There are no facts, only interpretations.
– Friedrich Nietzsche
This quote is deliberately provocative, I know. Invoking German philosophers to prove a point is dicey, but hear me out – this is a critical point for real estate investing:
It is important to understand just how broad the spectrum of risk is for any investor. Your position, objectives, finances, goals, and circumstances play a huge role in your overall risk.
Facts in real estate certainly exist. We know the federal interest rate, property values for the past twenty years, or how many dollars are in the bank. How we interpret these and decide on our overall risk is very much open to interpretation. Risk is relative. And that can change over time and with unexpected future events.
Let me tell you a story.
My father, who I interviewed for episode two of the podcast, was one of many bank owners in Mexico in the 1970s and early 1980s. Banking was an honorable profession and our family did well. If in 1980 you would have told him that two years later he would lose his bank, he would have laughed. The economy wasn’t great, but no one expected President Jose Lopez Portillo to nationalize all banks, paying bank owners next-to-nothing.
Now, this is a big, unexpected event. But what about the small, everyday events that change real estate investment risk?
Let’s say you are considering purchasing a Class B multifamily unit with four units – a fourplex. The unit is over 10 years old and needs some renovation, but nothing major. The property is well-located, has a good tenant history, and was well-managed. The risk metrics are solid. Cash-on-cash return is strong, the cap rate is 9%, the equity multiple is 1.85x, and IRR is north of 14%. Your plan for the property is to start generating cash flow in year three after recouping renovation expenses. A good plan and good metrics, right? Unexpectedly, you had permit delays in year one, a loan payoff modification in year two, and a down cycle in the local economy in year three. Now cash flow is pushed off to year five.
Some investors might be ‘in the red’ having to wait two more years for cash flow. If an investor needs income for their livelihood, this would be devastating. The risk of this happening might not be acceptable to some investors. This is what makes real estate investing risk far more subjective than many investors admit. Your personal position determines what is and isn’t risky.
All About Risk Metrics
That Class B fourplex sounded good, especially after listing the cap rate, equity multiple, and IRR. Those metrics really help to sweeten the deal. But, and this is what I tell investors starting out, those numbers can be deceiving.
The most important part of using investing metrics is understanding their limitations. Let’s take a look at a few of the most important metrics and where they fall short.
Internal Rate of Return or IRR
In general, the IRR measures the value of an investor’s money in one investment over time. IRR rates tend to be higher in shorter investments. Think about this as money being ‘tied up’ in an investment.
IRR is a good measure of the time value of money, but does not represent an investment’s total profit potential. Shorter projects can have huge IRRs and low total profits.
This is a relatively straightforward metric. This is the total profit plus the total equity invested, divided by the total equity invested. I look at this as ‘your money back, plus a percentage’. This is good for overall profitability.
What the equity multiple fails to do is to consider the time value of money, or how long the money is tied up in an investment. A 2x return on $10,000 sounds good, but is it over five years or 50?
This is another simple metric to calculate. To get the cash-on-cash yield, you simply divide the annual dollar income by the total dollar investment. This measures the cash distributed from an investment.
This metric can be tricky. Cash flow can vary from month to month. Cash-on-cash return provides a snapshot, and doesn’t take into account what any given month (or year) will return for cash.
How To Really Calculate Risk
We’ve seen how assumptions about the market and metrics don’t really provide a full picture of the risk of investing. Here at The Long Term Real Estate Investor, I advocate for safe, stable, smart investments against the trend of flashy returns.
If you really want to create a profitable philosophy for real estate investing, you need to define your risk profile. How do I recommend you do this? You need to understand your subjective risk tolerance. Long Term Investors need to consider the below questions, which will help to shape how they approach risk.
- Do you have a family?
- How stable and/or profitable is your career?
- How much capital do you have and how easy is it to secure loans?
- What will be your short- and long-term income needs?
- Are you partially or wholly diversified?
- Do you have children and if so, are they independent yet?
- Do you plan on having more children?
- What retirement plans do you have?
- What other major life plans do you have set out for your future?
You should come away from these questions with a general impression of your risk tolerance. This will influence how you approach every future deal. And this is what makes risk subjective.