Investing Architect

Category: Investor Mindset

  • The number one rule of investing

    The number one rule of investing

    As the Sage of Omaha eloquently put it, the number one rule of investing is Don’t Lose Money. At first sight it is a blatantly obvious piece of advice although I suspect most investors don’t realize just how sophisticated it really is.

    The Case Study

    Allow me to share a hypothetical case study with you. Suppose you invested $100,000 in the S&P 500 on January 1, 2006. For the purposes of this example, there are no management fees or costs. During 2006, this index grew 13.62% so at the end your investment would be worth $113,650. The following year it was up 3.53% so your investment grew to $117,661. So far so good. But as we all know, 2008 was not a very good year. The market dropped 38.49% so now your investment value dropped to $72,385. However, during 2009 the market came back with purpose closing the year  with a 23.45% gain and lifting your investment’s value to $89,359. And the rise continued in 2010 when the market was up 12.78% lifting your portfolio to $100,780. During 2011 the S&P 500 was flat so your value was unchanged.

    In summary, during a six year spell, your investment had a flat 2011,  four positive years with cumulative gains of 53% and one losing year where your investment lost 38%. So we should be up 15% right? Actually we’ve made a life changing $780 over 5 years. That ads up to two lattes a month! That’s before we consider the facts that over the same period,  inflation “ate” over 15% of our investment’s purchasing power and stock market investments usually aren’t free of management costs.

    The Explanation

    How could this be? Because in all kinds of investing every step back is worth about two steps forward. Every loss of capital takes almost twice the gain to get back even. It took until January 2013 for the S&P 500 to get back to the 2007 high again! Six years to get your head back above water with the leaches of inflation at work the whole time.

    I told you this was a hypothetical scenario but unfortunately this is the bitter reality that many people face all over this country. It’s how hard working folks come to consider pulling their hard saved money out of their Roth IRA  after it sits idle for an entire decade as those same fund managers draw billions in fees.

    How real estate investments are different

    But wait a second, you might ask – real estate isn’t immune to capital losses. In many parts of the country real estate prices plunged at least as much as the S&P 500 in 2008. But there’s a huge difference between a stock portfolio that relies primarily on value increases (appreciation) and a long term real estate portfolio. Say you invested the  same $100,000 in real estate in 2006 and it followed the same path as the stock portfolio. In other words, the value dropped substantially in 2008 then recovered back to the same amount by 2011. If you held on to the property through the whipsaw, your capital would be intact.

    But the big difference is that throughout, your portfolio gave you a return of 12%/year independently of the value of the capital.  So in this case, a real estate portfolio acted more like a dividend paying stock but with 3-4 times the return.  Let’s face it – it’s much easier to ride out a bad market while making 12% a year in the interim. Not to mention that there were fundamentally stable markets all across the country that didn’t experience the value roller-coaster as much (or, at all).

    Next

    What’s Buffett’s rule number two of investing? Don’t forget rule number one. 

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  • A two word mantra for Blueprint real estate investing

    A two word mantra for Blueprint real estate investing

    Lately I have been thinking at length about what is at the  core of our Blueprint real estate investing strategy. There are many moving parts and elements to consider when putting together such a strategy: Location of properties, assets specs, financing, asset protection, tax implication, exit strategies etc.

    But as crucial as are all those aspects, at the end of the day, the Blueprint real estate investing strategy can be summarized in a simple two word mantra:

    Buy Quality

    When you buy quality, you are really buying good tenants that take care of your investment and pay rent on time. When you buy quality, you are really buying low turnover rates, long term leases and low vacancies. When you buy quality you are buying more options, more flexibility and top dollar exit strategies.

    And last but not least, when you buy quality, you always outpace those who buy cheap.

  • What catching monkeys can teach you about real estate investing

    What catching monkeys can teach you about real estate investing

    The story goes that in ancient India, the natives used a clever technique to catch monkeys. Unable to catch them outright since the monkeys were much faster, they dug a hole in a tree trunk that was just big enough to fit the monkey’s open hand. Inside that hole, they placed some nuts to lure the monkey and hid. When the monkey would reach in and grab the food, he would make a fist that was bigger than the hole in the tree. The monkey was trapped and the natives would come out of hiding and catch him with ease. This technique worked because it would never occur to the monkey that if he just let go of the food, he could pull his hand out again and run away.

    We can derive three essential real estate investing lessons from that story.

    First, when you’re faced with an important real estate investing decision,  there are almost always more options than what’s readily apparent at that moment. As an illustration, last week an investor asked me for my opinion on a dilemma he was facing: In the price range where he was looking, there were only two viable locations and neither of them would serve the investor well. But he kept insisting that he had thought this through backwards and forwards and there were no other options. He had painted himself into a corner then continuously went over those same two steps that corner allowed him to take. When I pointed out that he could purchase an excellent property in a high quality location at a slightly higher price while maintaining solid returns, there was a long pause on the line. His assumption that the property had to be restricted to a certain price range wasn’t based on data or reason –  he just held it to be true and it negatively affected his decision making process. So next time you are faced with a similar situation don’t just accept the readily apparent options – there are always other alternatives.  You aren’t restricted to either going hungry or being trapped – You can just pull out your hand with no food and live to eat another day.

