So much of what concerns you as an investor (Captain Obvious alert!) is return on your capital. Everyone’s lookin’ for the property. You know the one — double digit cap rate, highest quality tenants, location to die for, blah blah. What happens next is the learning curve, right? We all found out where the extra high cap rates hang out — bring yer bodyguard. It swiftly evolves into two intersecting lines. One is a return with which you’d be happy — the other the level of risk it takes to produce said return — one with which you’d be comfortable.
And there’s the rub.
Lip service is given to the intimate relationship between risk and return, but often not much else. What’s worse, both risk and return are just as often misjudged by the investor as a result of their analysis of a given property. Though I used to believe risk was more routinely misunderstood, I’ve come to believe it’s probably the return side of the equation.
Risk seems more a victim of denial than anything else, though that’s purely an experiential observation from where I stand.
It’s that pesky relationship risk and return have had goin’ hot ‘n heavy for centuries that can and will chew you up ‘n spit you out if you ignore it. None of us are immune to the very simple reality which says the higher the risk, the higher the return. That truism goes hand in hand with the golden triumvirate of Mr. More is better than less, Mr. Sooner is better than later, and Mr. More, Sooner, is much mo betta.
There’s a thought process that seems to convince many real estate investors the extraordinarily high return their analysis shows them as reality, is somehow attached to a risk normally found runnin’ with a significantly lower return. We all wanna believe we’ve discovered the formula for finding high return properties without the ever congruent risk attached thereto.
It doesn’t happen people.
BawldGuy Axiom: Grandma wouldn’t lie. The higher the return, the more risk you’re gettin’ yourself into. High return? Low risk? Recheck your return. Something ain’t right, and it’s probably you.
I’ve done the same thing more than once. It finally hit me — either I was foolin’ myself, my numbers weren’t real, or my assessment of risk was, to be kind, substandard. It was the latter, by a landslide. Since that epiphany so many many years ago, I’ve done my darnedest to understate return, and overestimate risk. I try not to go overboard, but it’s been a practice with which I’ve become comfy.
Look, boiled down to its essence, the idea is to become as wealthy as possible — but slowly, not by next Thursday.
BawldGuy Axiom: The shorter time span demanded by investors to attain their growth goals, the higher the risk factor must be to achieve those goals. And the choir sings all four verses to, “Duh!”
Risk and return go hand in hand whether it’s high or low — it’s like gravity — you won’t defeat that investment principle regardless of what you think you may have found. Much like gravity, it doesn’t care what you think — it just is. Go figure.
BawldGuy Takeaway: Your analysis of a given property should always have as its foundation, the laws of Investment Physics. When the conclusion is high return with low risk, you’ve very likely discovered an inherent flaw in either your assumptions, your numbers, your conclusions — or all three. Analysis must forever and always be brutally honest, letting the chips fall how they will.
It simply cannot be scripted.
When investing in real estate for your retirement, allow me to suggest you keep some principles in mind.
1. Your #1 job is to do everything within your power to protect the original capital you’ve invested. Return is secondary. Nothing trumps this principle once your capital is invested — ever.
2. The assessment of risk, should be, um, relatively reliable. It’s the numbers you use for income, vacancies, and operating expenses now — what you predict for future years — that have the ability to make or break you. Don’t be artificially draconian, but be real. More on this topic next week.
3. When you’ve come up with your estimate of the property’s inherent risk and projected return, and it seems too good to be true, remember what Grandma told you, OK? Cuz she wouldn’t lie to you — if it seems too good to be true, it probably isn’t true. Find the flaw — be relentless in your search.
You might ask, “What’s too good to be true, BG?”
Let’s say you’ve found a property and decided the risk is very acceptable, in the high level of the ‘low range’ so to speak. You conclude the after tax internal rate of return (IRR) for a projected holding period of 5 years, ending with a sale, will be 17% annually.
Ya screwed up somewhere, cuz that ain’t gonna happen. High return properties carry commensurate risk — make that be your mantra.
BawldGuyCaveat: Though high return does indeed mean the risk is also high, please don’t make the common mistake of reversing that principle, cuz it simply doesn’t work that way. High risk MIGHT mean high return — OR low return — OR, God forbid a complete boondoggle loss of everything you invested. A reasonable return with comfortable risk, over the long haul, is what works.
Remember: Get rich slowly — not by a week from next Tuesday.
Finally, ponder what Grandpa told me the first time I visited him after switching to the investment side of real estate:
“Remember, it’s not called ‘risk capital’ for nothin’.”
‘Nuff said.
Let’s take a look at your portfolio, or get one started. Call me and we’ll laugh and scratch awhile. 619 889-7100 — Have a good one.
Related posts:
About BawldGuy
Dear Dad,
You never cease to amaze me.
Your loving son.
ps Are you sure you are not my father?
You have the hairline, that’s for sure…son.