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Converting a
lump sum into a monthly amount
The impact of an
annual amount
It's easy to figure out how much an item impacts
room rates by using member-months. Here's how it
works: Let's say a charitable foundation is going to give
us $30,000 a year forever, and you want to put all of it
towards lowering room rates. How much can you lower room
rates by?
The first thing you do is to divide the $30,000 by the
number of members. How many is that? Well, we have 188
beds in ICC, but we have only about 90% occupancy over
the whole year, so let's call it 169 members. So dividing
our $30,000 by 169 members we get about $180 per
member.
But that's per year. To figure the cost per month we
divide our $180 by 12 months and we get $15/mo.
Ta-da.
But since we're always going to be dividing by members
and then dividing by months, we can use a shortcut and
divide by member-months. 169 members x 12 months =
~2000. (It's actually 2030, but let's not split hairs.)
So to convert any annual amount into the monthly rate,
just divide by 2000. If that charitable organization gave
us $40,000 a year instead of $30,000, just divide by 2000
and we see the impact on room rates is $40,000 / 2000 =
$20. Very simple.
The same thing works in reverse when you have extra
expenses. Let's say the Texas legislature revokes our
property tax exemption and we suddenly have to start
paying $80,000 a year in property taxes. How much will
that impact us? $80,000 / 2000 = $40, per member, per
month. Ouch.
Actually, it doesn't have to be an extra
expense. For example, our normal maintenance &
facilities budget is around $200,000 a year. That means
that $100/mo. of members' room rates goes to pay for
facilities.
Note that this trick only works when you're talking
about annual savings or expenses. In our examples
above we assumed we got the $30k or $45k every
year from the charity (or paid out the $200k every
year for maintenance). But if we get or pay an amount
only once then it's different. That's what we'll tackle
next.
The impact of a
one-time amount
Lowering room rates with a one-time windfall is
a little trickier then lowering it with an annual bounty.
The first thing you have to consider is for how
long you want to lower rates -- for a year, 20 years,
or forever? The next thing you have to consider is when
you want the savings on room rates to kick in: the
methods that lower rates by a big amount and forever
don't actually start working until several years down the
road. First let's see the summary of our different
options:
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Divvy up windfall for 1
year
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Divvy up windfall for 20
years
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Loan out the money & collect
interest
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Pay off our debt early
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Buy another property
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When can room rates be lowered?
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Now
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Now
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Now
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Later
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Now
and
Later
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How long are rates lowered for?
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1 year
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20 years
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Forever
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Forever
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Forever
|
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How much can rates be lowered?
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a
LOT
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a little
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a little
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a
LOT
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a
LOT
|
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Still have windfall after lowering rates
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no
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no
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Yes
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Yes
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Yes
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Introduces cooperatives to a larger number of
people
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no
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no
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no
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no
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Yes
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Now let's look at each of these options in more
detail, figuring out what we could do with an extra
$300,000.
1. The simplest method: Divvying
up the money.
Let's say that your accountant finds $300,000 in
a filing cabinet. (That's not too far off from something
that actually happened, except the amount was closer to
$80,000, and the money was in accounts, not a filing
cabinet.) If you wanted to use that money to lower room
rates, how much could you lower them?
If you said $300,000 / 2000 = $150 then that works,
but only for one year. To lower room rates by $150/mo.
forever your accountant would have to find an extra
$300,000 lying around every year. That's pretty
unlikely.
Of course, you could blow your $300k windfall
by lowering room rates for just one year, so rates would
indeed go down $150/mo. for just that one year. But
considering that the money would be completely gone after
that one year, divvying up the money that way would be
pretty selfish and uncooperative.
We could divvy up the money over a longer period of
time, say five years. Then we're looking at a $30/mo.
reduction. But we have the same problem of the money
being gone at the end of that five years.
Now, the payments on our outstanding loans currently
cost us $90/mo. per member. When we pay off our loans in
20 years then room rates could go down by that $90/mo.
that we won't have to pay any more. So maybe our strategy
could be to use our windfall to lower rates for 20 years,
at which point the savings from paying off our debt will
automatically kick in. Nice try, but $300k over 20 years
divided by all the members just isn't that much money.
Room rates could go down only $7.50/mo. It's tangible,
but the benefit is pretty small, especially considering
that we'd be throwing our windfall away for good. So now
let's look at ways to try to get our impact on room rates
to be larger and/or last longer.
2. Loan out the money to another
group, and collect the interest.
Loaning out our windfall doesn't allow us to
reduce rates very much, but it does have one big
advantage: We can lower them forever. If we just
divvy up the money as in the previous example then the
money is all gone. Loaning it out generates interest
income for us and we get to keep our capital.
Here's how it works: Say we loan out $300,000 to a
group that wants to buy a house to turn into a co-op.
This group pays us back by making payments every month
for 20 years. Part of each monthly payment pays back the
actual money we loaned them (the "principal"), and the
rest of the payment is interest on the loan. The interest
is our profit from loaning out the money.
