The Gradients of Risk in Real Estate Investing
Don't let risk be the obstacle. Measure your appetite for risk and then get in the game.
In the world of Real Estate investing, there is a massive barrier to entry: Yourself.
Everyone has pondered what it would be like to own their own home or, better, to be a real estate mogul. We hear about them frequently in the news. Think Trump, Jerry Buss, Donald Sterling, Magic Johnson, Donald Bren, Sam Zell, Jay-Z, Schwarzenegger, and the Kardashians. All of these names are real estate moguls.
When we think about being a Real Estate mogul, most of us say, "Nah! Everyone knows it takes money to make money in Real Estate, and I don't have it, so that's that."
Except it isn't. Today I'm going to show you how you can begin your journey to being a Real Estate mogul, starting with what is comfortable for you. I want to break down your can't-do-it mindset, which is the true barrier to entry.
First things first, you can go big or small when it comes to real estate investing. If you're a first-timer, I want you to have confidence in your ability to successfully invest in real estate. I can't guarantee success. I can't do that for any investment that isn't rigged by me (that being none). Still, I can promise a high probability of success if you follow the advice I will lay out in the next few posts dedicated to investing in real estate.
I want to start by outlining the many gradients of real estate investing by the degree of (A) investment capital, (B) effort, (C) obligation, and (D) risk.
How Much do You Have to Invest?
First, the gradients of real estate investing by cost:
Buying Shares in a Real Estate Investment Trust (REIT) or REIT Exchange Traded Fund (ETF) - ($50+) You can buy as little as one share, and shares start at just a few dollars. Let the big boys manage the property and take an interest in their profits.
Real Estate Crowdfunding - ($500+) Get in the lending game. You play the bank and earn up to 18% interest. Like with any loan, sometimes the borrower defaults but that loan is backed by the property, so long as it doesn't exceed the property's value.
Buying a Tax Lien - ($5,000+) A segment most don't know about, where outsized profits can be earned, but it puts the V in vulture investing since you buy tax liens on unpaid property taxes. If they aren't paid to you, you may have the right to foreclose on the property. Are you ready to foreclose on someone's destitute Granny?
Buying a Timeshare - ($7,500+) You can pay less for a timeshare than $7,500, but one that will make you money will cost at least that much. Opportunities here can yield cash-on-cash returns of 10% or more, and as a bonus, you can use it for vacation instead in any given year!
Buying a Fractional Share - ($25,000+) Buy multiple weeks of timeshare through Fractional Share properties. Often more upscale than the typical timeshare, the appeal can be threefold: long-term capital profits, rental income, and upscale vacationing. It requires a bit more investment capital than the typical timeshare.
Investing in a Real Estate Partnership - ($25,000+) Get into a partnership with one or more partners to share the risk and tap into the expertise of one or more of your partners in the venture. Naturally, those with greater knowledge may want bigger profits as part of their contribution to the partnership.
Buying a Condo or Townhouse for Long-Term Rental (LTR) - ($25,000+) Make a bank your partner by putting 20% down and borrowing the rest from a bank. There is more significant profit potential when you do it on your own, but also a greater risk if you fail to do your due diligence.
From here on out, all the options listed assume using bank loans to acquire the property at the lowest suggested investment level.
Buying a Condo for Short-Term Rental (STR) - ($40,000+) Short-term rentals usually require upgraded furnishings, and you must fully furnish the property for your guests. Rents can be 3-4 times greater than for Long Term Rental. This is the current sweet spot (i.e., at its potential high watermark as a segment) of the real estate investing space. That said, resistance from city residents and the hotel lobby is making friendly jurisdictions harder to find and restricting the ability to operate existing properties this way.
Buying a Single Family Home for LTR - ($40,000+) Same idea as buying a condo for LTR, only stand-alone, with a lawn and exterior to care for. With no or lesser HOA fees, profits can be higher.
Buying a Single Family Home for STR - ($60,000+) Same idea as buying a condo for STR, only with higher capital requirements.
Buying a Multi-Family Property for LTR - ($100,000+) Why have one place to rent at a time when you can have several? The only thing separating an investment in a Multi-Family versus Single-Family is the amount of capital needed to acquire the property. Insurance and lending rules can change, but these aren’t obstacles so much as differences in where you go to secure these elements.
