A Different Approach to Investing Decisions

Investors often ask me whether a property is a good investment, compared to other options today. Cap rates, in other words.

I think that's the wrong question.

I prefer to start with the exit.

Start with the End

Before evaluating a property, I want to know how the story ends.

Why are we buying it?

Is the goal stable income? Wealth accumulation? Retirement cash flow? Appreciation? Reno-refinance-cash out? Generational wealth? Kid's college fund?

Until we know the desired outcome, it's impossible to know whether a particular property is the right fit.

Once we know how we want the story to end, we can work backward and determine what must happen between today and goal for the investment to be successful.

Every Investment Is a Prediction

Every acquisition is based on assumptions about the future.

What do we know?

What do we need to know?

How can we obtain that information?

What assumptions are we making about the unknowns?

What is the best case, worst case, and most likely case?

How likely is each?

Can we live with the worst case? If not, what can we do to reduce the likelihood? 

When evaluating opportunities for clients, I routinely model performance fifteen years into the future. Not because I can predict the future, but because I want to identify the assumptions driving the decision.

The purpose of analysis is not to eliminate uncertainty.

The purpose is to understand it.

Build a Value-Add Inventory

One of my investors once told me I was the first broker who systematically identified every value-add opportunity in every property he considered purchasing.

I assumed everybody did that.

The purpose isn't necessarily to pursue every opportunity.

The purpose is comparison.

Rent increases.

Expense reductions.

Additional income streams.

Expansion opportunities.

Redevelopment possibilities.

Alternative uses.

Every property contains possibilities. Some matter. Some don't.

But until you've identified them, you're comparing properties with part of the picture missing.

Beware the Refinancing Fairy

One of the most common assumptions I encounter involves future capital expenditures.

Investors know the roof will eventually need replacement, HVAC systems will fail, and so on.

Yet many assume they'll simply refinance when those costs arise.

I call this the Refinancing Fairy.

People assume the Refinancing Fairy always arrives right on time, carrying a bag of money and offering attractive loan terms.

Unfortunately, she doesn't always show up at all.

Future refinancing depends on future interest rates, future property values, future lender appetite, and future economic conditions. Even something as simple as reaching loan-to-single borrower limits for your preferred lender can send you scrambling for new relationships at refinance time.

None of those are within the investor's control.

When I analyze a property, I project major capital expenditures over the anticipated holding period and how it will affect that year's cash flows. If the number is negative, I recommend monthly reserves needed to fund them.

Whenever possible, I prefer investments that can pay for their own future needs through operations.

A roof replacement fifteen years from now should not be treated as a surprise.

It's a known future obligation.

The best time to think about it is before you buy the property.

The Analysis Doesn't End at Closing

Many investors stop analyzing when the deed gets signed.

I think that's when the analysis becomes most valuable.

Every acquisition is based on a series of assumptions.

Those assumptions should be revisited periodically.

Are rents increasing as expected?

Are expenses behaving as projected?

Are value-add opportunities materializing?

Has the market changed?

The sooner you see reality diverging from the original investment assumptions,  the sooner corrective action can be taken.

Real Estate Investing Is About Comparing Futures

Cap rates are useful, but only measure one point in time.

Cash-on-cash returns are useful, but typically limited to first year.

Internal rate of return is very useful, but it assumes you reinvest all profits. Most people spend at least some of their profits each year, so the IRR number skews their analysis.

Debt service coverage ratios are useful.

But they are all tools, not strategies.

An investment decision should evaluate an entire ownership cycle.

The best investors don't compare properties. They compare possible futures.

Then they choose the future that best aligns with their goals, resources, risk tolerance, and desired outcome.

Real estate investing isn't about finding the perfect property. It's about making better decisions. As my sister-in-law told me when I was having anxiety attacks about the perfect shade of white for my dining room walls:  "You'll never find perfect Denise. Pick something that meets your needs, stop looking, and commit."

Great advice for everybody.