Okay, great, how do we figure out how much we get in
interest? First we figure out what the monthly payment
will be. This is easy to do in Micro$oft Excel, just type
in the following:
=-PMT(InterestRate,NumberOfYears,LoanAmount)
You have to plug in your own numbers, of course. For
example, if we loaned out $300,000 for 20 years at 8%
interest, we'd type in:
=-PMT(8%,20,300000)
And the answer would be $30,555 a year. That's the
amount that the group would pay us per year, principal
plus interest combined, if they were paying us only once
a year. But of course the group is going to make their
loan payments monthly and not yearly. So to be more
accurate let's divide the interest rate by 12, and figure
that we're talking 240 months instead of 20 years:
=-PMT(8%/12,240,300000)
And the answer is that the monthly payments are around
$2,509/mo.
Okay, so now we know how much they're paying us, how
do we figure how much of that is interest? All we do is
take the total amount they pay us over the 20 years, and
subtract out the amount that we loaned them. What remains
is the interest they paid. Here are the numbers in
action:
- We loaned them $300,000.
- They'll pay us $2,509/mo. for 240 months, or
$602,160.
- The interest portion of their payments is the
difference: $302,160.
And getting way back to our original question,
we wanted to figure out how much a one-time windfall
could impact room rates forever. We now see that if our
one-time windfall was $300,000 and we loaned it out at 8%
interest for 20 years, we'd make $302,160 over those 20
years, or $15,108 a year.
And aha! Now that we have a yearly figure, we can
divide by our old pal member months: $15,000 / 2000 =
$7.50/mo. Bingo.
There are a couple of big IF's in this scenario,
though. The first is whether we can even find a
responsible group to loan the money to. The second is
whether they'll be good about making their payments. If
they don't pay us back then we can reclaim the property,
but there will be time and expense in doing so. It's
something to consider, making money is never without
effort or risk.
What we left out. There are some other nuances
that we haven't considered, but they're not that
important -- the answer above is perfectly acceptable for
casual "What-if?" scenarios and comparisons with other
ways we could leverage that money. Those interested in
the details can check the Appendix for what
we left out.
3. Pay down our debt, saving on
the annual interest expense.
First off, if you're unclear about mortgages or
loans, you might want to learn
all about mortgages first.
Good, you're back. Okay, as of 2004 we have around
$1.78 million in loans, for all our houses. (Actually, we
rent a couple of our houses instead of owning them, and a
few of the ones we own are technically not part of our
loan, but let's not split hairs.) We're paying about
$181,000 a year to the bank to pay back these loans. Our
old pal member-months tells us that this costs every
member about 90 bucks a month. In 20 years when we pay
off our debt then that $90 per member per month expense
goes away, and room rates could go down by $90/mo.
Whoo-hoo! Could we make that day happen sooner?
Sure we could, since in all these examples we have an
imaginary $300,000 we're playing with. We could take our
$300,000 windfall and pay down our debt, so we'd pay off
our loan early and save a bunch of interest. That hastens
the day when our $90/mo. obligation goes away.
How much sooner would our loan be paid off? That's
tricky to calculate. It's involved enough that it's
beyond the scope of this article, but I did write a
spreadsheet to answer that question which you can
download. (Loan
Prepayment spreadsheet.)
The answer is that with a typical set of assumptions,
making a $300,000 prepayment would shave six years off
our loan, so we'd pay it off in 14 years instead of
20.
You might be thinking, "Hey, if we pay off our loan
early, we'll also save a bunch of interest too!
Ooh, ooh, how much do we save?" Well, hold on there,
cowboy. If you take the money you save by not having to
make a mortgage payment and use it to lower room rates,
then there's your interest savings. You already
used it.
The summary for this section is that room rates can go
down $90/mo. in 20 years when our debt is paid off if we
do nothing, but by paying down the debt early we won't
have to wait the whole 20 years for that to happen.
Making a prepayment on your debt does not lower room
rates immediately.
What we left out. To make the math simple we
assumed that our $1.78M debt is in the form of a single
loan at 8% interest for 20 years. But in fact none of
that is really the case, except the $1.78M part. The
biggest difference is that our loans aren't the kind that
can be paid off early, but that's not a show-stopper
because the next time we refinance we can apply our extra
principal then. The variables we used above are adequate
for getting a rough idea of how soon we could pay off a
loan by making a prepayment, but those actually planning
ICC's future will want to have a closer look at the
details of ICC's debt.
4. Buy more properties, and get
the revenue from room rates, and spread expenses over more
members.
The great thing about buying more property is
that it lowers rates in the short term and the
long term. Let's see how.
We know that when we buy a house we get a loan to pay
for it, and then we make payments on the loan. That's our
annual expense in buying the house.
But we also get annual revenue, in the form of room
rates. Once we subtract out food, utilities, and
maintenance, that's how much much we make on the
house.
