“… not 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 meet up. A few of the investors 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% cash on cash return. Things were going well for a time, but as soon as the market recovered, vacancies began to rise.
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. But how did this happen?
Why Do We Overweigh 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. 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 25% 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 — because 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.
Campbell’s 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 not as important as the investment vehicle generating those numbers. Metrics are tools. Such as a compass, they can tell you where North lies, but they don’t tell you about the canyon in front of you.
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 larger costs. If we makes decisions solely on metrics such as pushing off a major structural repair because we want to keep our numbers in line with our projections or for cutting corners with shoddy work, eventually we will decrease the value of the underlying asset and its ability to generate cash flow.
Questions That Will Pull You Out of the Metrics Trap
We can start focusing on the big 3 factors that lead to a healthy real estate investment.
Factors such as:
Neighborhood: Is the neighborhood where the property is located a place people want to raise a family? If money wasn’t an issue, would people choose to live in this neighborhood?
Physical attributes of the property: (This includes floor plan, square footage, lot size, etc.) What attributes of this property will allow you to charge above-market rents? Is the floor plan larger than the comparable properties in the area?
Tenants: What type of tenants will be attracted to this property? Will people with steady incomes, great credit reports and clean tenant history want to live in this property?
Then How Do We Use Metrics?
We need to start respecting metrics as tools to help us make decisions instead of the sole determinant of decisions. Metrics can be used as a status report on how things are going and a tool in tracking trends and discovering relationships between factors.
How would you prevent yourself from being blinded by the numbers?
Let me know with a comment!