Rabbi Moshe Brown was looking forward to sinking his teeth into some juicy real estate investments. As a Rebbie with a large family, a boost in income would be most welcome, and real estate seemed like a great industry to enter. A recent article on GeltGuide had highlighted three strategies he could use to be successful in his new venture but he was still a bit scared. Financial risk and reward are connected and investing could lead to losses as well as gains. As a newbie, there was an even higher chance that he would get burned. What could real estate investors do to manage risks and increase their chances of profiting?
Cycles and the Double-Edged Sword of Debt
Real estate investors can make millions, but many lose fortunes as well. During boom times this is hard to remember, but Rabbi Brown is wise to consider both the reward and risk sides of the investment equation. In 2008, when real estate markets crashed, many investors, large and small, were caught unprepared. Although some righted the ship, plenty of others went under, crushed under the weight of weak properties and massive debt. It is human nature, however, to focus on the success stories and forget about those who failed. Ignoring the financial lessons of history, however, can prove quite expensive.
Real estate investors are particularly prone to financial ruin due to substantial use of debt financing. Mortgage leverage acts as a double-edged sword, magnifying both gains and losses. For example, if Rabbi Brown buys a house for $100,000 cash, a 25% shift in value, upwards or downwards, will register as a 25% gain or loss. But if he instead uses his money as a down payment to buy four houses with mortgages ($100,000 down with a $300,000 mortgage), the same 25% shift is multiplied by four to equal a 100% gain or loss (25% of the $400,000 portfolio)! And unlike an all-cash investment, a heavily mortgaged portfolio has little room for error in case of an unusual expense or loss of rental income. Lenders will quickly move to foreclose if mortgage payments aren’t met, locking in catastrophic losses.
The Circle of Competence
The central protection against investment loss is finding and sticking to an area of expertise. Warren Buffet considers this concept of a “circle of competence” one of the keys to his success. He only invests in what he knows well, raising his ability to spot both lucrative opportunities and financial traps that others miss. For example, Buffett ignored technology stocks for decades. Even during the 1990’s technology boom, despite their much lower returns, he stuck to the old fashioned insurance and consumer goods companies he knew well. This stance lead many to scoff that he had become an antiquity, but Buffett got the last laugh when technology stocks collapsed by 90%, while his boring investments surged ahead.
A circle of competence in real estate means finding an area and property type to become an expert in. Even successful investors get tripped up when switching abruptly into new locations, or property types like from apartments to industrial. For a novice like Rabbi Brown, the easiest place to begin investing is buying and renting out a house in a neighborhood he knows well. Location options may include where he currently or used to live, work or vacation. Everyone has an idea of the dynamics of life in a home, so a house rental is a good place to start being landlord. As his knowledge and abilities eventually grow, he can decide whether to expand his circle to include new territory and larger, more complex buildings.
Investment Finances: Securing The Foundation
Money is the foundation of every investment. As noted earlier, debt raises the investment’s risk and reward potential. However, all loans are not created equal but range from highly stable, 35 year HUD mortgages to the onerous short term “hard money” loans. Borrowing choices are a crucial component of a real estate deal, and Rabbi Brown should make sure to do his homework. Also, research into loan options can provide an indication of the investment’s risk. In the case of trouble, loan repayments take priority. If despite this preferred position, lenders do not want to put their money in jeopardy, it’s a red flag that the deal may be too risky.
The quip goes that a banker is someone who will lend you an umbrella when the sun is shining only to demand it back when it rains. Banks become very reluctant to put out any funds in a weak economy which may be the very time when a project is experiencing income shortfalls. It is important to keep a cash cushion available to tide over a real estate investments’ inevitable rough periods. Access to additional financial resources provides the staying power required to ride the peaks and troughs of the market. Rabbi Brown should, therefore, make certain he will not run out money at the wrong time which may necessitate bringing in an equity partner. Although this means sharing the profits, an assured half- loaf is often better than an iffy whole one.
Read about strategies to increase successes in Real Estate here and here.