The velocity of money in investing is a concept that focuses on the return of capital instead of the return on capital. It’s a way to achieve “infinite ROI” on your investments.
I wanted to share this concept with my readers and provide some examples to help illustrate it. So let’s dive in.
Background
The basic idea behind the velocity of money in investing is how fast an investment can return your original principal. It’s not necessarily about how fast you flip an asset (buy & sell) to earn a return though.
Investment opportunities that have a high velocity of money are ones where you are able to get your original investment back fast but still have residual upside/equity remaining. The speed varies, but generally speaking, it means getting your principal back in 6-24 months. Once you get your original investment back, you can put it to use in another investment, while still having equity/upside in your 1st deal. By doing this, you are earning a return on 2 different investments, but using the same pool of capital. You can rinse and repeat this many times over.
So in short, you earn returns on investments where you have $0 still invested – hence, infinite ROI.
Generally speaking, this is only achievable in private investment opportunities that allow you to have some control over the structure, terms, and movement of money. Below are two examples of this concept at play in real estate and private equity.
The Velocity of Money In Real Estate
The most common way this strategy is achieved in real estate is through value-add deals and cash-out refinancing (cash-out refi for short).
In a value-add deal, you acquire and renovate a property, improve it or add to it. The main goal is increasing the property value because it allows you to refinance your mortgage at a higher amount, based on the increased property value while pocketing the difference.
Let’s say you buy a rental property for $1m, and put $200k as a down payment and take out an $800k mortgage for the remainder. You spend another $100k cash doing renovations, so now you’ve invested a total of $300k of your own money.
After the renovations are complete, let’s say the property’s value has increased to $1.4m. Refinance your $800k mortgage with a $1.1m mortgage and keep the difference of $300k. You now have your entire cash investment of $300k back but still own the property. You can continue to enjoy the rental income and property appreciation, without having a dollar of your own money still invested. You’re free to reinvest your $300k into another deal.
The Velocity of Money In Operating Companies
You can basically apply the same approach used in real estate, but for an operating company. Private equity firms do it all the time, it’s called a dividend recapitalization (div recap for short).
The basic idea is, you acquire a company and you improve its cash flows in a short period of time. Once cash flows have improved, the company can borrow more money so you take out a loan and pay out a large dividend. This dividend can be large enough to pay back the cash you had to put up to buy the company in the first place.
However, unlike in real estate, with operating companies, there are more levers you can pull to return your principal without simply taking on more debt. Here are some examples:
- Sell a portion of the company – after making improvements to the operations, and increasing the company valuation, sell a portion of your stake of the company at a higher valuation. The proceeds could be large enough to return your original principal.
- Sell assets within the company – either sell assets that you feel don’t add net value to the business, or sell the assets and lease them back (this called a sale-leaseback). This can free up cash that you can use to return the principal.
- Payout dividends from business cash flow growth – operating companies not only produce far more cash flow per dollar invested compared to real estate, but they also have far more potential to grow the cash flow, fast. While real estate rents may only increase 3-5% per year, operating companies can easily grow revenues/profits 20-100% per year (or more). This means that they have the potential to pay out large dividends to return the original principal, without taking on more debt.
Bottom line is, through creative tactics, you can have your original investment in an operating company returned fast. This translates to owning a business to enjoy future profits and a liquidation event, without having a single dollar still invested in the business.
Important Considerations
Debt
This goes without saying, taking out more debt increases the risk profile of your investment. Your cushion, or margin of safety, decreases with the added debt. Whether the debt has recourse to you (the lender can come after your other assets) or not makes a big difference as well.
Deal flow
If you race to get your original principal back, you need to find another opportunity to invest in. If you don’t have sufficient deal flow, the capital might end up sitting idle. The number of lucrative deals you analyze on a regular basis makes a big difference.
Sacrificing larger returns
In real estate, once a property is renovated & stabilized, there aren’t any other major reinvestment opportunities. But the same can’t be said about operating companies, where reinvestment opportunities are abundant. Paying out a dividend to invest elsewhere may not be the best use of capital. You may be able to find far more lucrative opportunities by reinvesting in the business. As a result, paying out a dividend could mean sacrificing a much larger return in the long run.
I wrote an entire post on How to Approach Capital Allocation As An Entrepreneur which goes into a bit more detail on this topic.
Taxes
Real estate proceeds from cash-out refinancing are generally tax-free, however, dividends from operating companies are usually not. Always take into consideration after-tax proceeds.
Final thoughts
I think the velocity of money in investing is a great concept. This approach is in stark contrast to a lot of buy-and-hold strategies for private investments, where you don’t see your capital returned for a very long time, if ever (like angel investing in startups).
Hopefully this post inspires you to view private investment opportunities with another lens.
Hi there! I’m Jay Vasantharajah, Toronto-based entrepreneur and investor.
This is my personal blog where I share my experiences building businesses, making investments, managing personal finances, and traveling the world.
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