So the trick is to try to find a house whose price is
low enough that the amount we make equals or exceeds the
amount we're paying on the loan. That's tough to do, but
it's possible.
Why would we buy a house that doesn't do any better
than break even? Simple:
- We can spread expenses over a larger number of
members. Let's say that staff costs go up by
$15,000 one year, and you have to raise room rates to
pay for the extra expense. Would you prefer to spread
that cost over 150 members or over 200 members? The
more members, the easier it is to limit rate
increases.
- It means we acquire an asset for free. The
room rates we collect pay for the house, so we get a
new house without having to shell out our own cash for
it.
- Once the house is paid off, room rates go
down. You might pay $100,000 a year on a loan for
a $1M house. In 20 years when the loan is paid off you
no longer have that $100k/year expense. Room rates
could go down by $50/mo. for all members at that
point. ($100k divided by 2000 member-months)
This is why investing in property is so powerful. In
fact, it could be worth it to buy property that doesn't
quite pay for itself during the loan period. Members
might have to kick in an extra $6/mo. during the loan, in
exchange for rates going down by $50/mo. once the loan is
paid off. Plus, you have more members to divide expenses
among, and with another property you have a nice asset.
("Hey, nice asset!")
What we left out: Savvy readers might have
wondered, "Hey, if we really got the house for free
because it paid for itself, then we didn't need to use
our windfall at all. So how does the windfall apply?" The
answer is that buying a house isn't quite free
even if the revenue it generates for you covers the
mortgage payment. You'll also have to put a down payment
on the house, pay closing costs associated with the sale,
and cover startup costs like renovation, kitchen
equipment, furniture, and supplies. You'd use your
windfall money to pay for all that.
Methods Compared
So let's summarize the different ways of using a
one-time windfall to lower room rates.
|
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Divvy up windfall for 1
year
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Divvy up windfall for 20
years
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Loan out the money & collect
interest
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Pay off our debt early
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Buy another property
|
|
When can room rates be lowered?
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Now
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Now
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Now
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Later
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Later
|
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How long are rates lowered for?
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1 year
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20 years
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Forever
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Forever
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Forever
|
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How much can rates be lowered?
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a LOT
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a little
|
a little
|
a
LOT
|
a
LOT
|
|
Still have windfall after lowering rates
|
no
|
no
|
Yes
|
Yes
|
Yes
|
|
Introduces cooperatives to a larger number of
people
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no
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no
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no
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no
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Yes
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I hope this information has been helpful.
-- MBJ
Appendix:
Other
implications of loaning out money and collecting
interest
In our discussion about loaning out money and
collecting interest we said that the interest we'd
collect would be: Total Payments Received (minus)
Total Principal. Then we'd divide that by the term
of the loan to figure the amount we'd get annually. Once
we got that amount we could divide by member-months to
figure the impact on room rates.
For example: We loan out $300,000 for 20 years at 8%
interest. From Excel we'll see that the borrower will pay
us $2,509/mo. for 240 months, or $602,160. So the
interest they'll pay will be $302,160. Over 20 years
that's $15,108 a year. Dividing by 2000 member-months,
we'll see that the potential impact on room rates is
$7.50/mo.
It's perfectly acceptable to use that method to figure
out how much we could make by loaning out money. But for
the perfectionist, there are a couple of other issues we
didn't consider.
The first is that the amount of interest paid
varies over the life of the loan varies. When our
borrower first starts making payments most of their
$2,509/mo. payment is interest and only a little is
principal, while towards the end of the 20 years most of
their $2,509/mo. is principal and only a little is
interest. You might wonder, "What does it matter? We're
getting the same amount of money every month for twenty
years anyway." And you'd be onto something. The fact that
the amount of interest changes over the life of the loan
is academic, it's not really of much importance to us
when we're figuring our profit by making a loan.
The second thing we left out is a little more
involved: You might have realized that we don't have to
wait the full 20 years to get some of our money back
-- we actually start getting it back in the very first
month. Could we take that money we get back and then
reinvest it, by loaning it out again? Sure you
could -- once the amount gets high enough. Obviously we
can't loan out a piddling $2,509, no one can start a
co-op with that small amount of money.
Alternatively we could use the money coming in to pay
down our own debt early, so we wind up paying less
interest to the bank. That way we wouldn't have to wait
until we collected enough payments, we could apply any
extra money we had towards our debt right away. The
problem is that if we did that, we wouldn't be able to
use that money to lower room rates right away, which was
our whole goal in loaning out money the first place. We'd
get an advantage all right, just not right away: Paying
off our debt quicker means we hasten the day when we
won't have to make those big payments to the bank any
more, and room rates can go down accordingly.
But you needn't worry your pretty little head about
any of this -- remember that the $7.50/mo. answer we got
above is sufficient for our purposes. Just keep in mind
that you have the opportunity to loan out your principal
again or start paying down your debt early during
that loan you made -- you don't have to wait until the
end of the loan.
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