I’m fed up. I have been for years, actually. Everywhere I turn, I read and hear from investors obsessed with return on investment (ROI). Or worse, they talk about the internal rate of return (IRR), which less than one in a hundred investors really understand.
This is what drives some into speculative strategies cleverly cloaked as investments. We’ve never seen these successfully build sustainable wealth. More often than not, these speculative strategies lose money.
Speculation vs. Investing
Since I’ve been writing for BiggerPockets, my goal has been to educate investors on the difference between investing and speculating. With that in mind, here’s a look at the difference:
- Investing: When your principal is generally protected, and you’ve got a chance to make a profit.
- Speculating: When your principal is not at all protected, and you’ve got a chance to make a profit.
In short, high-stakes speculating is exciting, while lower-risk investing is relatively boring.
Books are written about speculation. Movies are made, too. Why? Because those “one-in-a-million” stories are exhilarating. Despite the high risk and poor odds, most of us dream about being the exception: “Maybe it will work for me. Maybe I’m the one!”
Stop believing those Hollywood lies. The path to true wealth is boring and far less dramatic than fairy tales.
Speaking of true wealth, have you ever considered what that is? It’s not defined by a Rolex, an exotic sports car, or a mansion on the hill.
True Wealth = Owning Assets that Produce Reliable Cash Flow
The truth is, you won’t obtain true wealth by obsessing over IRRs and clambering for the highest real estate returns any more than you would profit from checking individual stock prices hourly.
If you just want a high return, buy a lottery ticket. Lottery tickets pay the highest returns on the planet. But that’s not a viable investment strategy—ask any broke gambling addict.
If you want reliable investments, focus on risk-adjusted returns.
Here is the definition, according to Investopedia:
“A risk-adjusted return is a calculation of the profit or potential profit from an investment that considers the degree of risk that must be accepted to achieve it. The risk is measured in comparison to that of a virtually risk-free investment—usually U.S. Treasuries.”
There are various methodologies used to calculate risk-adjusted returns for stocks, real estate, and other assets. Unfortunately, I don’t believe any of them adequately measure risk for most investors, especially for real estate investors.
I used to think the Sharpe Ratio did the trick, but Warren Buffett and Stephen Marks convinced me their measurement (standard deviation) was a poor marker for risk.
Rather than theorize about math and statistics, I encourage real estate investors to carefully consider the likelihood that this investment will succeed or fail. Utilize this risk factor in your evaluation and comparison of investment opportunities.
Here are a few of the many, many factors you may want to consider in evaluating risk:
- The experience and team of the operator.
- The operator’s financial skin in the game for this investment.
- The debt (leverage, term, interest rate risk, and more).
- The operator’s operating and/or value-add strategy and execution potential.
- The location (there are a few dozen factors here, including population migration, crime, and more).
- The underwriting model (revenue and expense projections, tax and insurance hikes, and dozens of other factors).
- Macroeconomic and microeconomic factors that could impact the asset’s performance.
- Diversification of risk (this can mean many different things, depending on the deal).
- So much more.
Note that uncovering and evaluating these factors is a matter of thorough due diligence. Do you have the knowledge, tools, experience, and time to get to the bottom of these issues and a hundred more?
It’s a matter of having the courage to not get emotionally attached to the investment during the evaluation process. Emotional engagement causes investors to develop unhealthy biases that skew their thinking and decisions. Confirmation bias will tempt the investor to seek out and heavily weigh the evidence that supports their desire and to ignore contrary evidence.
You will want to compare the resulting projected risk-adjusted return to other potential investments available. Many investors compare their opportunities to the “risk-free rate” generated by U.S. Treasuries.
At the time of this writing, that rate is more appealing than it’s been for many years. Low rate or high, the return offered by Treasuries hasn’t stopped Warren Buffett from parking over $100 billion in cash in these instruments for over five years and counting.
WWBD? (What Would Buffett Do?) An Application of Risk-Adjusted Return
In the most ominous weeks of the 2008 financial crisis, Warren Buffett invested $5 billion in Goldman Sachs as its share price was hurtling toward zero.
But he didn’t invest in common equity or debt. He invested in preferred equity—and created a lot of wealth for both himself and his investors.
In the spirit of Buffett, we’ve been discussing preferred equity investments for commercial real estate assets to create theoretically higher risk-adjusted returns for investors.
It may not be 2008, but we think the current economic storm warrants similar out-of-the-box thinking. And I think preferred equity provides investors with a theoretically safer position in the capital stack, with contractual cash flow and upside, in times like this.
A more protected position in the capital stack, contractual returns from day one, management controls, forced sale rights, personal guarantees, cash management, and reserves are some of the factors that potentially reduce risk for many preferred equity investments. This is how our team is applying risk adjustments to our portfolio in the current environment.
Ready to succeed in real estate investing? Create a free BiggerPockets account to learn about investment strategies; ask questions and get answers from our community of +2 million members; connect with investor-friendly agents; and so much more.
*All investments are subject to risks, including the loss of all principal invested. Past performance is no guarantee of future returns, and the investment objectives of WREIF may not be achieved. Investors should consider the investment objectives, risks, charges, and expenses carefully before investing. For a prospectus or a summary prospectus with this and other information about the Fund, please call (800) 844-2188 or visit the Fund’s website, wellingscapital.com. Read the prospectus carefully before investing.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.