I aim to earn 15% or higher returns on all my hands-off real estate investments. When the average person hears that, they immediately react dismissively: “What?! You must be sinking money into high-risk investments then.”
It reveals that they think about investments on only one axis: risk versus returns. In other words, they think two-dimensionally about investing.
Guess what? There are other dimensions to investments—other factors that should affect what makes a “good” or “bad” investment for you personally in the present moment.
As you become a more sophisticated investor, start thinking three-dimensionally about your investments. Here are some factors to consider.
1. Liquidity
When you buy a stock, you can sell it at any time. When you invest in real estate, you usually lock your money up for years on end. And when you do decide to sell, it often takes months and costs tens of thousands in seller closing costs.
It applies to both active and passive real estate investing. In fact, most passive investments come with no liquidity whatsoever—you get your money back on the operator’s timeline, not your own.
Imagine someone told you, “I can earn you 15% annualized returns with low to moderate risk, but once your money is invested, you have zero control over when you get it back.”
You might earn distributions along the way in the 5% to 10% range. You might get great tax benefits. But what you can’t get is your money back upon demand.
Suddenly, it starts to make sense how an investment can offer high returns with low or moderate risk when you realize there’s more to the story than just risk or returns.
2. Timeline
No liquidity or low liquidity doesn’t tell you when you can reasonably expect to get your money back. Can you expect your money back in one year? Three? Five? Ten?
Many real estate syndications aim for a timeline of four to seven years. Once invested, your money is locked up.
I run a passive real estate investment club called the Co-Investing Club by SparkRental. We try to mix up the timelines on the investments we make so that investors can stagger their repayments.
For example, the shortest investment we ever made was for nine months. We’ve also invested for 12 months, 15 months, three years, and everything up to “indefinite.” Don’t get too scared off by that last one—the operator plans to refinance and return our capital within four years or so, but the investment will be held indefinitely for ongoing cash flow after that (what some investors call “infinite returns”).
3. Minimum Investment
Likewise, say an operator says, “I have an investment that pays a 20% annualized return with low risk—but the minimum investment is $1 million.”
More commonly, the minimum cash investment for either active or passive real estate is $50,000 or $100,000. But I’ve seen minimum investments at $250,000, $500,000, and yes, $1 million.
If you don’t have the minimum investment available, you can’t partake, no matter how high the returns are or how low the risk is. That’s unless you go in on it with a group of other investors—like our Co-Investing Club or your own group of friends and family. In our case, I invest $5,000 at a time in each monthly deal that we look at together as a club.
If you form your own private investment club, it depends on how many members you gather and how consistently they each invest.
4. Accessibility
Even if you have the money, you still may not be able to invest. Why? Because the Securities and Exchange Commission (SEC) restricts access to most private equity investments to accredited investors. To qualify, you need a net worth of at least $1 million (not including equity in your home), or you must have earned at least $200,000 a year for the last two years ($300,000 for married couples).
Notice that I said “most,” not all private equity investments. That’s a core value of ours: finding investments that allow everyone, not just wealthy accredited investors.
5. Tax Benefits
In our equity investments, we get the full tax benefits of owning real estate. We get not only depreciation but also accelerated depreciation from cost segregation studies. Plus, all the expenses deducted will be passed on to us when we get a K1 at the end of the year. That means that most of my K1s show a “loss” on paper, even though I collected cash flow from distributions throughout the year.
When the property does sell in one, three, or five years from now, I pay taxes on the profits at the long-term capital gains tax rate.
Debt investments don’t come with any of those tax benefits. You get a 1099-INT at the end of the year, and you pay taxes at the regular income tax rate.
Don’t get me wrong: I invest in debt too. It just doesn’t come with the same tax benefits—which adds another dimension to the investment.
6. Diversification
Imagine I have nothing but Cleveland rental properties as my entire investment portfolio. Another Cleveland rental property comes along—should I buy it?
I could, of course. But that adds to the concentration risk in my portfolio, even if that new prospective property itself looks relatively low risk and offers high potential returns.