Buying a Multi-Family Property for STR - ($150,000+) Same as buying other STR properties, but with more capital required to deliver the better finishes, guests will expect. Once again, this is in the current sweet spot of the real estate investing space.
Buying a Commercial or Industrial Property - ($250,000+) Bigger dollars are usually required for commercial investing. This investment needs a more accurate assessment of its current or potential value to realize significant profits. The tenants are long-term and more stable than residential properties.
How Much Elbow Grease Are You Willing to Put In?
Real Estate Investing can come in different gradients of effort. If you already have a job, do you want another one? There are options depending on your answer:
Letting a general partner manage your property - Low Effort. Let the professionals do the work and take a share of the profits for investing your money in the project. Lower risk but also lower reward.
Hiring a property manager to handle your LTR property - Low to Moderate Effort. When you hire a property manager to manage your Long Term Rental, the manager's quality will significantly impact how much work you have to put in. They earn 8-12% of the rent, which sometimes isn't enough to keep them focused on your property as they should. At the end of the day, depending on the quality of the person or company you hire, you may have to manage the manager.
Hiring a property manager to handle your STR property - Low to Moderate Effort. Since managers are better compensated for this work (25-30%) and you can see regular feedback through online reviews, it is easier to stay on top of managers handling this property.
Managing your own local LTR - Moderate Effort. Taking this obligation on yourself cuts out a layer of expense but adds a minor job to your regular tasks. The amount of effort will depend on two factors: (1) tenant selection - higher quality tenants cause less wear and tear on the property and, as a result, require less handling. (2) proper care and maintenance - keep everything in good repair, and you will get fewer calls late at night for a clogged drain or leaky pipe.
Managing your own local STR - High Effort. Running a Short Term Rental well means responding quickly to your guests and ensuring turnovers are completed without mistakes. Staffing for or doing the housekeeping day in and day out is a monumental task. The money can be great, but so is the effort required to pull it off successfully.
Managing your own long-distance LTR - Moderate to High Effort. When managing a long-term rental long distance yourself, you must have a team set up locally you can count on. That may include a real estate agent, lawyer, multi-talented handyman or trade specialists, and gardener. Once the team is in place, if it is a good one, your effort may only be moderate, but any weak links can find you taking a long drive or flight to deal with problems they can't or won't deal with.
Managing your own long-distance STR - High Effort. Consider all the challenges I've laid out for managing your long-term rental and multiply them by at least two. Add housekeeping to the list and lots of them to back up those that call in sick from time to time. Also, consider adding external on-site cameras so you can remotely see what activity is happening during turnovers to ensure no hitches.
How Many Obligations do You Want to Take On?
Real Estate investing can come in differing gradients of obligation. This differs from effort in so much as this is about how directly responsible you want to be for the overall results of the investment:
Investing as a minority interest in a general partnership - Low Obligation. Here you are placing your trust in the ability of the managing partner(s) to operate the property or portfolio of properties in a manner conducive to shared profits for many investors. Your obligation is your share of the investment, but your earnings will be less than those of the managing partners.
Investing as part of a joint venture - Low to High Obligation. Joint ventures are smaller than general partnerships, involving two or three partners. Like a general partnership, they can vary in obligation depending on what you bring to the table. If it is only money, your obligation may be minimal. If you bring expertise in addition to cash, you may find yourself doing more work than your partner(s). Hopefully, with somewhat higher compensation for the funds invested.
Investing as a sole proprietor - High Obligation. It's all you, baby! There is no one else to deal with the financing, lining up a property manager, or contractors to come out and complete needed work at the property. The most significant advantage of this approach is having the most control over your investment. Decision-making concerning the property is yours exclusively. As a married person, you might never truly be a sole proprietor. Make sure your spouse is on the same page before proceeding with a real estate acquisition or attempting to avoid the conflict of a joint venture will fail.
What is Your Risk Tolerance?
