Why Risk is the Most Inaccurately Assessed Factor When Investing

by | BiggerPockets.com

Put 10 investors in a room, and they’ll come up with 11 definitions of real estate or note investment risk—and far more ways to assess that risk. Then there’s the risk about which more experienced investors are wary—the risk of missing out on opportunities due to either lack of info or market changes they mistimed. Yeah, as if we can time the market, right?

Beginning around the end of 1975 ’til around Labor Day of 1979 in San Diego, there was no risk in buying residential income property there. Then, in October of ’79, the tune changed to a dirge. Interest rates went through the roof. Think maybe I’m exaggerating? How ’bout a 16.5% FHA rate? A 21% prime rate? An 18-19% investment property rate? Then, as if all that wasn’t bleak enough for ya, how ’bout 14% inflation?! All that happened from the second half of 1979 to 1982, give or take.

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But Wait—There’s More!

1981 made it far worse with a nasty recession. The feds then cut taxes everywhere, and the Federal Reserve gave us the medicine nobody wanted, but that was the recipe for a faster recovery. Fed Chairman Volcker then began to squeeze inflation by limiting the amount of new money comin’ out of the Fed. Strong medicine indeed. There were months when the annual unemployment rate, which reached 9.7% at one point, was sometimes over 10%.

Given all that bad news, imagine how well some investors were positioned in San Diego income property (residential) with single-digit fixed rate 30-year loans. The vast majority were able to weather the horrible economic years of the early ’80s, which lasted in my view ’til around the end of ’83 or maybe spring of ’84. But though things were far better in December of ’83 compared to the previous four years or so, they were still not super attractive. For example, I put a client into a 7-unit apartment building in an excellent location. I found him an adjustable rate loan indexed to the 11th District Cost of Funds. He thought I was a magician ’cause the initial rate was below 12%! Starting at 11.75%, it was revisited every six months, adjusting to the COF Index. His interest rate on that loan decreased every six months for several years, something he got very accustomed to pretty easily.

Those who abstained from acquiring income property in San Diego before October of 1979 were sentenced to the sidelines for the next 4-6 years, depending upon their comfort zone. Meanwhile, those who did buy more property or pull cash out via refinancing at single-digit fixed rates before it all hit the fan were well positioned to take advantage of the repeat of the same rapid inflation in the second half of the ’80s. Those folks pretty much repeated what they’d done a decade earlier, which was trade up at least once, and for some happy investors, three times in just six years or so. Yes, the appreciation was that pronounced.

Back then, risk was also potentially losing out on the “last chance” of gettin’ in before the music stopped for awhile. The same thing happened at the end of the ’80s with the onset of the infamous S&L Crisis, which left the market more or less moribund for several years.

Takeaway: It’s a mistake to look at risk only in the arena of property or note acquisition. The risk of not investing can sometimes be just as debilitating to one’s future retirement success. It falls under the heading “shoulda, woulda, coulda” and is usually part of a sad story told to grandkids. I’ve got a few of those stories myself.

use-debt

A Common Example of Risk Myth

Everybody knows that buying non-performing first position discounted notes secured by real estate is far riskier than buying the performing note across the street. Common sense, right? Would you rather stay away from non-performing notes in first position secured by real estate or include them with your performing note portfolio? Let’s do the math and you decide for yourself. Over the last 2.5 years or so, I’ve kept a running count in my head. The vast majority of folks come in believing the opposite of what they originally knew as settled fact.

  • Let’s look at a normal middle class neighborhood with two homes, identical in every way.
  • They’re both worth $150,000 and both have a $100,000 loan balance on a first position note with identical terms.
  • You can buy the performing note for $80,000.
  • The price for the non-performing note is $50,000.

Related: Stop Swinging for the Fences: How I’m Building a Multi-Generational Wealth Engine the Low-Risk Way

Payments come in regularly and on time from the performing choice. There are no payments, of course, from the defaulted note. These projected note purchase prices are taken directly from my own recent experience THIS year. I took a quick average and went from there.

Which One Do YOU Want?

If the performing note pays off in, say, 7 years, you’ve made a nice cash-on-cash return via the payments plus the profit of 20% at the payoff. (Yeah, I realize there is principal in the payments.) If, on the other hand, you opted for the defaulted note, here’s where you might end up.

