For most people, when they invest in real estate, they will get an average return. I would consider average usually being somewhere between 4-10% on their initial investment. Most like to think when they walk into an investment, the returns are going to be much higher. Perhaps in the first couple of months or years they are higher, but then a sprinkler system breaks, followed by a water heater and then some carpet needs replaced and 5 years down the road, the roof had to be redone and all of a sudden, what was supposed to be a 15% ROI has now become the 2.5% ROI.
A quick side note- If you're thinking that 2.5% is still an okay return, when you consider that inflation averages about 3.1% per year, 2.5% only slows the bleeding. Ironically, a lot of people don't see inflation as a real thing that impacts them. As a case in point, think back about 20 years, what did the average candy bar cost back then? Usually if you walked into a small neighborhood grocery store, unless you went king size or bulk, it was about 50 cents per bar. Now at the same type of store it's about 80, which is about 2.4% inflation per year. Gasoline 20 years ago was about $1/gallon +/-. Now it's about $3.79. This is about 6.9% inflation per year over 20 years. We buy a lot more gasoline than we buy candy bars, so the weighted average is huge. Who would have thought back then that we would be paying more now for a gallon of gas than for a gallon of milk? Averaging all the increases in commodities over the 20 years comes out to a little over 3%/year average on everything. Some things have actually come down in price as well, which is what holds this average down. Look at the technology sector for a case in point. We buy more tech devices these days, but for item type and quality they are much cheaper than what we used to pay. For most of us, our smart phone is way more powerful than our best computer in the 90’s. These are things that all of us buy. My point is that your cost of living is going up every year, so unless you have all the funds you'll need for the rest of your life, don't settle for a return under or at the rate of inflation. (This is why bank CD’s are a terrible investment).
So back to the original point of why investments don't turn out how we expected them to and why the majority of investors will only get average returns.
As the first key and I apologize as I’ve said this many times in past blogs, the problem is almost never the actual investment property itself. It was failing to consider future expenditures or forecasting higher than reasonable income in the original analysis over the expected hold time that eventually will cause the demise of most spectacular returns. Poor management leading to high costs and vacancies can take a toll as well.
The second is that in order to find the truly spectacular deals, you have to be in the right place at the right time, under the right circumstances. As a casual investor, working another job or keeping occupied with other ventures, to be frank- you’re looking at very low odds to find the sweet deal. I would guess that 99% of the amazing investment deals go to those who are hunting, have real estate connections all over and are constantly putting themselves in the path of potential investments. In other words, the professional real estate investor buys the cake before it ever makes it to the display case. They find the 12% cap rate acquisition, usually fix the problems and then sell it to another less aggressive investor for a 7.5% cap rate, netting the difference of a 4.5% equivalent cap rate in equity. This is how most real estate developers make their money as well.
To be fair, this is perfectly justified. They’ve taken all the property risk and then turned around and sold the property to an investor that doesn’t want property risk, but is willing to deal with the less risky “market risk” which include vacancy and normal market demand factors.
Because most people are not real estate investment professionals, they won’t find the amazing deals. For this reason I tend to disagree with a lot of the big real estate investment seminars and their “wholesaling” strategies. They tend to give investors unrealistic ambitions given the amount of time and resources they have available to allocate to this strategy. I’ve had a lot of “wholesalers” call me and ask me if they brought me a good deal if I would buy it. I told them that I would be happy to jump on it if they brought me something that was really a good investment. I’ve only once seen anybody actually come back to me with a property and it wasn’t a good deal for him, let alone for me after he added his wholesaling price onto it. His didn’t have a solid analysis foundation, so he really couldn’t tell what was and wasn’t a good deal in the first place. For those not familiar with the term “wholesaling”, it in essence refers to a person finding a property, getting it under contract or option to purchase and then assigning the contract to another investor for a fee. My suspicions are that this is technically violating real estate transaction law as it’s difficult to argue that the fee is not a commission, which would require a real estate broker’s license in most states. Idaho’s real estate commission has said that this type of transaction does require a broker’s license. If you’re looking to try and wholesale a property, perhaps a better strategy would be to find an equity partner and you purchase the property with them. Once you own a percentage of the property, then it is fine for them to buy the remaining equity from you. No state that I know of has laws against the for sale by owner approach.
So now that I’ve put a dampener on all of your ambitions of making huge returns in real estate, you’re asking- is there any way for me, a person that works in a different industry and realistically won’t ever have sufficient time nor interest at becoming a full time investor to make a return of higher than 4-10% on my money? The answer is yes, but not one without some asterisks.
You can either wait for the lucky deal or here is my suggested way to get higher returns on your money.
- Find a full time real estate investor with a proven track record of successful investments and who goes after aggressive deals. Ask if they would be open to you jumping in as a passive, capital partner on some of their deals. Most big investors do use capital partners on a frequent basis.
- Many are going to tell you no, as they will only want to invest with accredited investors (those that make over $250k/year over multiple years or have over $1,000,000 in net worth of investments, not counting their home) This covers the investor from SEC liability when something does go wrong. If they say no, go to the next investor until somebody says yes.
- Know that they are likely going to be investing into some fairly high risk ventures and that there is a chance that you could lose as much as you’ve invested or in some cases, more than you originally invested. Read what they send you. Generally speaking, the higher the rate of return, the higher the probability that something could go wrong.
- You’re not going to get much of a say in the operations of the investment, so be prepared for that. Nor do you want to be too inquisitive as it creates more work for the investors and your constant pestering will likely prevent you from being invited to participate on future deals. Obviously ask questions where you’re not sure if they are being honest, or acting in the partnerships best interest. But on the day to day items, it’s best to stay out of their way and let them do what they do best.
If you don’t feel comfortable with that approach, nor see dedicating yourself full time to the investment world, then it’s time to adjust your investment goals and make them more attainable by being more realistic on your average rate of return needs, aka your discount rate.
If on the other hand you do like the approach and would like to learn more, but aren’t sure where to start, feel free to contact me and I’ll give you more information on people and areas where you could start.
Author: Mark Bitton