What a Failed Hedge Fund Can Teach Us About Risk in Real Estate

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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.

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.

Related: 3 Types of Risks Real Estate Investors Regularly Take

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.

Related: What Property Owners and Managers Need to Know about Risk Management

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!

About Author

Leon Yang

Leon Yang is an active real estate investor in Las Vegas. He is a buy and hold guy who also likes to flip from time to time. His main passion is to traveling to the less traveled places and inspiring others to become financially independent through real estate.

11 Comments

  1. Stephen S.

    What I do now is to maintain a large invested-cash fund. It generates a nice return while I wait for a disaster and it can be converted into un-invested cash in a few hours. But that is not what I always did. And it’s probably not imediately practical solution for many of the people participating in this forum.

    When I was younger / starting out I essentially ‘played the odds’. Yes; there is always risk – no question about that. But assessing the likely-risk is a very important part of it. Bad things Can happen. Like an earthquake or sinkhole could swallow up my house. Or I could be struck by lightning. Or maybe kidnapped by malevolent gypsies. Because after all; there are all Kinds of potential risks in the world.

    But I don’t feel that the likelihood of any the last three things I mentioned are likely enough to happen that I need to ever give them any Thought – let alone take any action – to shield myself from their potential harms. And of course my point is in regard to how important a risk is. About the importance of assessing just how much anti-risk is well reasoned for your circumstance. Risky risk is not desirable – no question about it. But very unlikely risk? I’m willing to pay myself to take those kinds of risks myself.

        • Daniel D.

          I’m not Greg, but I bet he’s referring to the fact that when you need that equity portfolio to bail you out of a jamb it might be worth only half of what you thought it was worth.. the same forces that could make your worst-case real estate empire get stressed could be stressing your equities. Personally, i think if the portfolio is large enough in relation to your real estate carry costs or debts it is not too much of a concern. My backup reserve is also in a (hopefully well enough) diversified portfolio.

        • Stephen S.

          Well; in that case maybe I am an even worse example because I do not believe in diversification and never practice it – except unintentionally. Diversification is a self-serving brokerage house scam to me. It’s intended primarily to conceal the fact that the ‘financial industry’ is primarily staffed by salesmen who know very little about the stock market or how to increase one’s capital by participating in it.

          In Greg’s defense; it could only be someone who puts faith in the concept of diversification as an effective money management tool who could conclude that I would be an effective money manager if I presided over a 50% decline in principal.

          And of course you are correct in the idea that one’s ‘cash reserves’ alone cannot make up one’s entire equity portfolio. It would be imprudent for someone to, for example; budget away / save 10% of annual gross rent on a single property and buy common stock with it. That would not be a true ‘cash reserve’ in my opinion. But once the reserve-fund is substantial enough, and spread over covering a sufficient number of properties – it would be foolish not to invest it where it would produce the best return.

  2. Brandon Schlichter

    I think the best strategy would be to be in the middle. Manage leverage and risk while trying to grow. I don’t think it’s EVER a good idea to mortgage to the hilt, however if we look at extreme events in the past 100 years in real estate markets, while downturns do happen up to 20%-30% in a market, rarely do they go more. So to me it would make sense to have ample reserves and loan to only 60%-70%. That way if the market downturns you still should be able to get out of your investment or discount rent to tenant a property quicker.

  3. The thing I like about real estate is that it’s more consistent than the returns you get from a basket of stocks — there’s less principal risk. The thing I like about stocks, bonds, derivatives, etc, is exactly what makes them different from real estate — they lack the liquidity risk problem inherit in buying property that the author talks about. One should balance these risks, most of the time. (Hey, sometimes you have to jump on a really good deal at a time when your capital is low relative to a perfect world scenario.)

  4. Jordan Finkelman

    Depending on the reserve size, why not just purchase bond funds? You can earn 3% tax free and diversified across hundreds if not thousands of munis. Or a combination of bonds and equities. If your reserve fund is 70% equities, 30% bonds, you will still earn a decent return in between the 3% yield on bonds and 7 or 8% long term average for stocks, meanwhile serving as a backup to the real estate portfolio.

  5. Trevor Ewen

    From Burton Malkiel’s ‘A Random Walk Down Wall Street’ –

    J.P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, ‘What should I do about my stocks?’ Morgan replied, ‘Sell down to your sleeping point’ Every investor must decide the trade-off he or she is willing to make between eating well and sleeping well. High investment rewards can only be achieved at the cost of substantial risk-taking. So what is your sleeping point? Finding the answer to this question is one of the most important investment steps you must take.

    I think about debt in the same way. If my leverage would keep me up at night in the worst cases (all my tenants aren’t paying/units vacant), then I am probably over-leveraged.

  6. I think that you should also take into account what you have to lose in your risk vs. return assessment. For example, if you have one single family rental and you mortgage it to the hilt and the worst case scenario hits and you lose it to foreclosure, then you lost your downpayment and your credit gets dinged. If you have 1 million in equity, then you have more to lose.

    So the question becomes, “Is it better to have lots of fully mortgaged properties or fewer that have lots of equity?” In my opinion, you need a bigger emergency fund for fewer properties if you stand to lose all your equity if catastrophe strikes. I also remember an investor saying that if you owe the bank $30,000 and you don’t make your payments, they foreclose. If you owe the bank $30,000,000 and you don’t pay, they try to work something out with you. I stay up at night worrying that I am underleveraged!

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