Financial Reference

I could have a blog just documenting the material errors I read in the financial press. My biggest victim would be “Money” Magazine. While they have many good articles that should help a lot of people manage their finances, they need to refresh their economics.

This month, they made a mistake any Econ 101 student could find. In an article entitled “Landlords in Waiting” (page 62 of the September edition for avid readers), they analyze involved in whether someone should rent or sell a house they own.

Depending on the assumptions used (i.e. the increase in value of the property and assumed net income per year), after two years the rental could be -$600 or $33,940. (Of course, these are only two outcomes, neither of which will occur, but the scenarios give you an idea of how important your assumptions are.)

The author claims that if you should rent if you think you are going to clear $33,940 but sell if you think you are going to lose.

The problem with this analysis is two-fold. First, the analysis doesn’t account for the paydown of principle on the mortgage. Second, and more importantly, there is no cost of capital for the equity portion of the investment.

People rarely forget about the explicit costs of the debt associated with an investment, but often forget about the cost of the equity. In fact, the article neglects to mention what the equity investment is.

Without this information, there is no way to know what the return on the investment or net present value of the investment actually is. The investment may be good or bad (which is found by comparing the expected return to the cost of capital), but we will never know.