“[N]ot everything that can be counted counts, and not everything that counts can be counted.”
—William Bruce Cameron
I was talking to a group of real estate investors at an investor meetup. A few of them purchased buy and hold properties in the middle of the Great Recession. They focused on the numbers and closed a buy and hold deal with a potential 25 percent cash-on-cash return.
Things were going well for a time, but as soon as the market recovered, vacancies began to rise.
Related: How to Calculate Cash-on-Cash Return
Why did the vacancies increase?
The tenants lived there due to the recession. As soon as their incomes rose, they left ASAP. As a result, the investors dealt with frequent tenant churn, theft, and vacancies. Over time, the properties turned into huge liabilities.
The investors had a golden opportunity to purchase quality properties at a discount, but instead they picked losers. How did this happen?
More than likely, they were relying too heavily on metrics.
Why Do We Overemphasize Metrics?
Occasionally I watch the show “American Greed.” I cringe when I see these con men prey on poor investors.
I thought it was the hucksters’ way with words and charm that allowed them to steal people’s money. But actually, that wasn’t it. The cons told the investors what they wanted to hear: “You can make a quick buck by investing in X.”
The lure of a fat return quenches our collective thirst for money.
It happens to most of us. We see a property and think to ourselves, “Yes, it’s in a shady neighborhood; yes, it was constructed in 1910; and yes, it looks like crap. But look at the 15 percent cash-on-cash return.”
So, we pull the trigger and then decide which Caribbean Island we will retire on.
Sadly, that’s where most real estate investors fail. They focus only on the numbers and neglect the factors that drive the numbers, which results in the utter failure of their investment.
How Can Metrics Hurt Our Investments?
Donald T. Campbell created numerous works in the field of social science and psychology. Unfortunately, most of his work isn’t known in the investment community, so I took one of his laws and put an investor’s spin on it.
A Campbell-Inspired Real Estate Law:
“If real estate investment metrics (e.g. return on investment, cash-on-cash return, etc.) are used as the primary reason for investment decisions, odds are the investment will fail.”
Numbers are important, but they’re not as important as the investment vehicle generating them.
Metrics are tools. Similar to a compass, they can point you north; however, they won’t warn you about the canyon ahead.
Post-purchase, if we continue to heavily focus only on the numbers, we will make poor decisions in the short term that can potentially cause long-term losses and more substantial costs.
If we make decisions solely on metrics—such as pushing off a major structural repair or cutting corners with cheap, shoddy work in order to keep our numbers in line with our projections—eventually we will decrease the value of the asset and reduce its ability to generate cash flow.
How to Pull Yourself Out of the Metrics Trap
Investors should instead focus on three factors that lend themselves to a healthy real estate investment.
Consider the following when sizing up a neighborhood:
- Is the neighborhood where the property is located a place people would want to raise a family?
- If money wasn’t an issue, would people choose to live in this neighborhood?
- Is this neighborhood within the path of economic development?
- Are new businesses being started in the area?
- How are the schools?
- Are people forced to live here or are they choosing to live here?
The physical attributes of property include the floor plan, square footage, lot size, and so on.
Ask yourself these questions:
- Which characteristics of this property will allow you to charge above-market rents?
- Is the floor plan larger than comparable properties in the area?
Think about the following with regard to tenants:
- What type of tenants will be attracted to this property?
- Will people with steady incomes, great credit, and clean tenant history want to live in this property?
So, What’s the Best Way to Use Metrics?
We need to start respecting metrics as tools that can help us make decisions as opposed to being the sole determinant of decisions.
Optimally, metrics should be used as a status report on how things are going. They’re a tool for tracking trends and discovering relationships between factors, which can then be considered as part of the overall decision-making process.
How do you prevent yourself from being blinded by the numbers?
Leave a comment below!
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.