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Risk vs Reward, what is a 'deal?'



Investor clients often ask me to find them a deal. The source of the question is simply to find them something that is under valued so the buyer can capture that value on the purchase. However, when you make those investments they often come with not so obvious risks and time commitments. So depending on your risk tolerance and how much time you want to spend maintaining your investments, choose your class carefully. Here are my opinions on a few asset classes.

Single Family

Risk: low

Reward: low

This is often the first investment a new real estate investor makes. It seems the easiest and most straight forward. These investments usually make under a 10% return annually and require maintenance as well as managing tenants. Most of the returns on these investments come from appreciation and holding them for a long time. The risk is low assuming you put in enough equity and there is a strong rental market that creates some cash flow. If you really need to liquidate the asset, you are likely to be able to and recover your capital and a gain.

Fix and Flip

Risk: medium

Reward: medium

People love these in concept. Shows like HGTV have encouraged a lot of people to try them. I love that because it promotes entrepreneurship and we need people to rehab houses. It's a great mom and pop hustle, side business, or full time business. The rewards on a fix and flip are better than those of a single family but require a lot more capital and a lot more time. So this isn't really investing in my opinion because it is too active. It is a second job.

New Construction

Risk: high

Reward: high

Building a new home with the intent to sell it almost a year later is considered speculation. You are betting that the market doesn't move enough to throw off your financial model so you can sell the completed home to a yet to be known buyer in the future. These can be very profitable, especially in an appreciating market. However they also come with debt risk assuming you use a construction loan and sales risk. You better build what the market wants. In my opinion a safe spec build should have at least 20% gross margin in it to start the project. Debt can leverage that return even higher. I've done almost 60 of these as the owner manager. I've always hired builders as they have that domain expertise. They charge a good fee and it is worth it. Being the general contractor is a hard job and requires good relationships with lots of trades that will show up and do your job. So I highly recommend hiring a professional who has been the GC for at least 50 homes if you are new to this type of deal. They are complex, full of delays, and surprises. They are not for the feint of heart, but the exits can be very gratifying.

Multi Family

Risk: low

Reward: medium to high

Multi-family can be considered anything as small as a duplex or as large as a several hundred unit apartment complex. In this scenario I am going to refer to apartment complexes of at least 35 units, the more the better. In multi-family going bigger is generally better in my opinion because the cost to manage each door goes down with scale. Multi-family is popular because if you buy it right, it pays you the very next month after you buy it. Many promoter's goal when buying these is to buy one that can be upgraded with the ability to increase the rents or operating income by other means to increase the valuation. Since these properties are sold as a multiple of their revenues, increasing said revenue increases the value by that multiple. These deals are typically several million dollars to purchase, but you can also get non recourse debt on them so you are not personally liable to the debt if the building performs well enough.

The most popular way for individual investors to participate in these is to join into a syndication of investors that pool their money to provide the equity required to own a fraction of an apartment building. The same $100k you might put into a single family house now controls a portion of 100 doors instead of all of one door. You automatically spread your risk out and make it neigh impossible to loose the revenue stream all at once. This makes this types of investment low risk in my opinion.

The rewards can be high by holding onto the property long enough to sell at a higher multiple for double digit annualized returns in three to five years. Market conditions of course change and this isn't always the case, simply the goal.

Notes

Risk: low

Reward: low/medium

Notes is an industry term for loans. A note just means you lend money to those who want to borrow it and collateralize it with real estate. You might think, why would anyone use a private note if they can just go to a bank? Well banks turn down borrowers for a lot of reasons, and one of them might be bad credit or lack of regular income like what you get from a job. Still many borrowers work in industries with irregular income like construction, small business ownership or may simply be independently wealthy and retired. These borrowers often have lots of equity in their properties and need small short term loans to refinance or get liquidity for other reasons. The combination of loan types is vast and too long to list here, but in short this is lending money to another person in exchange for a promise (note) and a lien on an asset worth more than the note itself.

I classify these as low risk if originated properly they should be secured by an asset that could be easily liquidated at a discount for more than the value of the note. I classify these as low to medium reward because the returns can be equal to and even greater than what you can typically accomplish with a single family rental. The downside to notes is that they do not appreciate like a real piece of real estate. You only get the interest, so long term holding an asset can be better. However if you cycle notes in shorter terms you end up compounding at a higher rate and can outperform a static asset.

Conclusion

Determining what to invest in depends mostly on your risk tolerance and how much time you want to spend juicing up your returns with your labor. If you have a lot of time and energy, maybe spec building will be your thing. If you have a lot of money but not time, then notes might be your hang. I also know a lot of investors that just collect single family houses, manage them themselves and get wealthy along the way. There isn't really a right or wrong way, just whatever works for your situation.

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