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6 Principles for Investing in Real Estate That Will Make You Rich (Slowly)
I get questions from investors regularly that sound more or less like this:
- Should I buy this rental property?
- Is this a good buy at this price?
- Would you still buy this property in light of COVID-19?
All good questions. As we all know there is no sure fire way to determine whether a potential real estate purchase will turn out well. That’s why I titled my book Mastering the Art of Commercial Real Estate Investing. Investing in real estate really is more of an art than it is a science. That said, I believe if you apply the six principles I mention below, you have a much higher probability of investing successfully.
These principles I’m about to share with you help thwart two counter-productive emotions that if not resisted will likely torpedo your chances of being a successful real estate investor. What are these two emotions? Fear and greed.
Fear & Greed
Fear prevents us from buying at the bottom of the real estate cycle. It causes the average investor to sit on the sidelines while all the good investment opportunities are snatched up by seasoned real estate investors. Fear also urges us to sell after the market plunges which absolutely makes no sense.
Greed, on the other hand, urges us to buy when the market is overheated, typically at or close to the top of the real estate cycle. In my opinion the fear of missing out (FOMO) has done far more harm than any other factor affecting real estate investment returns. As the saying goes, “You make your money when you buy,” is very true. And if you buy an overpriced property, it is highly unlikely that it will ever yield a reasonable cash-on-cash return.
Warren Buffett said it best when he said, “The most important quality for an investor is temperament, not intellect.”
Six Principles for RE Investing
If you follow these six real estate investing principles, you should be able to protect your real estate investments from the common pitfalls that can adversely impact your returns.
James Montier, the author of the well-known book The Little Book of Behavioral Investing, wrote a white paper called “The Seven Immutable Laws of Investing.” In his thesis, he identifies seven principles for sensible investing in the stock or bond markets. I was intrigued by the title, so I read the article and somewhere along the way realized that six of these seven “immutable laws of investing” also apply to investing in commercial real estate.
Always insist on a margin of safety
In other words, the goal is not to buy at fair market value but to purchase with a margin of safety because property performance, market conditions, and the like may not live up to expectations. This means finding a property that is underperforming in the market, but, with a change in ownership, the property’s performance will turn around.
This time is never different
The four most dangerous words in investing are “This time is different.” The dot.com bubble that occurred from 1999 to 2001 is a perfect example. Investors were buying stock in companies that hadn’t turned a profit because they expected these companies would become the next Google or Amazon.com. Stock prices soared, and even though it made no logical sense, the contention that was bandied about was “this time is different.” The same was true of real estate prior to the Great Recession. Many people believed that house prices could never go down, that we had hit a new permanent high. In both examples, however, a speculative fever resulted in a bubble that caused stocks and house prices to plummet in value.
Whenever someone starts saying, “This time it’s different,” get out of that investment as quickly as you can.
Be patient and wait for the fat pitch
Mr. Montier states in his white paper: “Patience is integral to any value-based approach on many levels. … However patience is in rare supply.” In commercial real estate, there is a time to wait and a time to act. When things go bad, like what occurred after the Great Recession, the tendency is to dump our rental properties as quickly as we can. But the prudent thing to do is wait.
Most investors suffer from an “action bias”—a desire to do something. But often the best thing to do is to stand at the plate and wait for the “fat pitch.” A “fat pitch” is a baseball analogy where the pitcher is behind in the count and his next pitch needs to be a strike or he’s walking the batter. He knows that, and more importantly the batter knows that. So the batter just patiently waits for that fat pitch that he can hit for extra bases. Likewise, real estate investors need to be patient as they look for those buying opportunities that will be home runs for them.
Humans are prone to the herd instinct. Investors are often no exception. When everyone is buying, investors typically buy; when everyone is selling, they sell.
In 2009, during the worst of the recession, a group of us put under contract an apartment that had been foreclosed on by the lender. It took me six months to find a lender who would finance this property. Today, the property is by far my best investment. The value has shot up dramatically, and the property is truly a cash cow.
Are all the bargains gone in a high-priced market? I don’t believe so, but finding them is certainly more challenging. Anytime can be a good time to buy. But if you go along with the herd and sit on the sidelines with them, you may miss out on some of the best deals to be had.
Be leery of leverage
As an investor, I’m always trying to improve my property’s cash-on-cash return. Adding modest amounts of debt to be paid from the property’s cash flow is the easiest way to substantially improve its cash-on-cash return. Why? As you add debt, you reduce the equity invested in the property. Counterbalancing reduced equity is an incremental reduction in the property’s cashflow after debt service resulting from the monthly mortgage payment modestly increasing.
So leverage can positively influence the property’s cash-on-cash return. But there is a limit, and we investor’s need to be very leery of leveraging our properties too much. In many instances, those owners with properties that were over-leveraged in 2008 paid the ultimate price—the loss of their properties. Those homeowners prior to the Great Recession who used their homes as ATM machines learned the hard way too. Seven million homeowners lost their homes to foreclosure during the last recession.
Never invest in something you don’t understand
This is just plain old common sense. All too often, I have found myself talking with commercial real estate investors who are clueless about their property holdings. This puts them at the mercy of their real estate advisors. Many times these advisors have a different agenda than the owner. The owner, not knowing the fundamentals of CRE, is unaware of the conflict of interest. It’s a simple truth: If you don’t understand the investment concept, then you shouldn’t be investing in it.
As long as you follow these six fundamental principles of CRE investing, you can be confident you’re investing wisely. Otherwise, you can go through life being part of the herd, following the latest trend only to be sadly mistaken when the real estate market turns.
Those are my thoughts. I welcome yours. What real estate investing principles do you live by?