What a Failed Hedge Fund Can Teach Us About Risk in Real Estate
Some of you may or may not have heard of Long Term Capital Management, a hedge fund that imploded way back in 1998 despite its previous successes as well as having pretty much the smartest guys in finance in the room. They pioneered the Black-Scholes options model in which they used extensively in their investment for profits. In their eyes, the model allowed them to get sure profits. There is no risk, they said! They thought they hedged them all.
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With the idea that there were no risks in their investments, they leveraged their investments to the hilt to magnify their returns. While that strategy had worked for awhile, no one expected that the Russians defaulting on their debt in 1998 could have caused a catastrophic consequence to their investment.
How Does This Relate to Real Estate?
For the most part, we are investing in real estate with leverage as well. We have many people who advocate investing with no money down methods. We have many people using mortgages like FHA to get into investing with little down. As much as we wished to own real estate outright, we have been using debt to begin investing. And repaying debts, unlike tenants paying rent, has to be done every month.
Yet when we purchase correctly, we should be getting a steady stream of income every month. Some of you may be getting $200 a month in positive cash flow; others may get $400 a month. It is certainly important to get positive cash flow every month, as it shows that you are better positioned to hold the investment in the long run. So if every property we acquire has positive cash flow, isn’t it better to acquire as many as we can?
What the Long Term Management Capital guys failed to price in were “fat tail” events. In other words, most events fall like a bell curve, and chances are that most things happen in a normal range, but on the extreme tail of the curve, really bad things can happen or really good things can happen. For those guys, they thought the probability of losing everything was really, really, really close to zero.
As real estate investors, do you often think about what’s the worst case scenario for you? If you own one investment home, you know that the house could go vacant, tenants can stop paying rent — or worse, your AC or water heater can break down. You are aware that you do need some cash reserves to make it work.
With Additional Properties Comes Additional Risk
But what happens when you own two homes? What if BOTH houses go vacant, tenants stop paying rent, AC and water heater break down? Okay, you need to account for some additional risks, right? Chances are, you might not keep the reserves required for both properties because you think both homes getting the worst scenario is not that likely. You may be right.
But what happens when you get a third property? Chances that all three of them getting the worst case scenario is even unlikelier, right? Isn’t where that benefit of diversification comes in? If one house goes vacant, we’ve got the two other houses working for us, right? Then shouldn’t we get more houses? The more we have the more diversified we are.
Are You Ready for the Worst Case Scenario?
So now we are starting to think like those Long Term Capital Management guys, aren’t we? The truth is, there is diversification and we do get to benefit from that. But on the other hand, we are increasing our magnitude of loss in the case that happens — despite the fact that we are lowering the probability of that particular magnitude of loss. Think of it like a lottery in reverse. Every day that one dollar goes into buying a ticket to your total demise (you have to pay out that lottery).
The chances of that happening is super, super small. But what if that happens? Are you prepared?
While I’m definitely not discouraging people from buying more investment properties, I’m advocating the idea that one should prepare even more reserves as one acquires additional properties. Those reserves should not be proportional to the increasing number of houses. It should be a bit more exponential. That way, you are better prepared for that fat tail event, or black swan, or whatever people like to call it nowadays.
What do you do to prepare for the “fat tail” events? If you own multiple properties, what steps do you take to protect yourself against worst case scenarios?
Leave a comment, and let’s chat!