“Step right up! Come one, come all! Today we’re offering an opportunity to quadruple your money!”
Would you take this deal?
After all, who wouldn’t want a 300% profit on their investment?
So, would you?
The correct answer is… it depends.
It depends? On what?
I’m glad you asked. It depends on the risk involved. And the holding period.
Knowing the risks
If you could immediately quadruple your investment with zero risk, of course you would make that investment.
But what if this “opportunity” carried a million to one odds? Then this would be called the state lottery, and I’m guessing virtually none of you indulge yourself at that casino on a regular basis.
While we can easily see through the risk and fallacy of a speculation like that, I’m afraid that many of us don’t know how to critically evaluate the risks of alternative assets. This is the purpose of this post.
Note that there are many alternative investments: art, ATMs, music royalties, oil, and more. This article is only about real estate since that is the arena of my experience.
Why is evaluating risk so difficult?
Risk is an inherent problem when investing in alternative assets. Risk is often a result of insufficient information. Investing in stock and bond markets carry risk, too, but their popularity and widespread adaptation result in thousands (or even millions) of eyeballs on the same information. And a century of regulations purportedly result in greater transparency and reporting standards that allow comparison across thousands of publicly traded options.
Not so with most real estate and other alternative investments. The inherent fragmentation of these asset types results in heightened difficulty when evaluating their relative risks. The lack of available data, systematic reporting, and studies can heighten the risk of the unknown. And the risk can go up even more at the individual asset level.
As inferred with the example that opened this post, risk should be evaluated in conjunction with returns. The following chart explores one astute investor’s attempt to quantify and evaluate these risks and returns.
This chart was created by BiggerPockets member Christine Kwasny. Christine is a passive investor with my firm, and she reached out to me late last year to discuss the topic of risk evaluation for alternative assets. This chart is based on her own research and opinions – feel free to differ with her.
Christine was puzzled, as I sometimes am, by the question of why investors often favor stocks, even in the face of widespread evidence that supports investing in real estate.
She said, “Strangely, despite glowing reviews of the many benefits of real estate investing, it seems many investors still lean heavily on stocks versus alternative investments within their overall asset portfolio, and I can’t determine why. Perhaps they don’t understand the relative risk of stocks versus real estate. Perhaps they desire liquidity. Or maybe they can’t create a diversified portfolio of syndicated deals, as one can with stock index funds that would greatly mitigate one’s overall risk.”
How to understand this chart
The Y-axis (vertical) shows her take on the relative nonquantified risk of an investment in each asset type. The highest risk is at the top. She ranks investing in an individual project, company, or stock in this category. She ranks bond index funds at the bottom, as a very low risk investment.
The X-axis (horizontal) evaluates the 50-year average and range of returns for each asset type. Cash shows the lowest average return at a few percent, while Christine ranks syndicated growth portfolios at the top of investments with a quantified range, estimating returns of 15% to 20%.
This top-ranked asset type is perhaps the hardest to understand. (And please note this is of particular interest to me since this is what my firm does.)
She defined the syndicated growth portfolio this way: “I consider an investor’s allocations to a ‘syndication portfolio’ as investments spread across many well-vetted projects that minimize direct project risk, and provides strong diversification to further dilute risk exposure…”
Why is this chart great?
I love this chart. Christine has dug deep to pull together the data points on this chart, and I wanted to get this in front of you. Note that this chart doesn’t prove that you need to invest in real estate. (That’s not the point.) But it does give you a grid to compare potential outcomes in light of risk and return.
It’s notable that Christine has two real estate investment types on this chart. She ranks self-owned real estate as a lower-risk asset than syndicated growth portfolios. But this asset type also shows a lower average return (at about 5 to 15 percent) than syndicated portfolios (at about 15 to 20 percent). This is commensurate with our discussion on the nature of risk and return.
Factoring in the time value of money
As someone who has invested in both of these real estate types, I want to add a comment. The often-significant expenditure of time and hassle in managing self-owned real estate needs to be factored into the equation. Owning and managing properties is a hassle. And that adds to the risk.
For most passive investors in syndicated real estate, however, this is one way it shines, and in my mind, reduces the relative risk. Before the selection of either a property or syndication, there is a lot of analysis and research involved.
But after the decision is made, a syndication investor’s effort is typically limited to their walk to the mailbox to get their monthly or quarterly check. This is a significant advantage for investors who have busy lives, demanding jobs, or enjoyable retirements.
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How experience reduces risk
One way to reduce risk is to gain knowledge and experience. When I did my first flip in 2000, I didn’t know what I didn’t know. But after flipping dozens of homes in the next several years, and losing money on some, I had a wealth of information on how to evaluate a deal.
Two decades later, I’m in the same boat as I evaluate syndicators and assets on behalf of accredited investors. The knowledge our team has gained helps us make better decisions—which reduces the risk.
For example, I learned firsthand about the risk caused by competition from a nearby ground-up self-storage project from an investment near Tampa. On a subsequent due diligence trip for a different investment, I went to the local planning and zoning commission armed with the right questions. That’s how I learned about two new facilities in the works and canceled a $2 million investment in that project.
In your case, you’ll find that gaining a depth of knowledge about a topic will reduce your risk and increase returns. This is one reason Warren Buffett spends up to eight hours daily reading. His massive knowledge allows him to sniff out great deals that others miss. And his investors are the beneficiaries.
Before we wrap up this discussion, let’s look at one more helpful chart. This one, assembled by Thomson Reuters, only includes core commercial real estate, not residential. It compares the annualized returns (Y-axis) versus risk (X-axis) across major asset classes. The goal is to be as far to the left as possible (low standard deviation/risk) and as high as possible (high return).
Check it out…
As you can see, core commercial real estate has by far the highest return per unit of risk of all these asset classes (according to this source for this time period). Perhaps that’s why almost all of the Forbes 400, the wealthiest individuals in America, invest in commercial real estate.
So, what do these charts mean to you, Mr. or Mrs. Investor?
These charts provide a reminder and a calling to carefully evaluate both risk and return for every asset class and deal you invest your time and money in. And these charts can help you evaluate where to get started if that’s where you are.
And I view this as a call for focus. Since it’s impossible for you to have deep knowledge of all these asset classes, I recommend you pick one, or more likely a subset of one. And go deep on that. Learn all you can, do all you can, and become a subject matter expert.
If you’re already making a good living in your occupation, consider outsourcing your real estate investments or partnering with someone who is obsessed with it as their full-time gig. Residential investors can “passively” invest through private lending in notes, hard money funds, flips, and more. Commercial investors can passively invest in syndications or funds.
As a member of the BiggerPockets community, you’re in the best place on the planet to go deep in real estate and to connect with like-minded active and passive investors who can help you along the path to your goal.