    Second, everything that shines isn’t necessarily gold. In the real estate investing world, we are constantly taught to “keep an open mind” and not turn down a deal that might not fit all our criteria exactly. “Sometimes you just have to be creative” – the advice usually goes. I’m certainly not against open minds or creativity. But sometimes when the only tool you have is a hammer, everything starts to look like a nail.  When you have a solid investment plan that produces specific investment criteria, it inevitably eliminates some deals from your consideration. But in the end, that’s a good thing. Because it’s fine to be an open minded, creative investor as long as that flexibility does not lead you down a path that isn’t aligned with or (worse) goes against your goals. Next time you see that tree trunk full of goodies, it’s perfectly fine to whistle past it if your plan advises your to stay away from that type of tree.

    Last, you can’t make money in this business if you don’t take risks but as Warren Buffet says: Don’t ever test the depth of the river with both feet.  It’s not the end of the world if you pass on a deal that might have made you money if it ensures that you don’t go all in and get wiped out. In Wall St they have a saying:  Bulls and bears make money but pigs get slaughtered.  It’s a fine line between ambition or drive – both necessary ingredients to a successful investor- and greed. The stories of successful investors ending up in bankruptcy court due to greed are too numerous to mention. If you ask them, they will tell you that absent the greed, they could have taken a completely different path towards a prosperous retirement. But instead they kept chasing the next deal and the next one after that losing sight of risk in the process. Like the monkey found out, sometimes what might look like a “great meal”, may be the trap that seals our demise.

    Gelada baboon

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  • Real Estate Investors: Know thyself before you wreck yourself

    Real Estate Investors: Know thyself before you wreck yourself

    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?

    Meanwhile…

    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. 🙂

     

    Do you know me enough ...?

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  • Your most important wealth building tool

    I’m writing this from Terminal D of Houston’s Intercontinental airport so I’ll be brief. Brevity notwithstanding, the concept I want to talk about today will deeply affect your success with real estate investing.

    Most aspiring real estate investors think that success in this business looks like a series of home runs. You know, you buy a house, flip it, double your money – then rinse and repeat till you get to your desired number of millions. Or the other popular choice: Buy five dozen homes, leveraged to the neck, rent them and walk to your mailbox to collect your wheelbarrows of money.

    What I want to share with you today is this: Real estate is where you come to put your capital to work not where you create your capital. You see, you already possess the most important wealth building tool. It’s your income. Think about that for a second. When put to work properly, your income provides the savings that become the capital you invest. In addition your income provides the support that allows you to leverage that capital and acquire a higher asset value than you would paying cash. And most importantly, your income helps you pay off your properties faster so you can retire sooner.

    Knowing that your income is your most important wealth building tool is one thing. But realizing that how you choose to spend that income can make a difference between retiring a millionaire and working till you’re 90 is the very heart of my point. When you increase your overhead by taking on debt payments – credit cards, cars, furniture etc – you are impairing your ability to build wealth.

    Look, I have a “live and let live” kind of mentality. I won’t sit here and tell you how to live your life and how to spend your money. However, it’s important to understand that there’s a huge opportunity cost to debt payments. When you take on that $800 car payment, you aren’t just agreeing to pay that amount every month for 5 years. You are also forfeiting the wealth that that chunk of your income could build for you.

    Success in real estate investing isn’t a series of home runs. It’s a well planned long series of hits. And the “bat” you need to get those hits you already possess. It’s up to you how you use it.

  • Everyone is a genius in a rental bull market

    Everyone is a genius in a rental bull market

    The rental market in Houston Texas is hot. Rents have been rising steadily for the last 4-5 years with average time on market dropping to under 30 days. Landlords are in the driver’s seat and the high demand for their properties allows them to ask for longer term leases, higher credit tenants and rent escalations built into the deal. What’s most important is that this rush of demand is fueled by real economic and job growth, not some artificial inflation. Under the current conditions you could literally close on any property on Friday and have a long term tenant in place the following Friday. And he probably had to fight off four or five other applicants to get accepted.

    In the current market, it is easy for an investor to feel invincible – feel like they can’t go wrong. All the talk about quality of neighborhood, school district, amenities, upgrades etc. seems irrelevant. After all why would you go and spend 40% more money on a “better property” when you can buy cheaper, lower grade assets for a fraction of the price. With rental demand as strong as it is now, they will both rent out quickly and your ROI will be much higher on the lower end stuff. Right?

    Mark Cuban said: “Everyone’s a genius in a bull market. Recessions are the great equalizer”. These are good times for investors but they’re also dangerous times. The euforia produced by the rental bull market can fool shortsighted investors into dropping their guard and skimping on asset quality. Incoming rent will cover all the cracks in your asset selection for the time being. There’s a funny thing about cracks though. No matter how often you patch over them, sooner or later they always show through in times of great tension. So ask yourself this: What would happen to your portfolio if the rental market weren’t this hot? If there were fewer tenants looking for properties and competition among assets, would they pick yours? In other words, would your portfolio withstand the test of time and all the changes in market conditions it brings?

    If you are a long term investor, the number one factor you have to seek when building your portfolio is Quality. Don’t listen to the siren calls of cheap properties in cheaper locations. Build a portfolio that will perform no matter the market.

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