Patrick Donohoe explains what Economic Value Added is and how it applies to real estate investors.
Don’t miss this episode where Patrick Donohoe explains how Economic Value Added is added and how to apply it to your future investment deals.
Mike: Welcome back to the FlipNerd.com REI classroom, where experts from across the real estate investing industry teach you quick lessons to take your business to the next level. And now, let’s meet today’s expert host.
Patrick: Hi, everyone. I’m Patrick Donohoe with Paradigm Life and I am the host of REI Classroom today. And we are going to be discussing a concept, actually an accounting concept, called “economic value added.”
Mike: This REI Classroom real estate lesson was sponsored by uglyopportunities.com.
Patrick: So economic value added is . . . it’s actually very, very intriguing. It’s usually used in the corporate world. So if you look at companies like Whole Foods, Coca-Cola, GE, AT&T, and there are a number of others, they all use this, this method. So it’s originally developed by Stern Stewart, which is just a big accounting firm. But as I looked into it, personally, I found that there’s some application to personal finance and especially when it comes to real estate.
So let me kind of briefly discuss what economic value added is. So economic value added is essentially when you make an investment, you value the actual cash or the money you’re putting into an investment with what’s called a cost of capital. And in personal finance, I use opportunity cost. What that means is if you put money into a property, piece of real estate or any investment, you lose the interest you could’ve earned somewhere else. So that’s known as opportunity cost. So the idea behind economic value added, when it comes to real estate, is to use that method.
And I felt it’s really helped me become a better real estate investor and a business person so that when I actually do put money into a deal or put money into my business, the return of that money, essentially, I treat as a return of principal, then I add an interest charge on top of that, which is opportunity cost. And I don’t really consider the investment profitable until I’ve received back the capital I initially invested, plus whatever that rate of return is or the interest charge that I’ve made to myself.
Now, it sounds somewhat confusing, but if you really go and research how economic value added works, it has total application to real estate investors. And in my experience as a financial adviser, I see a lot of real estate investors, a lot of scenarios, and really, in the end, it comes down to the behavior of the real estate investor as it relates to their success. I mean, often times, properties definitely play a role into it, but in the end, it’s really the behavior and how management occurs on cash flows and cash, and so forth of the real estate investor.
So economic value added is a really, really cool concept and I’m going to give one more application to it. So I know many of you guys are probably real estate investors and you get to a point when you’re investing in real estate that you cap out on the amount of properties that you can buy with a mortgage. And so often times, you have groups that form and those groups kind of trade services, whether it’s cash or capital, or credit. And so looking at a group that, that I became a part of a few years ago, there were six of us, and we got to the point where we’re able to split deals six ways and someone would do the mortgage. We did some syndicated deals as well.
But we ran into this issue where we eventually got to the point where we could not split the investment six ways. Some people had money, some people didn’t. So what we did is, we used the economic value added principle, so what that is, is when you inject money into the partnership, into the entity, if you have a disproportionate amount of money, we valued that amount of money with basically a 10% charge. So what that means is you inject money, the property or the investment is split six ways, but then, when it comes to the investment returns, whether it’s cash flows, or if you sell the property or cash out, the money is returned to the initial individual who put in their share, plus 10% on that excess money.
And so it’s been hugely valuable for our group because we’re more willing to participate, especially when there’s a disproportionate amount of money or disproportionate amounts that are there when you’re wanting to do a deal and you’re part of a partnership that is doing that deal.
So anyway, that’s basically economic value added. There are several different applications. We definitely encourage you to research it. Also, my firm, Paradigm Life, we teach a concept that allows you to essentially use this whole economic value added principle with every real estate deal that, that you’ll ever do. So you can reach and learn more about what we do, we have a whole section on real estate on our website, it’s www.paradigmlife.net.
Mike: HomeVestors, the “We Buy Ugly Houses” folks, is a franchised system of hundreds of real estate investors that have purchased over 65,000 houses. If you’d like to learn more about the most powerful real estate investing system in existence, whether you’re a pro looking to take your business to the next level or whether you have no experience at all, but a burning passion to be successful in real estate investing, please visit FlipNerd.com/ugly to learn more.
Please note, the views and opinions as expressed by the individuals in this program do not necessarily reflect those of FlipNerd.com or any of its partners, advertisers or affiliates. Please consult professionals before making any investment or tax decisions, as real estate investing can be risky.
Are you a member yet of FlipNerd.com, the hottest real estate investing social community online? If not, you can join for free in less than 30 seconds and get access to hundreds of off-market deals, vendors in your market to help you in your business, and you can start networking with thousands of other investors just like you. Get your free account now at FlipNerd.com.
Please check out the FlipNerd family of real estate investing shows where you can access hundreds of expert interviews, quick tips and lessons from leaders across the real estate investing industry. They’re available at FlipNerd.com/shows or simply search for FlipNerd in the iTunes store.