Finally, Real Estate investing can come in various gradients of risk. In any of these scenarios, you can elect to manage the property on your own or have someone do it for you. That choice will increase operating costs, but depending on your experience managing properties (or lack thereof) as compared to a professional and competent property manager, the resultant risk could be higher or lower with either choice. This list speaks only to the comparative risk of the type of property acquired:
Paying cash for a ready-to-rent property - Low Risk. The work to get it rent-ready is done. Always have a third-party inspector confirm that for you. Once verified, with no loans on the property, you can rent the property at levels below market, always have your pick of tenants, and still generate a profit. While you are not leveraging your money, cash-on-cash returns will be lower for the investment. However, this approach can be as good as it gets in uncertain times.
Borrowing for a ready-to-rent property - Low to Moderate Risk. Your main limitation here is needing to cash flow to cover your costs. A loan is likely to be your biggest hurdle, and if rents drop (which they rarely do), you could become cash flow negative for a time.
Paying cash for a fixer-upper to rent - Low to Moderate Risk. The primary risk in paying cash for a fixer-upper is discovering a significant issue with the property. Unexpected repairs can come with higher labor and material costs than expected, eroding the hoped-for returns on the property.
Paying cash to fix and flip - Moderate Risk. You've left the income zone and stepped into the speculation zone. As a cash buyer of a fixer-upper, you stand to lose some portion of the capital invested. If you aren't going for income, it will matter more how well you've vetted the profit opportunity of the property.
Borrowing for a fixer-upper to rent - High Risk. When borrowing for a fixer-upper, the first issue is any loans will be on less attractive terms than traditional lenders offer. Higher interest rates, origination fees, shorter terms, balloon payments, there is much not to like about borrowing for this purpose. Do your homework and then some before acquiring properties under these conditions.
Borrowing to fix and flip - Very High Risk. I cannot recommend this approach to anyone in the present market. This is a speculative profit play made harder by the unattractive terms of any loans to acquire the property and still complicated by the unknowns of a fixer-upper. Some score big on such business, but they are rapidly dwindling in number as housing prices have flagged.
Paying cash for an undeveloped property - Moderate Risk. The Beauty of paying cash is nobody knocking on your door in search of payment unless you count the ever-present tax collector. Remember, the undeveloped property will not generate income. This is a purely speculative play until you necessarily spend more money to put the property into service or sell it to someone else.
Borrowing for an undeveloped property - High Risk. Pure speculation unless you have a good plan to put it to work, and the borrowing covers that plan. Until you put a shovel into the dirt, the potential for surprises will always lurk beneath the soil.
Finding the Right Real Estate Investing Opportunity For You
With the outline above, you can dial into what kind of investment will work for you. In 2009, I was a newbie investor with moderate funds, willing to put in some elbow grease and a moderate risk appetite. Since housing prices where I lived didn't pencil out for good cash flow, I decided to buy ready-to-rent long-term rentals long distance. The risk of fixing them up was removed, and I hired a property manager to do the heavy lifting. It was this experience that taught me about the need to manage the manager. For a time, until finding a better property manager, it was like a second job. Live and learn! Would I do it again? Certainly, but perhaps after reading this blog first. 😁
Let's look at a few other scenarios to show how there is a Real Estate investment opportunity for every first-timer:
Scenario #1: Newbie RE investor with limited funds (less than $5,000), not wanting to put in much effort, and with a moderate tolerance for risk: Suitable investments for this person would include REITs and REIT ETFs
Scenario #2: Newbie RE investor with moderate funds ($25,000 to $100,000), willing to put in some effort but with low tolerance for risk: Suitable investments for this person would include REITs, REIT ETFs, Crowdfunding Loans, Tax Liens, RE Partnership and paying cash for a Condo or Single Family Home in a lower cost part of the country.
Scenario #3: Newbie RE investor with substantive funds (above $100,000), willing to put in significant effort and a high tolerance for risk: For this person, the world is their oyster! As a newbie, I'd avoid self-managing a long-distance Short Term Rental or speculating on fix-and-flips or undeveloped property. Better for this person to find a mentor to advise them if they choose to dive into higher-risk opportunities.
So now the ball is in your court. Suitable options exist for everyone. The only real barrier to investing in Real Estate is you!
Until next time, may peace and prosperity be with you.
The Natural Economist
Next up: A deeper dive into investing in Timeshares…it may be the best worst investment you ever make.