A thoughtful portfolio-matching method preserves principal while lowering risk.
(As is customary, I am an investor wanting to express my personal views, not a financial advisor. Please consult your financial professionals before attempting to make any financial decisions.)
Important Covid-19 update: This information was posted before anyone realized we were facing a global pandemic. As a result, it may lack the critical information required to make a successful investment today. Some of the material may be ancient, faulty, or irrelevant.
Many individuals have asked me how I choose the conservative deals in my portfolio. There are numerous approaches to due diligence, and I’ve developed one that works well for me. My method is brutal, beginning with thousands of discounts in my inbox each year. In the end, maybe 2 to 4 of the investments I make do survive.
This series explains what I look at and why. I appreciate feedback from other conservative investors and will incorporate ideas I like into the articles. Furthermore, active investors should find that this helps them better comprehend and assess the more immense risks they accept. (If you are a non-accredited investor, much of this information does not apply to you.)
Why “Go Big or Go Home” May Send You Home Too Soon
Warren Buffett has two investing principles. The first rule is “never lose any money,” and the second is “never forget rule #1.”
Warren’s risk-averse approach works since investing losses hurt returns far more than gains help. For example, if I lose 50% this year, I must recover twice as much (100%) the following year to break even.
As a result, I believe that focusing on capital preservation and risk minimization yields the best long-term results. Unfortunately, it isn’t easy to locate conservative deals that satisfy this requirement. However, it is feasible, and here’s how.
The 4 Steps of Analyzing A Deal
Honestly, I don’t thoroughly investigate an offer until late in the process. If I had completed property-level deep dives on every sale on my desk, my family would never have seen me. And there are much easier and faster techniques to eliminate offers before that point. So, here’s how my method works:
1. Portfolio Matching (takes a few seconds for each deal)
Before I look at any offers, I consider my portfolio and what needs to be added (including keeping an eye on the real estate cycle). When I notice a new transaction, I quickly discard it if it does not match (which weeds out 75% of the candidates run off the bat.) In this part, I want you to know that I’m covering managing a portfolio, assessing timing, calculating risk against reward, and putting it into a coherent plan.
2. Sponsor Quality Check (15-45 minutes each deal)
Next, I examine the essential components of the sponsor’s quality. This approach eliminates another 90% of the remaining investments. Part 2 discusses getting deal flow, examining the sponsor’s experience, long record, and skin in the game.
3 and 4. Property due diligence (takes time per deal)
I thoroughly examine the property and legal documentation. This approach eliminates around 99% of the remaining investments.
Finally, I have an investment (and a sponsor) that I’ve put through its paces but am delighted to have in my portfolio.
Let us now discuss portfolio matching.
How much real estate do you require?
Most investors will invest in whatever crowdfunding or syndication venture comes across their desk that they like. As a result, the portfolio is unbalanced and under-diversified, with far more risk than is necessary. Frankly, I believe it is critical to take a step back and make a plan.
The first stage is selecting how much of my whole portfolio should be in real estate and then adhering to it.
I’m currently content with a range of 20 to 45%. However, I know people who are 90% and others who are 10%. I don’t assume there is a correct or incorrect action because it depends on the individual’s financial situation. The main thing is understanding the risk/reward ratio and choosing the optimal option for your portfolio.
After deciding on a real estate allocation, the next step is to consider timing.
Everything Depends on Timing
According to Paul Kaseburg, timing is one of the two most critical factors in successful long-term real estate investing. Academic research has demonstrated that as long as a sponsor is competent, timing is crucial in determining which ventures succeed and which do not.
There are two phases to correctly timing real estate.
The first step is understanding the real estate cycles, and the next is planning a portfolio to reduce risk based on the position.
Let’s start with the first step.
Real estate has two distinct cycles: physical and financial. Vesting in the incorrect strategy at the wrong time in the cycle might be disastrous for your portfolio. Hence, it’s critical to understand them and stay up to date on financial news to strategize effectively.
I feel like we are approaching the conclusion of the physical cycle but are just halfway through the financial process. Others may hold a different viewpoint. The main thing is to understand that there are cycles, monitor the market regularly, and adjust if and when your perspective differs from reality.
After a person understands real estate cycles, the second component of time is portfolio management.
First, I’d like to take some steps back for any newcomers. There are so many real estate investments that it might be intimidating. However, only four items account for 90% of the diversity.
If you’re a rookie, I strongly advise you NOT to invest in ANY individual deals until you grasp ALL of the ideas here, particularly the risk/reward trade-offs. Otherwise, you’ll probably incur considerably more risk than you think.
