Why Risk Is the Most Inaccurately Assessed Factor When Investing
Put ten (10) investors in a room, and they will come up with tons of definitions of real estate, not investment risk. Not only that, they will have a lot of ways to assess that risk. Another thing, there is also a risk about which more seasoned real estate investors are cautious; the risk of letting good opportunities pass because of either lack of data and information or sudden changes in the market they miscalculated. But hey, as if we can time the market, correct?
It is really hard to go from zero to a real estate hero and generate your first buck. At the onset around 1975 until Labor Day of 1979, there was little to no risk in purchasing residential income property. Then the following month, the tables have turned and interest rates went as high as the sky. Imagine a 16.5% FHA rate and a 21% prime rate? How about an 18-19 percent rate in an investment property? Wait, there’s more, how about a 14% inflation? All of these occurred in a span of three (3) years from 1979 to 1982.
Hold your horses, the year 1981 made it a lot worse with a recession. The Federal cut taxes everywhere and the Reserve supplied us the cure nobody has ever wanted. But the truth of the matter is, that was the recipe for a quick recovery. Volcker, the Fed Chairman started to squeeze inflation by restricting the amount of new money released by the Fed. That is a concrete cure indeed. There were months when the yearly employment rate reached almost 10% at a certain point, and sometimes went beyond that.
Despite all the “not-so-good” news, imagine how well some real estate investors were placed in residential income property with single-digit fixed-rate thirty (30) year loans. The broad majority were able to weather the storm brought about by the terror economic years in the early 80s which prevailed until the early months of 1984. But although things were a lot better in December of 1983 compared to the last several years, the condition was still not enticing.
Say, for example, your client was put into a 7-unit multifamily apartment situated in a great community. And you found him an adjustable-rate loan. Verily, his interest rate on the said loan will decrease every six (6) months for several years. In San Diego Alone, those who abstained from purchasing income property before October of 1979 were placed on the sidelines for the next six (6) years, but dependent on their comfort zone.
On the other hand, those who did not purchase property or obtain cash out through refinancing at single-digit fixed rates before it all hit the fan were safely placed to take benefit of the repeat of the similar rapid inflation in the next half of the 80s. These people repeated what they have done ten (10) years earlier, which was trade up, and for some lucky real estate investors, three (3) times in just about six (6) years.
Back then, the risk was prospectively losing out on the “last breath” of obtaining in before the music stopped for a while. A similar scenario occurred at the end of the 80s with the emergence of the S&L crisis which left the market declining over the next several years.
Key takeaway. It is wrong to regard risk only in the zone of property or note acquisition. The risk of investing can oftentimes be just as devastating to one’s future retirement success.
Some Traditional Example of Risk Myth. It is a known fact that purchasing non-performing initial position discounted notes protected by real estate is a lot riskier as compared to purchasing the performing note across the street. This is a no-brainer. Would you rather avoid non-performing notes in the first position protected by real estate or also put them in your performing note portfolio?
Let us make computation and you see for yourself. Over the last three (3) years or so, a lot of individuals come in believing the opposite of what they originally knew as settled fact.
In a normal middle-class community with two properties, identical in each way. They both have a worth of $150,000.00 and both have a loan balance of $100,000.00 on a first position note possessing similar terms and conditions. You can purchase the performing note for $80,000.00 while the amount for the non-performing note is $50,000.00.
Regular payments are on time from the performing choice. On the other hand, there are no payments from the defaulted note. These projected note purchase amounts are obtained directly from studies and averaging.
Which side are you on? If the performing note pays off years from now, say seven (7) years, you have garnered an excellent cash-on-cash return through the payments together with the income of 20% during cash out. On the one hand, you choose the defaulted note, you might end up doing these:
- You pay around four grand to foreclose.
- You install new carpet/paint and hype a light fix-up at around ten (10) grand to make it stage-ready.
- You have to pay your back taxes to the tune of three and a half grand.
- You now have at least $67,500 invested.
- You let go of it for $150,000.00 within market value together with sales and closing fees pegged at 8%.
- The net price is around $139,000.
- Please remember that you have $67,500 invested which leaves you with an extra of about $70,500.
This may all occur in about six (6) months, more or less. Regularly, it may land at an average of eight (8) months. For tax purposes, you may prefer to make it at about thirteen (13) months, because you can be able to claim a long-term capital gain approach. At that point, your tax rate is approximately pegged at 15%.
But the question is, what if you cannot let go of the property away? In the year 1984, people not only experience huge local real estate values starting to rise again. The net income coming from the debt-free real estate cured their wounded pride as they waited for values to hit high or anything they had in mind. In 1986, almost all properties were easily sold and came out smelling like fresh cookies out of the oven. But, lessons learned here.
When you look back at the recession in the mid-70s, a similar situation had played itself out. And the similar scenario is being utilized after the 19080s for foreclosures used in the mid-90s. Although it looks and sounded longer for that one. And in the year 2002 onwards, real estate values have appreciated enough to have garnered an entire race of brilliant minds. The most updated example has been there for the last several years. Those who had first position notes on homes defaulting after the conclusion of the bubble burst or recession hit, found themselves searching for tenants and not buyers. When your home is foreclosed in November of 2010, sometime from 2014 up to the present you likely would sell and obtain a good profit.
In all these scenarios, the investor choosing the non-performing note or land contract in the first position came out positively better as compared to if they purchase the performing note across the street. It would take you three (3) to nine (9) years to satisfy your liens and obligations but you cannot apply that range to a given note. They just pay off randomly. On the other hand, the non-performing portfolio turns over a range of one (1) to two (2) times annually. Except for the stated economic downturns mentioned above. Truthfully, is that in retirement, most look at passive income from performing assets and not the labor-intensive type of assets like what we are discussing here. It is best recommended to stay away from the temptation of purchasing the non-performing notes/land contracts without seeking professional help. This is because what the majority do not or will not tell you is that it is almost impossible to purchase a defaulted first position note in your community.
To add, none of those were in the first position, and none were considered non-performing. This simply means that you will be investing in something a lot far, say a thousand miles.
Conclusion. When you realize, investing about $50,000 instead of $80,000 for the similar debt amount secured by the similar value of the property, practically on the similar street and community is not riskier as compared to the alternative. Oftentimes, common knowledge is nothing but a traditional myth.
“Believe your math and not your myth”.
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