Real estate investors come in different varieties. Some are so risk averse that they keep six months of payments in cash reserves for each investment property they own. Others don’t really feel like they’re investing unless they’re going “all in” on some deal every week. But no matter where you fit into the risk spectrum, you should know exactly where you stand before you start investing. Then pick investment vehicles, strategies and advisors that suit that investment “personality”. I know that on the surface it sounds like a cliche piece of advice you might expect to find in a Yahoo Finance article. But in fact, it is crucial to your real estate success. Two cartoonish case studies for you:
Nathan Vegas wants to get started in real estate investing. He loves risk and adores leverage. He wants to invest in real estate for cash flow so he can quit his job and do what he loves. He wants to reach the desired level of cash flow by next Thursday by 6pm. So the strategy is to purchase investment properties that sport a freakishly high cap rate so he can get the highest return on his current capital. And there’s not much time left so he won’t have time to do any proper due diligence but that’s a risk he’s willing to take. After all, how wrong could these proforma statements be?
Brenda Conservative has been mulling over investing in real estate for seven years now and is just halfway through her due diligence. Her favorite topic when scrutinizing investment properties is: 7 ways buying this house could lead to bankruptcy. Just as she’s getting close to pulling the trigger on an acquisition, a new report about how Europe is imploding stops her in her tracks. She wants to retire in 20 years but wants to make sure she doesn’t make any fatal mistakes. Even after making the first purchase, she hesitates to act on other good opportunities because she feels like she’s moving way too fast.
I’m obviously exaggerating profusely and humorously. But I do it to illustrate this point: Who you are and how you think about real estate investments matters in the highest degree. Real estate is a long term investment vehicle and in many ways it’s like a pot roast. It requires time to yield delicious results. Without it, you’re left with a piece of tough, chewy meat. Nathan in the example above, wants to create cash flow before building a sufficient capital base so he tries to shortcircuit the system by buying high “yield” assets. We all know what happens when you shortcircuit… What he is sacrificing to obtain speed is the quality of his portfolio. And when you sacrifice quality you tend to find out very quickly that there’s significant difference between “actual” and “pro forma” and only one of them matters to your banker. Nathan is trying to fit a square peg in a round hole – that is use a long term investment strategy to accomplish a short term goal that requires a huge risk undertaking. He would be better served by using shorter term riskier strategies like flipping or wholesaling strategies. He might even venture outside of real estate and open a business or invest in small cap stocks – both high risk high reward propositions.
Conversely, Brenda wants to reach her retirement goals and she has time on her side but her risk aversion can stand in her way. Because without acquiring the necessary assets to build up her capital base, she will never achieve the level of income it will take for her to retire, regardless of time. But her aversion for risk can’t be discounted away either because it outlines her comfort zone and that’s who she is at her very core. Instead, the real estate investment strategy that better suits her style is one that involves quality assets in great locations even if rates of return are more tame.
Last but not least, who you are should align with where your investment advice is coming from. Brenda shouldn’t work with an investment advisor that urges her to try flipping homes and Nathan shouldn’t work with someone like myself. 🙂