Understanding the four real estate investing techniques is critical since it is the only way to grasp your risks and build a diverse and safe portfolio.
1. Strategies (core, core+, value-added, opportunistic)
A well-diversified portfolio is built on core real estate.
Real estate is located in a high-demand urban center of a central metropolitan area (such as New York, Los Angeles, or Washington, DC) and is rented to creditworthy renters.
Because of the high tenant demand, core investments are nearly as safe as bonds but offer far larger yields. Tenants (such as a Starbucks franchise) are frequently backed up by a rent guarantee from the parent business (Starbucks Inc.), which protects the investor if the tenant leaves.
In contrast to the stock market, core investments fare exceedingly well during business cycle downturns.
Here’s a look at how core real estate compares to stocks. Take note of how equities fall throughout every business cycle slump (every 3 to 5 years). However, fundamental investments remain positive and only turn negative during more severe financial crisis downturns (which occur about every 20 years)
Keep in mind that many crowdfunding sites and sponsors mislabel techniques as more conservative than they are. A supposedly “core+” fund may have riskier leverage at 75% or a strategy with much higher execution risk, such as value-added. As a result, it is critical to triple-check the details.
2. Capital stack choice (debt, equity, and more exotic variants/blends)
All real estate investments involve land and structures on it. If interested, you can invest in real estate in two ways: with debt or with equity.
Because the two have radically different risk and return profiles, understanding the distinctions (and where they lie in the “capital stack”) is critical to selecting the optimal investment for you.
In general, debt is better than equity. Why? It’s because the debtholders are paid first even if something goes wrong and the property is foreclosed and sold. Equity investors frequently have no remedy in a liquidation situation like this. Even when they do, they have a significantly greater danger of incurring losses or being wholly wiped out than a debt investor in the same business.
3. Residential versus commercial (residential versus commercial)
Commercial assets are priced based on an investor’s potential revenue and appreciation. Residential homes are valued for various reasons that have nothing to do with the property’s value as an investment.
Also, residential properties do not often generate as much cash flow per square foot as commercial assets. As a result, home investing is typically less profitable than commercial investing.
4. Specialized asset subclasses
Specialized asset subclasses have similar characteristics that are subject to the same laws and regulations.
A careful, conservative investor, in my opinion, favors varied techniques, choices, and options depending on the stage of the cycle. Portfolio planning is one approach to accomplish this.
We are near the end of the physical cycle but in the middle of the financial process. If this is correct, the subsequent slump will occur within the next few years. If this is the case, a prudent investor will apply the brakes rather than the gas pedal.
As a result, I’m defensive. I have an excess of leverage-free debt money and debt-free equity (while underweighting debt-financed equity). These do not have the high predicted returns of highly leveraged stock and may appear too mundane to a more aggressive investor.
Yet, I’m okay with it because the returns are still good. They protect my portfolio from the two major threats that devastate investments during a downturn: the risk of debt default and being unable to refinance.
I do make a little amount of debt-financed equity investment. But, if I do, it must be with modest leverage and exceptionally seasoned and high-quality sponsors.
Even though I feel like we are still in the middle of the financial cycle and not at the finish, no one knows for sure. The last six physical cycle recessions have had a 50/50 chance of occurring. So, because I’m a conservative, I plan as if the financial cycle slump is inevitable.
If there is a financial cycle downturn, many of these will be in jeopardy since they would be unable to refinance (just like in the Great Recession). Again, I want to believe that the next recession will be moderate, so this may be overkill. However, I “prepare for the worst before hoping for the best.”
I also keep a lot of cash, hoping to capitalize on distressed chances during the next downturn. As the cycle progresses, I prefer the safety of lower execution risk core and core + over higher execution risk value-added. I’m not going to touch opportunistic right now since it seems too hazardous.
How My Portfolio Management Will Change
In many ways, I’ll do a 180° after the subsequent slump and then recover. I’ll take advantage of the situation when it happens by “pressing the gas.”
Then I’ll be overweight in leveraged equity (but not overly leveraged because I’m conservative). I’ll be more aggressive in terms of value-added and even opportunism. I’ll also be adding deals financed with medium-term 3 to 5-year debt. But for the time being, I’m being calm.
That is my plan. You may hold a different perspective on the cycles or be a more or less conservative investor. Your approach will be different in that instance. However, regardless of your method, the most important thing is to have a plan.
In conclusion
My portfolio matching approach eliminates 75% of new investments in a matter of seconds because they are not a match for me. If they do match, I go to the following stage.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.