  • You pay around $4,000 to foreclose, give or take.
  • You put new paint/carpets and light fix-up to the tune of $10,000 to make it sale ready.
  • Then there are the back taxes owed, around $3,500 or so.
  • You now have around $67,500 invested.
  • You sell it for the $150,000 market value with sales and closing costs of 8%.
  • That nets you around $138,000 or so.
  • You have $67,500 invested, which leaves you a profit of approximately $70,500.

This all happened in, let’s say, 6 months, give or take. I’ve done it in 18 days, and one took just over a year. Most of mine land in the 4-8 month window. For tax reasons, you’d almost prefer it to take 13 months, as then you’d be able to claim long-term capital gain treatment. Your tax rate at that point, at least for most folks, would be 15%.

But What if You Can’t Give That Home Away?!

That first happened to me in 1981. The only sales happening then were the ones with the buyer gettin’ the seller’s permission to insert a syringe in their jugular just to begin negotiations on price. Forced to hold on to free ‘n clear properties, by 1984, we not only saw massive evidence of the national economy recovering in a big way, we saw local real estate values begin to go up again. The net income from the debt-free real estate soothed our wounded pride as we waited for values to hit whatever magic number we had in mind. For me, it was 1986. Boom! We sold everything and came out smellin’ like a rose. ‘Course, we also acted as if we hadn’t been nervous as cats in a room full of steel plated rocking chairs.

But we learned a lesson.

Looking back to the recession in the early onset of the mid-1970s, the same scenario had played itself out. After our 1980s experience, we saw that same script used for foreclosures caused by the S&L Crisis in the early-mid 1990s. Though it took longer for that one, by 2002-ish, real estate values had gone up enough to have created a whole new generation of geniuses. 🙂

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The most recent example has been ongoing for the last several years. Those who had first position notes on homes defaulting after the bubble burst/Dow crashed/recession hit found themselves lookin’ for renters, not buyers. Imagine having foreclosed in, say, November of 2010. Sometime between 2014 and now, you likely woulda sold and made a pretty hefty profit. Some did even sooner than that.

In all these scenarios, the investor opting for the non-performing note or land contract in first position came out appreciably better than if they’d bought the performing note across the street. Now, please don’t take from this that I’m against performing liens, as that’s the furthest thing from the truth. Roughly 65-70% of what I and/or my various investment groups acquire are indeed performing. A rough range for performing liens to pay off is 3-9 years, though you can’t ever apply that range to a give note, not ever. They pay of randomly, period. The non-performing portfolio tends to turnover around 1-2 times yearly. Obviously, the exception to that are the above mentioned economic downturns. The truth is that in retirement, most much prefer passive income from performing assets, not labor intensive investments like what we’re discussing here.

Related: A Look at the Rewards, Risks & Rules for Investing in Rural Rental Properties

My plea to the DIY crowd is to avoid the temptation of buying the non-performing notes/land contracts without experienced professional help. I know, I know, your eyes are rollin’ in the back of your collective heads as you read that. What most don’t or won’t tell ya is that it’s almost impossible to buy a defaulted first position note in your own town. I’ve been buying notes/land contracts since Ford was in office, and the only reason I could was ’cause I owned a brokerage, and other brokers called me with the opportunities that never really hit the public eye. Also, NONE of those were in first position, and none were non-performing. This means you’ll be investing in something far away, usually at least 1,000 miles. The closest town in which I’ve bought a first position defaulted note/land contract was in Nebraska. No, really.

Takeaway: As you can easily discern, investing $50,000 instead of $80,000 for the same debt amount secured by the same value home on the same street is definitely not riskier than the alternative. Sometimes common knowledge is nothin’ but common myth. But don’t believe me, believe the math.

Do you agree with this assessment of risk in real estate investing?

Let me know your thoughts with a comment!

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

15 Comments

  1. Nick B.

    Jeff,

    I agree with your two house hypothetical example but I wish I had such an easy choice in real life.

    So, here are the real life questions:

    How often do you see a first position non-performing note at 50% discount from UPB with another 100%+ potential gain on sale?
    Who would be selling such a gem and why?
    How do you find them?

