How do you manage real estate risks?

My most recent post – of a long series – on 401k’s v real-estate (which is a dumb comparison: like comparing the container with the drink that you might put into it … when, what we are really trying to compare is Mutual Funds v Real-Estate) sparked a long series of detailed comments about the risks and rewards of real-estate …

… I encourage you to read that post and the associated comments here. The discussion culminated in a great series of comments/questions by Jeff who also asked:

I agree, the “technical risks” need be manageable. But, how much does the management of these risks (infusion of cash when necessary) reduce your return?
For instance, do you keep a safety net for possible negative cash flows (high-yield savings account, CD)? Do you then bundle the two investments (investment property return plus safety net return) to determine the actual return of the investment property?
Do you pull cash out-of-pocket to cover short falls? Since you don’t receive any additional growth from this new cash and the new cash is added to your capital investment amount, it drastically reduces your present and future return from the investment.
Do you borrow more money to cover the cash flows? Since this borrowed money provides no additional return it puts you in severe negative leverage situation. Further, that loan has to be paid back with future cash flows from the investment property that you were expecting to give you the return your initially expected–for lack of a better term–compounding the damage of the negative cash flow.
Do you use a cash flows from another property to cover the short falls? This seems to be the best solution for the property receiving the infusion of cash, but to what extent doe sit reduce the return of the other investment property–by reinvesting its cash flows in an investment that provides no additional return? Put differently, it is a loss of opportunity to invest those cash flows in something that will bring additional return–rather than saving your RE investment from foreclosure.

When you experience short falls in RE investing, which one of these options is best? What did you do when you experienced cash short falls, and why? …and what effect did/does it have on your annualized return?

As I said, great questions, but the first comment that I would make (actually, did make) is:

I would caution you to remember the phrase: “paralysis by analysis” … in a practical sense, once I satisfy myself that (a) a certain type of investment is within my skill/interest level, AND (b) is LIKELY to meet my investment targets, AND (c) I can cover the risks – usually through a ‘reserve’ which may or may not be sitting in a shoebox with the word ‘RESERVE’ etched in the side, then … shoot … I’ll close my eyes and just go for it!

In other words, if you are going to be a success in real-estate investing – indeed, any endeavor where you expect to achieve more than the average person expects/can achieve – then you need to have a bias for action.

Often, we have to proceed in a world of imperfect information …

… magically, once we jump in a lot of these types of questions just seem to fall away!

But, to try and answer Jeff’s question:

Technically, YES the ‘reserve’ is part of the investment and lowers the returns e.g. if you are earning 20% on the investment and only 4% on the CD’s sitting in ‘reserve’ then obviously the actual return lies somewhere between the two.

BUT pulling ‘free cashflow’ out of one property to help service another, doesn’t actually reduce the return of the first … but, the amount of cash that you put IN to the second property affects ITS return.

But, at the end of the day, it’s the COMBINATION of all of these returns that counts: will you, or will you not make your Number, or whatever target you set?

The only real benefit of analyzing the return on each individual investment once you have made it is if you then intend to do something about it e.g. trade it for something better …

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