What is risk?
According to the modern financial theory - Risk can be divided into two elements:
- systematic risk = market-based
- unsystematic risk = industry or business based
The differentiation is straightforward and makes sense.
An investment’s exposure to market risk is measured in a concept called beta, which has been taught in B schools for a long time.
Put simply, the β of investment measures its exposure to market risk by indicating whether it’s more or less sensitive than the market.
In short, it represents what we have heard a million times
High risk = high reward or Low risk = Low Reward
Taking an example of stocks investing so more people can relate, it means a highly unstable stock should mean a high rate of return – which in turn means that a business with a highly unstable price would also have a very low intrinsic value (risk = reward, high market-driven price volatility = low intrinsic value).
Why I think Beta does not make sense?!
Firstly, beta uses market prices to measure risk – instead of core business fundamentals.
The market often has nothing to do with the underlying economics of a business, property, or real estate portfolio. So how can the market tell us anything about the riskiness?
Secondly, the theory says that a stock with significant price drops(i.e., a high beta stock) is riskier than one whose price doesn't drop by that much.
But let's say, if the underlying fiscals of a business with $100 a share haven’t changed, do we just say that business suddenly becomes riskier if its price drops to $60?
In fact, the stock now arguably has a higher safety margin and should be considered less risky.
Thirdly, in real estate investing, Beta can fail to account for investors' influence on the investment.
Investors have direct access to the economics of a real estate investment. i.e, You can increase rents(= revenue), decrease expenses, improve management, etc
These are all the reasons why beta theory becomes blurry and why I subscribe to value investing methods as championed by Buffet, Munger, and others, where instead of using market prices to measure risk, you use core business fundamentals to make investment decisions.
Value investors buy dollar bills for $0.60 and would be even happier if we could buy a dollar bill for $0.40.
Buffett also had a thing or two to say about beta in this article The Superinvestors of Graham-and-Doddsville.
So what is risk per Buffett?
To Buffett, risk has zero correlation with the market. Risk simply means the chances of you losing your initial investment. If Buffett is likely to lose money on an investment, he just doesn’t invest.
I love real estate because risk management is a function of your knowledge and implementation as opposed to stocks, where others drive your investment.
This is all to say; I implement specific business and risk management fundamentals to drive my acquisition strategy and downstream management of my assets, making them agnostic to what is going on in the market.
With my desired acquisition velocity, I needed to be extra careful to protect my blind spots while advancing fast.
My methodology was simple: research the triumphs and failures of the most successful real estate investors who have gone through multiple cycles.
I then extracted commonalities from these seasoned investors to build a foundation.
To further strengthen it, I then use macro business fundamentals to spot any white spaces because the world is ever-changing, and some macros might not have existed in the past years.
Anyhow, let’s dive into the framework and how I handle different types of risks.
The economy is like a sea; no one knows when the choppy waters will arrive or how severe they will be. The only thing we can do now is build a decent boat or, better yet, a submarine.
So, here's how I handle it:
- Buy for cash flow - if extrinsic factors press down your rents or increase expenses(eg - in inflationary periods), having cash flow upfront prevents you from going negative = preventing financial burden.
- Get long-term fixed loans - Fixed rate for long term means, the debt payments will not spike on you.
- Have cash reserves for 6 months per property in the absolute worst case scenario.
I've seen a lot of lists showing fantastic markets to invest in, but keep in mind that it's not about how good a market is but how it will be in the event of a bear market. So don't just buy because the cash flow is good. You want to make to mitigate the future.
This is how I go about it.
- Historical performance during the dips: Looking at the two images below, it appears to me that the Rochester market has never recovered from past losses and is continuously sinking. Huntsville, on the other hand, is experiencing strong job growth.
(If you are not seeing the images below, please load them in your email client)
Surprisingly, Rochester is frequently mentioned as a top location in articles since rents have increased, and there is now good cash flow. And it might work for many people if they have a short-term (one or two-year) hold period. But that worries me in the long run.
- Buy in areas of population and job growth: Similarly, rising population equals increased demand for homes, which means rents will remain stable or continue to grow.
Avoid oversupplied locations: You want to ensure that supply does not exceed demand, or rents will be pushed down. You can be more specific and look at the permits issued, but I find that looking at the rental demand growth over the last few years is a fair proxy.
If rents are rising quickly, it's a good sign that demand is outpacing supply. Some people like to look at vacancy rates, unemployment rates, and days on the market, but the rental growth indicator, in my opinion, says it all.
- The market should have at least five different industries: To avoid a situation like Detroit, stay away from areas with only one primary industry. As an extra precaution, ensure no industry or company owns more than 20% of the job market. I also try to choose regions where healthcare is the most important industry since healthcare is always in demand.
- Landlord-friendly: I stay away from states like New York, where tenants can reside indefinitely without paying rent.
- A Great Property Manager: PMs can make or break your portfolio, and most of them excel at being poor. Not all of them are incompetent, but many of them are. The PM business model is, in fact, fundamentally defective. The incentives are not aligned with the investors when they charge x percent per month. They profit from your losses, such as charging for leasing or adding markups to maintenance services.
Many people aren't as concerned about this as they are about the main market, but I believe it adds an added degree of security. I strive to identify the sweet locations where I can rent to decent tenants.
The following are two good indicators:
- Good school districts or areas with a thriving social scene.
- Convenient to highways, stores, supermarkets etc- a plus!
However, remember that the higher the quality of the tenants, the lower the cash flow. My trick is spot-checking returns in good school districts with my Chrome extension, Ostrich.
It allows me to be 80% efficient in locating micro-areas with significant revenue flow while maintaining tenant quality.
I arrange professional home inspections once the offer is approved to uncover significant faults in the property upfront. I would never buy a property without a home inspection.
I just let go of a home with a 17 percent cash-on-cash return because the seller refused to allow an examination. I also limit ongoing dangers after closing by conducting recurring inspections every six months.
Spend $100 now to save $10,000 afterward.
A terrific tenant means everything to me. I'd rather wait a little longer for the good tenant than risk putting in the incorrect one who might not pay.
The following are the checks:
- Professional background checks: It displays eviction, credit score, and financial history, informing us about payment patterns and abnormalities. For this, I use Zillow checks.
- Have suitable leases in place: As an investor, this is your most important document. Consider all scenarios where it can go wrong and include provisions. I paid a couple of thousand dollars to vet it by several lawyers.
- Due diligence on documents: Check the tenant's rent payment history and employment. Obtain bank statements and contact past employers to do so.
- Comply with the Fair Housing Laws: This is a deciding element. Knowing the laws will help you avoid being sued by the tenant. If you have a property manager, they will or should be aware of this, but if you are self-managing and interacting with renters, it is crucial to choose your words carefully.
Legal & Tax Risks
- Best insurance practices: It should go without saying that you want the proper insurance since the downside is enormous. You have people staying in your investment. Consider Umbrella insurance in addition to your landlord insurance if you don't establish an LLC.
- Multi-layer asset protection: I am layers removed from potential lawsuits. 1 - I have every property in an LLC 2 - Then, I have my LLC in a holding LLC 3 - And then my Holding LLC is in a favorable state
I also follow best practices for LLCs, or they will be useless. Look up "piercing the corporate veil+LLC"
- Anonymity: You can build sophisticated systems, but most lawyers will tell you that anonymity is the best defense. There is a whole industry around lawyers targeting property owners.
That’s a wrap and you made it 🙌
Seth Klarman, a billionaire hedge fund manager, sums up my sentiment on risk very nicely -
“Investors should always remember that the most important metric is not the returns achieved, but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night.”
Thank you once again. I really do appreciate people reading.