Joe Engel was sorely disappointed with his real estate investments. He’d invested $50,000 with each of two real estate syndicators and was counting on the projected $8,000 in annual income. But nothing doing. After just a few months, the payments stopped. Joe was told that the properties could barely cover expenses, forget about paying preferred returns to investors. The good news was that, eventually, the properties would probably recover and he’d get his money back. A friend of his had lost all his invested equity after a property foreclosure.
What lessons can be learned from this difficult investment environment?
Lessons Revisited “Acharei Mos”
As Rashi in the beginning of Parshas Acharei Mos explains, a warning is much more powerful when accompanied by a frightening anecdote. Warnings that real estate investing carries risks seems a bit hollow during boom times, when everyone is making fast money. When real estate deals explode and the environment is much rougher, it’s easier to absorb the realities—that all investments have risks, quick money is the exception, and taking due diligence shortcuts will almost certainly come back to bite you sooner or later.
Ignoring the Fine Print
Investment pitches usually contain some version of the following caveats in the fine print: “All investments carry risk,” “You may lose some or all of your money,” “Past returns are no guarantee of future results,” “This information is from sources believed to be accurate, but investors should do their own due diligence,” or, “We may steal your money, but hey, someone’s got to pay for my jet.” Okay, the last example is (hopefully) unusual, but most investors wouldn’t pick it up because they ignore all the technicalities and nuance. This is a shame since the fine print is where the most important due diligence information is hidden.
All Investors Take Risks
Deal promoters highlight their rosy projections, hoping that investors, impressed with the deal manager’s supposed prowess, focus only on the investments’ supposed potential rewards. But risk disclaimers and projection assumptions are not there for show. Although many do very well investing in real estate, others do just okay, and some lose money. Every financial downturn claims many victims, including some “heavy hitters.” Just because someone is doing really well today doesn’t mean they won’t be the next “acharei mos” example. Actually, those flying the highest have often thrown caution to the wind and are prone to fall the hardest.
Investment cycles create confusion, which is one of the main reasons investors struggle to properly evaluate risk. During euphoric segments of an economic cycle, everyone is making money almost effortlessly, and it seems like a terrible waste not to jump in. Ironically, due to exuberant pricing and fierce competition, boom times are often the worst times to buy in. On the other hand, when markets are depressed, people are scared to invest even when fundamentals and prices are much more attractive. I call this phenomenon the “paradox of risk.” The worst deals tend to happen during the sunniest economic times and vice versa.
Leverage is Double-Sided
Another lesson often learned the hard way is that leveraged investments are a double-edged sword. Due to generous mortgage availability, real estate returns are particularly magnified by leverage, so good times become explosive and bad times become catastrophic. Before investing, it’s crucial to analyze how secure the investment’s underlying capital structure is and model what cushions exist for error and changes in general interest rates. Long-term investments juiced with floating rate debt are really gambling, embedding tremendous risk in what may otherwise be safe investments, as many are now learning the hard way.
Not Watching Workers
The Gemara (Bava Metzia 29b) says that a great way to lose money is to not oversee your workers. Ignoring this, many investors trust managers of deals without much oversight or accountability. In turn, many of these syndicators turn around and hire third-party managers across the country, hoping that minimally managed vendors will do their jobs despite paltry oversight or controls. Property management is challenging even when it’s your own team working down the block, forget about long-distance, outsourced relationships. Investors often recall the aforementioned Chazal’s management wisdom only after their money is down the drain.
Another thing investors tend to ignore is the massive conflict of interest built into some investments, especially the typical real estate syndication model. Even Moshe Rabbeinu and the greatest tzaddikim were warned that financial incentives blind people. Many real estate syndicators with minimal skin in the game take significant upfront fees, which incentivize doing as many deals as possible while downplaying the significant risks faced by investors.
Sheker Dover, Kesef Notel
Most people understand that a broker’s guidance needs to be taken with a grain of salt. What many don’t understand is that when a friend, relative, chavrusa, coffee room macher, accountant, or shul hocker recommends a deal, they are often not disclosing that they getting a commission. i.e. acting as a broker. This practice of non-disclosure is likely halachically problematic, and it extends across many industries, but that is not my issue here. The bottom line is, undisclosed conflicts of interests are a huge pitfall that investors need to be aware of.
Hiring a Ganav is a Financial Hazard
Outright fraud is rare B”H. But it’s astonishing how some people with known reputations for playing fast and loose with other people’s money are still able to fundraise vast sums to invest. Some investors may not be aware of the soiled reputations, but others may like the idea of having a chevrahman manage their money. He may be a ganav, but he’s my ganav and he will use his “talents” on my behalf, they naively think. If that’s your approach, don’t be surprised when you join the list of victims.
Don’t be a Tam
Bizarrely, many spend more time planning their vacations than researching an investment. But if you want to have a decent chance of protecting your money while earning solid returns, you or an unbiased hired expert need to do serious due diligence with regard to the people touching your money and the actual underlying investments they are pitching. If you can’t do investment due diligence, you don’t belong getting involved in the investment. Similarly, if you don’t have enough capital to diversify within an investment niche, it’s not for you. Hopefully, you’ll learn this without losing a great deal of cash.