Low interest rates naturally prompt investors to move into new asset classes as they seek micro goals to fit within macro themes. In particular, levered or unlevered investments in income-generating investments are of overwhelming interest.
The two most popular vehicles for income creation are (at least now, it seems) levered or unlevered real estate, as well as dividend stock investing.
As with anything in finance, there’s a ratio (or twenty) for that. One ratio I see in the blogosphere is the so-called “yield on cost.” Yield on cost describes the current yield based on the investors’ initial investment.
Problems with simplistic ratios
Yield on cost has its purpose. For example, if I buy a property today for $100,000 and generate $10,000 in net rental income from the property, I could accurately describe my yield on cost as 10%. The same is obviously also true for any number of alternative investments. Say…common or preferred shares of stock.
The problem, however, is the yield on cost, though interesting, has no tangible value past the initial time of purchase. Here’s why: it’s built upon the current yield against the historical cost. I’m completely ignoring the asset’s current value if I look at yield on cost.
Suppose I were to have purchased a $10,000 home in 1970 which I rent out for a total net rental profit of $10,000 per year. My yield on cost is 100%! I’m very obviously a very talented investor, right?
There’s not enough information to know. If my $10,000 in unlevered rental income is derived from a property with a current value of $300,000, I’m clearly a very poor investor. Alas, historical yield on cost is often used to justify holding any cash-flowing asset even at valuations that are much too high.
When yield on cost matters
Yield on cost truly matters once. It matters on the day you buy an asset.
Past that awesome adrenaline filled day, yield on cost ceases to matter.
What matters at that point is your yield on tax-adjusted sale price. I made that up, but the yield on tax-adjusted sale price is the yield of an income asset against the current amount you would stand to receive (less taxes) from the sale of this particular asset.
I insert taxes into the equation because many investors forget just how much of a factor taxation plays in an investment. Case in point: if I own $100,000 of stock that yields $10k in annual income, I may have a cost basis of $60,000. Therefore, the remaining $40,000 is subject to capital gains taxes. At 15%, that works out to a total sale price of $100,000 less $6,000 in taxes for $94,000.
So, should I sell this investment, I’ll have a $6,000 tax liability immediately. Any new investment idea must be at least 6.38% better to jump over that hurdle. See why Warren Buffett’s favorite investment period is “forever?” He essentially delays capital gains taxes forever, and ever, and ever. Capital gains taxes represent a real cash cost, which is much better delayed, or, in Berkshire Hathaway’s case, pushed off forever.
Anyway, if at any point you’re holding a stock that is overvalued but offers an excellent yield on cost, consider again the idea of selling it. Keep taxes in mind, though. If the over/undervalued spread is larger than the tax consequences, let it go. I see far too many people justifying their positions based on a very old average initial investment. Sunk costs are irrelevant, except when it comes to taxation. Consider your purchase price only when the IRS wants its fair share.