution and always pays its debts. Problem is, Canada bonds don't pay much interest; your return on your investment is small. For the sake of this illustration, let's say it's 2 per cent. At the end of a year, your $100 will be worth $102. Obviously you're not going to get rich on this deal. On the other hand, you're not going to lose your hundred bucks either.
Now, if you took that same $100 and invested it in, say, a cocaine deal, you might expect to earn $1,000. Clearly that's a way better return on your capital. But the risk? Off the scale. You could lose your hundred bucks, get arrested, do serious time or wind up with some sleazy dealer stealing your money and leaving you dead on the floor.
Let's say those two examples anchor the ends of an investment continuum. One end is low risk, low return; the other, high risk, high return.
Most commercial investments, and certainly hotels, fall somewhere in between. While there are a lot of variables that have to be measured and guessed at in making an investment decision as complex as a hotel, once they've been determined, it all comes down to this: How much cash will this investment earn every year for its useful life? In doing this kind of cash flow analysis, no one cares what happens 20 years from now. The - I apologize in advance for this bit of jargon - net present value of cash flow 20 years down the road is irrelevant. That's actually important. The further in the future you get, the less valuable the presumed cash flow is to your decision today.
Still with me? Good.
Someone building a hotel projects how much they'll make from renting rooms, holding conferences, feeding guests and renting all the commercial shops they don't actually operate themselves, in other words, all the cash from all the possible sources where people spend money in hotels. They project that for all the future years germane to doing the analysis, the actual number of which isn't relevant to your understanding.
They convert that future stream of cash to a present day value because their investment decision has to be made today. The discount rate they convert that at - because remember, tomorrow's return is based on the interest rate your money's going to earn - reflects the return they feel they need to put their substantial capital at risk in building the hotel in the first place.
Remember as well, they know what the costs of building the hotel are to a fairly certain degree, unless they screw up the construction or interest rates shoot through the roof. Let's not get hung up on what the various construction costs, operating costs and financing costs are. You don't need to know that; the people making the investment decision do.
So you know the costs going in. You have a reasonable projection of the cash flow in the future. You've picked some discount rates - interest rates if you will - to convert that future cash to its present value. You take that present value and subtract the costs and you get the holy grail of the math of finance: the Net Present Value (NPV).
If a Canada bond pays two per cent and your future cash flow discounted at two per cent leaves you with a zero NPV, you'd have to be some kind of fool to take on the risk of building a hotel that wouldn't pay you more than a riskless government bond. True? But if you discount the future cash flow at, say, 15 per cent or 20 per cent before your NPV is zero, that isn't a bad return at all. Way better than bonds but with risks more acceptable than cocaine.
Okay, let's get away from math. Whew! The actual discount rate isn't important to your understanding. Neither are concepts like leverage. What is important is that commercial developers base their decision on whether or not to build something on this concept of rate of return which is driven completely on their faith in the future cash flow of their investment.
People buying residential property don't.
You buy a house, or in this case a Whistler condo, for a whole bunch of reasons other than future cash flow and rate of return. You buy a Whistler condo because you like to ski and bike in Whistler and would love to stay in your own place. You buy them for bragging rights, "Yeah, baby, I own a place at Whistler." You buy them to impress your friends and business associates since you can let them come stay at your Whistler place.
And, to some small degree, you buy them because you hope they're a good investment and go up in value. After all, you've been dazzled by the pro forma, which is usually a ridiculously inflated version of someone's pipedream of future cash flow. But if you were to really analyze them like a commercial investment - based on a realistic assessment of their ability to generate cash or, heaven forbid, an historical analysis of their performance - you'd probably end up paying about a quarter of what they're going for.
I know that sounds shocking but having been one of the greater fools who actually bought a Whistler condo, you're going to have to trust me. However good an investment it seems like it's going to be, it isn't. Especially if you're like 90 per cent + of purchasers who live somewhere other than Whistler and are going to turn your investment over to a property management company to manage on your behalf. By the time they're through milking your "investment" you'll be lucky if you see any clear cash flow from it.
And that'll be part of what we'll look at next week. But no more math, promise.