    Thank you
    Nick

  2. Jeff Brown

    Superb question, Nick. In the last 6 months either I or my note investment group as acquired give or take $500,000 in non-performing first position notes/land contracts around the country. The range of purchase price has been roughly 45-55¢ on the dollar. (of loan balance) It’s almost always not a private party. Bottom line is that most investors need to know a guy like me. Believe me, Nick, there are hundreds of guys like me who can help you.

    • Nick B.

      Jeff, you did not really answer my questions 🙁

      Let me try to rephrase them:
      – what percentage of all the notes that you review are 1st non-performing, selling at 50% UPB with another 100% in equity?
      – why a lender would sell such a note at 50% loss if they can foreclose, sell the property and at least recover their original principal?
      – if you find a note like that and sell it to an investor, what is your mark up?

      Thank you
      Nick

      • Jeff Brown

        Thanks for the second chance, Nick. 🙂

        I’d say 70% of defaulted notes/land contracts (1st position) are priced at 45-55¢ on the dollar owed. The max LTV requirement I overlay for my team is 75%, which is using the actual loan balance. Example: 60k loan balance at sale would require a minimum property value of 80k. When you say ‘another 100% in equity’, I’m unsure of what you mean, specifically.

        The example post used is slightly higher in market value than some for sure. Here’s a middle of the road example from my own portfolio, from 2015. Paid $18k for a defaulted 1st position land contract with an unpaid balance of $36.5k. That house was a fixer for sure and only worth around $42k. Sold/closed the house in 108 days from original purchase with net proceeds of $30k. A local flipper bought it. An $18k investment turned into $30k in less than 4 months. If I’d of flipped it myself I would’ve netted around $60k in about 6-8 months. I chose not to flip it due to a business in the small town closing its doors, as I’m a chicken at heart. 🙂

        On the other hand I’ve literally had some non-performing liens earn me 200-300% annual yield. But those are clearly the outliers, and not the norm by any stretch. My typical yield on non-performers put in terms of annual rate is in the range of 50-65% or so. Thing is, and here’s the rub, Nick, I not only get to cherry pick, I get to do that on a national basis. That’s why I say to find a guy like me.

        The lenders from whom I buy are often institutional in nature and don’t do things the way you ‘n I would. We’d surely do what you suggest, which is sell the property and at least recover their principal, right? Think about the recent tsunami of foreclosures after the bubble burst/recession etc. The lenders merely had to rent them out while waiting for prices to recover. They’d of come out lookin’ like geniuses in a few short years. But they chose to wholesale them to places like private investment groups, hedge funds, and the like, right? They decided their self-interest was better served by gettin’ those bad loans off their books. Not practical to us, but apparently to lenders almost everywhere.

        I keep markups my own business, Nick. But I will tell ya that nobody buys a secured lien from my firm who doesn’t get a double digit cash on cash return of at least 10% on the payments alone. The discount would of course significantly increase that yield at payoff. I categorically refuse to sell non-performing notes/land contracts to individual investor clients. They simply don’t have the expertise or the experience to make me still be able to sleep at night. That’s why I have groups.

        Were these answers better?

        • Nick B.

          Yes, Jeff, these answers are a lot better! Much appreciated.

          So, how does your group work? Is this a private fund where investors buy units or shares but have no say in what assets are purchased, how they are managed, etc.?

    • Jeff Brown

      Hey Justin — Another really solid question. Much of the country’s local markets are of too high of home values for the average investor to be able to afford notes there. Take CA, or the whole west coast for example. A small note balance can be as high as $250,0000! The competition is much tougher now than in times past, but still not like for real estate investors. However, using me as an example, I’ve never bought a 1st position note locally, ever. Not saying it’s totally impossible, but there’s either high prices, know super knowledgable pro you know, or just not enough local notes for sale.

      If you’d like to find out what’s possible, reach out to me and I’ll hook you up for sure.

      • Katie Rogers

        However, a non-local (to you) note is local to somebody. Take CA again. The CA might be local to me. I might like to buy a first position, non-performing not an foreclose myself rather than wait for the property to go through the lender’s foreclosure procedure and/or end up at auction on the local courthouse steps.

        • Jeff Brown

          Absolutely accurate, Katie. Devil’s Advocate — For the price of one CA purchase you can spread things out with 4-8 using the same capital amount.

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