In the investment space, the term “holy grail” is thrown around quite a bit, implying there exists one perfect investment opportunity that can help you achieve your financial goals. However, while there are certainly many good investment opportunities out there, the term “holy grail” can be a bit misleading — the investment opportunity that is best for one person might not be what is best for another.
So, if you have a little bit of capital saved and are looking to enter the competitive real estate investment space, you might be wondering where, exactly, you should begin. When all else is equal, here are a few of the characteristics we find to be desirable in an investment:
High Rate of Return
Naturally, the return — or the amount of money you earn on your principle — is why you choose to invest in the first place. Return is how the market rewards us for taking risks. At a bare minimum, you need your investment to keep pace with inflation, which lately has hovered around 2% to 3% per year. In most cases, you want your return to be much higher. In real estate, 8% to 10% is a commonly cited goal, with some risk-tolerant investors seeking returns that are even higher.
Once you make an investment, you’re probably not going to want much additional work. A passive investment, as the term implies, is one in which the post-investment effort from the investor is minimal. There is a huge difference in the amount of effort required to simply put money in a REIT and trying to actually buy and sell specific properties.
In a speculative market, like real estate, there is always a risk that you might end up losing money. Your willingness to tolerate risk will likely depend on many factors, including your current life situation, the amount of money you have, and your personality type. Before making any investment, whether in real estate or not, ask yourself, “How much could I potentially stand to lose and what are the (reasonable) odds of me losing it?”
Defining the Holy Grail
Keeping these factors in mind, it seems the best way to define the holy grail of real estate investing is as an investment that offers high expected returns, minimal effort, and minimal exposure to risk. Usually, risk and return are positively correlated (i.e., more risk means more reward), so finding this exact holy grail can be relatively difficult. However, there are still plenty of instances — particularly in the dynamic real estate market — where there is a bit of a mismatch and returns significantly outweigh the risk.
In many cases, you will need to make quick decisions. But with the need to be decisive, there is also a need to be prudent and make sure the investment you choose is compatible with your investment profile.
Minimizing the Likelihood of Loss
Oftentimes, the expected return you’ll receive on an investment is much more speculative than the expected risk. The final return you’ll receive can depend on many factors beyond your ability to control, such as how the geographic market matures, how long a property remains on the market, whether tenants are able to fill a property, and even local legislation.
With expected risk, on the other hand, there are a few things we can typically look for that help signal a low-risk real estate investment:
The collateral is what will be taken in the event of non-payment. This is the key differentiator between real estate and many traditional investment vehicles. When you invest in real estate, you are investing in tangible, real property, rather than an idea. In real estate, the property itself is usually the collateral, which offers some additional downside protection.
When making a real estate investment, it is important to work with a competent, transparent, and disciplined management team. These will be the individuals who help direct the project once it is actually in motion, allowing you to put in minimal effort. With better and more experienced management on your side, you’ll be much more likely to have your principal investment protected should any problems emerge.
Depending on the type of investment, cautious underwriting can present itself in many forms such as conservative market assumptions and rent growth, which we could dive into for days. However, for the purpose of this article, we’ll discuss one very important item: leverage. Leverage is a term used to describe how much capital you can access for how much capital you are putting down. If the value of the project is significantly greater than the down payment, this represents a high loan-to-value ratio (LTV), which is considered risky. It might be possible to access a $1M loan for only $50,000 down, but this LTV of 95% is incredibly high, and such a loan should only be entered into upon careful consideration. For commercial projects, stick to investments with an LTV of about 75% or lower.
Diversification is the surest way for investors to limit the overall risk of their current portfolio. In real estate, there are multiple ways to diversify. The most obvious way is to invest across many different types of property including multifamily, residential, senior living, industrial, self-storage, mobile home parks, triple net single-tenant retail, raw land, and others. Furthermore, you can also diversify by geographic location. Purchasing property in different markets across the country, along with purchasing property in different areas (urban, suburban, rural, etc.) can help protect you from the future unknown.
Finding the Holy Grail
Now that you know what to look for — and more importantly, what to avoid — you might be ready to make a significant real estate investment. As suggested, there are several ways to enter the private realm.
A real estate syndication, for example, is an organized group of real estate investors, led by a specific investor in such group (aka a sponsor). The sponsor will be responsible for running the fund and making key decisions, along with communicating with potential investors. Rather than saving to buy a rental property on your own, you can invest in a group that purchases several properties, helping you reduce your exposure to risk and your need to be hands-on.
When comparing funds, there are many things you’ll need to think about. The payout timetable and the types of investments being made by the fund should both be carefully considered. Most importantly, you will want to make sure that the return you are receiving appropriately matches the risk you are being asked to take.
There might not be such a thing as a perfect investment, but with some basic principles in mind, you can move closer to finding the type of investment that’s right for you. In that sense, the holy grail just might be within reach after all.
About the Author:
Seth Bradley is a real estate entrepreneur and an expert at creating passive income while still working as a highly paid professional. He’s closed billions of dollars in real estate transactions as a real estate attorney, investor, and broker. He’s the managing partner of Law Capital Partners, a private equity firm focused on multifamily and opportunistic acquisitions.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.