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, yadda yadda. What happens next is the learning curve, right? We all found out where the extra high cap rates hang out — bring yer bodyguard. It rapidly evolves into two lines intersecting. 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 seem more a victim of denial than anything else, though that’s purely an experiential observation on my part.
It’s that pesky relationship risk and return have had goin’ hot ‘n heavy for centuries that can and will chew you up and 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 much 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, wanting. It was the latter, by a landslide. Since that epiphany so many many years ago, I’ve done my best to understate return, and overestimate risk. I try not to go overboard, but it’s been a practice with which I’ve become very 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 congregation says, “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 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.
When investing in real estate for your retirement, may I 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 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.
3. When you’ve arrived at 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.
But, you 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 — let 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.
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.
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I think #1 could be miss leading. Dont forget about the ever confusing principle of sunk costs. Too many times investors hold on to dogs because they want to make back their original principle.
It always helpful to forget about your original basis and look at what you have and if it is maximizing its growth potential in this location. It might be better to take the loss and move to a new neighborhood, property type, etc.
Hey Michael — Point well taken. However, in the context of this post, it’s been made clear we’re talking about folks who don’t currently face decisions about their ‘dogs’. Many other posts have addressed that topic thoroughly — and yes indeed, sometimes it makes sense to cut the chord and move on.
Also, #1 was a ‘Rule of the Road’ for investors in general, surely also widely quoted in your industry as well.
Good to here from you. By the way, best of luck with our new site!