Posted by Randy on April 22, 2006 at 09:16:25:
I just want to say that I concur with above post. I am constantly impressed with the level of nuanced intelligence manifest in Ray’s posts.
Respectfully Ray! - Posted by David
Posted by David on April 20, 2006 at 20:54:44:
Hello Ray and other seasoned investors. I have read past articles in the archives. The one thing I contiue to stumble upon is the verbage “according to you investment goals” and “according to your investment criteria”. I dont really know how serious those statements are to write an full length article about. So my question is when you first started out in commercial real estate investing real estate for that matter. What kind of goals and criteria did you establish, understandibly your Father I believe had already been in REI so I assume all of that was preestablished.
The one thing that races in my mind is; What kind of return would I want?, What kind of return is “minimal”,or “reasonable”?
Thank you for your Guidance,
DAVID
Re: Respectfully Ray! - Posted by ray@lcorn
Posted by ray@lcorn on April 21, 2006 at 14:24:20:
David,
Very good question… and the reason I haven?t written an article about it is that developing a personal investment criteria involves much more than just picking an acceptable return. I?ll try to give you a brief overview, but it may raise as many questions as it answers.
Look at real estate returns in context with all other investments. The risk-free, no-effort rate of return comes from government bonds. The rate on the benchmark 10-year Treasury bond, about 5% right now, is known as the “safe rate” and forms the floor for minimum returns for any investment. If you can get that with no effort and no risk, then it stands to reason that if you?re going to take on risk and expend effort, you should earn more right?
Every other securities investment carries more risk than the T-bond, so returns are increased to compensate. Corporate bonds are priced from just below 6% for the best credit companies, to 9%-11% for firms with uncertain prospects (think GM), and 20% and higher for highly speculative or distressed debt. The premium over the safe rate represents the increased risk in holding the investment.
Once you leave the world of securities and passive investing, in addition to the increased risk, investments such as real estate require some degree of ongoing investor effort to produce the return. That effort is also compensated by increased returns, in addition to the risk premium.
Quantifying risk and putting a price on effort, however, is a subjective and ambiguous process. Risk is like the judicial definition of obscenity; we know it when we see it. Most of us use intuition as a substitute for hard numbers, or create a number based in intuition. We intuitively know that the ?A? property in a growing market with no deferred maintenance holds less risk than the ?C? grade turnaround, and would expect to pay more for the former than the latter.
So then it’s easy to see that as risk and effort increase, so should the returns.
In my estimation, any real estate investment (other than a credit-tenant deal) should yield at least a 5% premium to the corporate bond market just because we have to show up and do the footwork on the property and the market. If I can stay home and buy bonds online and get a 7%-9% return, then why would I leave the house for any less, much less go in debt for the privilege? I figure that my capital and credit are worth at least a 5% premium for the simplest and safest deals.
Therefore, by that measure an “A” property with no deferred maintenance and a stable rent roll would require a 12%-15% cash return.
For most “B” and “C” properties, we not only have to do the upfront research, but will have ongoing responsibility to direct and manage the asset. I would add another 5% for the use of my time and expertise, and that level of risk and effort would require at least a 20% return.
But there is more to the story. Setting the targeted return will also depend on where the investor is on the wealth curve. The three stages of building wealth are:
- Get Started
- Get Rich
- Stay Rich
The largest rewards are in the second stage. The first stage investor is just learning the ropes, usually with limited capital, and taking outsized risks just isn?t wise. The third stage investor has already done the home-run deals and needs to diversify, reduce exposure, and perhaps reduce the time spent in producing wealth. The second stage investor has the necessary knowledge, capital and energy to take on projects that produce the outsized returns we all love to hear about, but also willing to take on the increased risk and effort required to be successful.
And that?s still not all? the above speaks only to the quantification of the projected return, usually the first year, known as the ?going-in return?, and is only one element in forming a complete investment criteria. Too many people get hung up on that one number and lose sight of the big picture. The return (aka cash flow) is only one of the four ways to profit from real estate, the other three being appreciation, equity growth and tax benefits.
This is where deal structure and strategy come into play. Having a plan for the property and the structure to support that plan is the real key to creating home-run deals. It is quite possible to structure a deal for very low cash returns in the first year, in order to create upside value (forced appreciation) over a two- or three-year hold period that produces a cumulative return of 100% or more on the investment.
The key to building a solid real estate portfolio is to use deal structure and strategy to minimize the risk, and maximize the returns from all four sources of profit. Your investment criteria is the roadmap that navigates through the choices of property type, location, condition, and investment objectives to produce the desired returns.
ray
p.s. I devoted an entire chapter (25 pages) to the subject of forming your personal investment criteria, including how to quantify risk, opportunity cost, leverage and liquidity in my book “DealMaker’s Guide to Commercial Real Estate”. See http://www.creonline.com/catalog/b-140.html
Re: Respectfully Ray! - Posted by Killer Joe
Posted by Killer Joe on April 22, 2006 at 24:22:04:
Ray,
If the readers of your post had any idea that the entire content of “DealMaker’s Guide to Commercial Real Estate”, all 2" thick of it, reads at the same level that this posts does, you’d need a bigger building to house the shipping department for this ‘bible’.
Sorry for the shameless plug, but I have never run across such a thurough explaination of this market as your book. It cast light on issues I’ve dealt with for years without ever seeing it explained so completely. Especially from the investor side.
Thanks, not only for giving me a reprieve from the fogs of my past, but also Windex for my crystal ball. That is a welcome combination in my world. I keep this book on my desk and enjoy its wisdom on a regular basis. I find it an incredable reference manual for my growth. For me there is no substitute. Again, thank you for this unique “brain dump”, it’s irreplacable.
KJ