New investors rarely stop to address the subject of risk tolerance. People who have never done a single real estate deal see others making a lot of money in real estate and want to jump right in. They never stop to understand the true risks of real estate.
Most investors and books will tell you that real estate is a pretty safe asset class to invest in. This is certainly the case if you are buying core buildings or if you are employing a reasonable buy and hold strategy. Sadly, many investors hear safe investment and assume that opportunistic investing is just as safe.
If an investor is solely a real estate flipper, he/she is taking more risk than investing in the stock market. That might be a surprise to some, but consider the returns. On average the stock market returns 9-13%, while flippers should expect 15-20% returns on their capital investment.
This higher return is certainly accompanied by more risk. First, consider the fact that in the stock market your downside risk is typically capped at 20-30%. Very rarely does the stock market lose more than 10% in a given year. Additionally, a single blue chip stock is not likely to even have that kind of a loss. In contrast, a flipper has a very real chance of losing all of the money invested in a deal. The odds of this are even higher for a novice flipper.
Another aspect of real estate investing is the sweat equity or opportunity cost of the investors time. I can go into my E*Trade account in about two minute, buy a Dow Jones ETF (exchange traded fund), and essentially guarantee myself a 9-13% return on that money for 20 years. However, if I decide to flip property I either have to hire a property manager or I have to act as general contractor, organizing the work to be done. Either way, investors will still spend a tremendous amount of time working on site or dong something with the investment.
Taking this logic one step further, if I have a job granting me a salary of $100,000, I probably have to give that up to flip houses. If I don’t give that up, I have to hire a manager that would cost $10,000 per job (on the low end). As these costs rise the return from flipping must also rise. Many investors never consider the cost of their time when calculating their return on investment. This is a huge mistake. Investors should add a salary cost line for themselves to compensate for the time they spend on the job.
I am not going through this exercise to discourage flippers, but rather to encourage investors to seek the right returns. If your upside after all costs are calculated is only 10% (or less!), you need to think hard about the deal you are about to do. Most entry level flippers get anxious for deals and take investments that do not offer a reasonable return. In a good market many flippers get away with this; however, as the market turns (like now) these same flippers find themselves losing a lot of money.
Finally, don’t let getting burned once keep you out of the business. If you are in a business where the returns are 20-30%, there will have to be deals that result in huge losses. Understand this, learn from this, and get back in game.
-Michael Cook, theFlipBoard.com
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