Capital allocation is a method of apportioning financial resources to different sectors within a business to increase efficiency and thereby maximise profits. Some of the most successful CEOs have been recognised for their outstanding commitment to capital allocation, which has had a profound effect on long term investment returns.
The most famous CEOs (both past and present) who have proven themselves to be excellent capital allocators include:
Warren Buffet of Berkshire Hathaway
Jeff Bezos of Amazon
Henry Singleton of Teledyne Technologies
Tim Murphy of Capital Cities
Bill Anders of General Dynamics
Generally speaking, when assessing a CEOs success, we measure against a fixed metric of the per-share increase in their company’s intrinsic value. All of the CEOs listed above have achieved phenomenal compound interest returns for their shareholders which were sustainable over long periods.
In this article, I would like to introduce the concept of capital allocation to a property investment business and its importance. The report covers four out of the five methods of capital allocation relative to a property business.
- Merges and acquisitions
- Invest in organic growth
- Repurchase shares
- Pay down debt
- Pay dividends
I have chosen not to discuss the repurchasing of shares, as this is more relevant to public companies and is less useful for property investors growing property portfolios.
Why is capital allocation so crucial in a property business?
In a property business, capital allocation is fundamental to the long-term growth and overall profitability of the company. Where a property investor decides to spend money determines how quickly their property portfolio will grow, and the level of operating cash flow that it generates to repurchase assets or debt consolidate. Capital allocation is therefore closely linked to the return on investment when buying investment properties.
As property investors and perhaps closer seen as CEOs of our property portfolios (businesses), it is, therefore, our job to ensure that we are making intelligent decisions for capital allocation.
We must, therefore, understand the various impacts of capital allocation techniques.
Joint Ventures – Mergers and Acquisitions
In property investment and development, I refer to joint ventures as our mergers and buying an existing portfolio of property as our acquisitions.
One way of aggressively growing a property investment portfolio is through joint ventures. In a joint venture, there will be more than one property partner who invests financial resources into a property development project. The main advantage of joint ventures as a growth strategy is that they allow property investors to share risk and raise additional capital to fund larger projects, so it is a suitable method and example of leverage.
Joint ventures are a great way of growing a property business and a viable method; however, it is critical that joint ventures are set up with the correct structures in place, and they require careful financial planning and legal agreements to protect each property investors position.
I have seen many amateur property investors falling victim to this through naivety and unforeseen circumstances, all arising from a lack of understanding and the correct knowledge.
Joint ventures work very nicely and have been responsible for my early success and exponential growth in my property business to date, but I always advise seeking specialist independent legal advice from a property lawyer before hastily jumping into any joint venture project.
Investing in organic expansion
Investing in organic growth is the purest form of capital allocation.
A lean decentralised business model is the foundation of creating long term sustainable wealth in property business. While many amateur property investors deploy a centralised business model, self-manage and choose to refurbish properties themselves, the most successful companies and individual property investors operate a decentralised model, allocating capital to grow operations.
The most successful property entrepreneurs utilise the services of property management teams, building contractors, and property sourcing agents to grow their property business with maximum efficiency. They allocate a percentage of their rental income to pay for these services.
This unique philosophy compared to the amateurs more conventional but ultimately flawed way of thinking allows the property investor to continue to focus on capital allocation and invest in property that provides a high return on investment, as opposed to becoming a tenant sweatshop, building labourer and property finder which adversely inhibits aggressive growth.
When growing a successful property portfolio, it is critical to know when to continue to use leverage to facilitate asset expansion, and when to pay down existing debt (interest only mortgages).
When interest rates are low, property investors are best off letting their debt run through to maturity. However, this depends on the mortgage loan to value across the property portfolio and the fixed interest rates against existing debt. It is also worth considering the occupancy levels across a property investors portfolio, as this will have a bearing effect on how to allocate your capital to maximise returns if deploying a debt consolidation strategy.
Conversely, high-interest rates encourage property investors to repay a proportion or all of the debt to reduce their mortgage loan to values which in return, assuming high occupancy levels will provide increased cash flow which over time can build for the next advance of capital allocation.
The key to paying down debt is to assess the financial returns of the investment. I encourage a long term cognitive approach, much like the strategic and unorthodox thinking of other successful CEOs mentioned earlier in this material. Knowing when to utilise the economy’s cheap monetary supply and how to use it, is what drives the success of multi-million-pound property investors.
To keep things simple and not digress or get confused between types of dividend payments and dividend stock, this explanation is going to be short and precise to a property investment business.
While paying dividends can be an essential aspect of maintaining shareholder relations and nurturing investors, the reality is that paying dividends is tax-inefficient for generating long term returns. Dividends are taxed twice, primarily at the corporate level and subsequently at a personal level.
Thus it makes mathematical sense to the intelligent property investor to not pay any dividends and re-invest the profits into purchasing more income generating assets. If you deploy this methodology long enough with laser-focus, not only will you understand that your tenants are buying your future investment properties, but the compounding effect of this can be massively enhancing which will be attributable to personal wealth creation, for yourself and your families.
How To Start & Grow A “Hyper-Profitable” Property Business
On this online masterclass, Richard shares with you exactly how he went from feeling unfulfilled in his corporate job where he was stuck trading his time for money to building a multi-million property portfolio and replacing his original salary whilst freeing up time to live life on his terms.