What would happen if the Cleveland unemployment rate rose and the population declined, driving down rents and property values? What if they never recovered?
That happened in my own hometown of Baltimore, by the way. In the 1960s, Baltimore City had a population of 1 million residents. Today it’s around 600,000.
I’d rather invest $5,000 apiece in real estate across many different cities, operators, types of property, and timelines. For that matter, I diversify across many types of passive real estate investments: private partnerships, private notes, real estate syndications, equity funds, and debt funds.
And that’s just my real estate investments. I also keep around half of my net worth in stocks.
7. Resilience
The notion of diversification hints at another dimension to investments: resilience to shocks.
Take recessions as a common example of a shock. Some types of properties are far more resilient in recessions than others. Class D multifamily properties experience high rent default rates, eviction rates, turnover rates, and vacancy rates in recessions. Class A down through B+ multifamily properties don’t dip nearly as much.
Another example is mobile home parks, where residents own their own homes, which are resilient in recessions. It costs $4,000 to $10,000 to move a double-wide mobile home and $10,000 to $14,000 to move a triple-wide—far more than continuing to pay the lot rent.
We’ve invested in mobile home parks in our Co-Investing Club, along with multifamily, retail, industrial, vacation rentals, hotels, and more. When we invest in affordable housing, we like to see an extra protection of risk in place. For example, we’ve invested in properties where the operator partners with the local municipality to designate half the units for affordable housing, capping the rents in exchange for a property tax abatement. The cash flow math not only works in our favor, but it also means that those units are virtually never vacant.
And in a recession, those units would become even more coveted.
8. Personal Values
Personal values also impact investors’ decisions. For instance, upstream oil and gas drilling has delivered 15% to 20% returns historically. Yet many investors don’t want to put their money in fossil fuels for personal reasons.
This kind of investment offers high historical returns and potentially low risk—and it doesn’t matter because there’s more to investing than just risk and returns.
9. The Many Types of Risk
It’s also worth noting that “risk” isn’t a monolith. Investments can come with many types of risks, and you should gauge all of them before slapping a simplistic label like “low risk” or “high risk” on an investment.
A few common types of investment risks include:
- Volatility (price risk)
- Inflation risk
- Interest rate risk
- Default risk (for debt investments)
- Disaster risk
- Political and regulatory risk
- Concentration risk (touched on above)
Stock investors know price risk and volatility well. But stocks come with other advantages, such as easy diversification and investing within tax-sheltered accounts, as well as liquidity.
Next, take bonds. Investors love to say, “Bonds are low risk!” Sure, many bonds come with low default risk—but they come with inflation risk and interest rate risk. Investors holding Treasury bonds in 2022 lost money on them, earning 2% interest while inflation scorched at 9.1%. That investor was losing 7.1% on their investment (even if they didn’t admit that to themselves).
Real estate investments can also come with interest rate risk. If the owner holds floating interest rate debt, higher interest rates will pinch their cash flow. Higher interest rates also drive cap rates higher, dragging down property values.
Likewise, some properties come with regulatory risk, while others don’t. Residential properties in extremely tenant-friendly jurisdictions offer the most blatant example.
I’ve written entire articles about ways to avoid some of these risks, and others have written entire books. But start looking at risk itself along many dimensions rather than just oversimplifying it.
Final Thoughts
How can investors earn high returns with low risk? Because those are only two dimensions out of many that affect an investment.
Personally, I don’t mind locking up my money for a few years if I can earn 15% to 20% returns on it with low potential risk. The last investment we made in our Co-Investing Club was a multifamily property already paying 8% in distributions, projected to rise to around 9.5% next year and the year after. It’s a three-year investment projected to pay 22.36% annualized returns, with enormous tax benefits.
But it has no liquidity, a three-year commitment, and a high minimum investment — if you were to invest by yourself, which is, of course, why I went in on it with 60 other investors.
As you become a more sophisticated investor, start thinking along all these dimensions as you look at prospective investments. Because that’s the difference between the average investor and the best investors: how many angles they look from when evaluating investments.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
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