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Michael Michaud is the founder of Invest2Success.com (http://www.invest2success.com/) and the Invest2Success Blog (http://invest2success.blogspot.com/). He has been investing and trading in the financial markets since 1989. He founded Invest2Success.com to empower individual institutional... More
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  • Trader's Approach To Residential Real Estate Investing 0 comments
    Jul 19, 2013 6:21 AM

    Trader's Approach to Residential Real Estate Investing

    By Dr Van Tharp Trading Education Institute

    Just as traders don't trade the markets, real estate investors don't invest in real estate, we invest in our beliefs about investing and real estate. My experiences as a real estate lender, homebuilder, developer, contractor, landlord and consultant have helped me develop methods that work. In addition, working through Van Tharp's Ultimate Trader program some years ago and trading stocks, options and futures since then have given me new perspective on real estate investing. As many readers understand the principles of Tharp Think, this article is about my beliefs; perhaps you may find them as useful as I find them.

    Business Owners and Investors

    Successful real estate investing works best within the context of being an Investor to or with a Business Owner (I use those two terms specifically as defined by Robert Kiyosaki in his CASHFLOW Quadrant® model). Many busniess owners in real estate appear to be Business Owners. Many investors appear to be Investors. Almost none of the "professionals" in real estate, however…

    Really know how to be a true Business Owner or deal with other true Business Owners.

    Understand the typical risk and reward profiles for their method.

    Make plans to manage a change in market conditions-even while it's very easy to know if they are in an up or down market.

    Act fast enough or act at all when market conditions do change.

    Think they have much new to learn as they believe they already know it and have done it all.

    I can say all of that because I myself have made each of those mistakes.

    Over time, I have learned to simplify and focus. Just as when a trader focuses on one market or one trading method to improve their performance, simplifying real estate investing across one or two property types, in one or two market areas or using one or two methods will also help your performance. It's also important to work with a few, systematic professionals. I have become most comfortable as an Investor to and with a few Business Owners who develop land and build homes.

    Risk

    Life is much more pleasant when we recognize and manage risk in any kind of venture. Van's concept of R multiples helps traders better understand, quantify and manage risk but the concept also works in real estate.1 "R" equals the initial amount we plan to risk; what we might reasonably expect to lose if things don't go favorably. An "R multiple" is the amount we actually make or lose on the deal divided by R, the initial risk. A profitable trade or deal yields a positive R multiple, a loss yields a negative R.

    Real estate tends to have a high win rate or rather a high probability of profitable transactions, typically 90%-99% - though these figures are skewed toward favorable market conditions and competent people. This high level of success tends to breed complacency, even overconfidence to the point that a loss can seem a virtual impossibility because "This deal is so good" or "I am so good" or both.

    More realistically, banks and larger institutions consider 0.25%-20.0% of the investment (usually a loan) as their initial risk or R.2 Smaller institutions, businesses and individuals typically think in terms of initial risk being 5%-100% of the cost of a property.3

    However, most of the people and businesses who invest in real estate don't truly recognize, plan for, or even seriously consider risk. In other cases, risk may equal "all the cash I want to (or can) use and all the cash I want to (or can) borrow to get into this deal." In these cases, R can equal all of their net worth.

    The second most common way that real estate investors deal with risk is to underestimate the average or range of losses. This is especially true for those with supposedly sophisticated risk models because they tend to use too little historical data (say 10 years) which causes them to underestimate or ignore the frequency of large losses. This is like a trader trying to use only a handful of trades (without having seen the -5R loss yet) to extrapolate a forty-five degree upward sloping equity curve over many years. Real estate investors also tend to ignore the possibility that future losses may be larger than past losses even though the disclosure documents say something like that everywhere. Perhaps this behavior exhibits judgmental biases at work?

    Reward

    Conceptually, real estate reward comes in two forms: periodic net income (usually monthly or annually) and the net gains from a terminal exit or sale. All of this is before tax effects.

    If you held a stock over a long period, you would add the accumulated dividends received to the capital gain on the sale of the stock to calculate your R multiple. For real estate, you would add the net periodic income to the net gains from the sale to calculate your R multiple - if your holding period is a few years or less. On the other hand, if your holding period spans one or more market cycles, it may be more useful to break the R multiple calculation down into multiple segments.

    All of this is fairly easy to calculate, but real estate investors usually forget or simply don't track many of the annual items to really understand their true risk adjusted reward.

    Some R-Multiple Examples

    Say you bought a house for $150,000 in 2010, with $30,000 down. You rented it out for three years, netting $15,000 in rental income and then sold it for $165,000, netting $26,500 (a bit less than your down payment) after paying transaction costs and the mortgage balance. Your total profit was $41,500. Your initial risk, or R, was $30,000 so your R multiple on this transaction was $41,500/$30,000 = 1.38.

    As another example, say I bought a piece of land in 2007 for $1,000,000, with $400,000 down and a mortgage for $600,000 (seller carryback, non-recourse). I have paid $10,000 per year for property taxes and maintenance and $36,000 a year for interest. I still own the land. My R-multiple at this point, six years later, is -.69, assuming R = my down payment of $400,000 (-276,000/400,000 = -.69).

    But -.69R doesn't take into account the value of the land that I'm still holding. Well, let's say that land dropped in value to $300,000 in 2009, so then my R multiple was -1.98, (-$92,000 for interest, taxes and maintenance, -$700,000 capital loss for -792,000/400,000).

    Now let's say I get an offer to buy the land today for $850,000 (net $780,000 on the sale transaction). Rather than calculate one R multiple figure for the entire holding period (which spans a market cycle), I prefer to calculate R-multiples by market trend. I'd keep the 2009 R multiple at -1.98 to measure performance in a down market and now I'll calculate my R multiple since 2009, an up market, at +.74 (-$184,000 for interest, taxes and maintenance, + $480,000 net capital appreciation = 296,000/400,000).

    By the way, those examples are actual transactions (though they were not mine) with rounded numbers for simplicity.

    R-Multiple History

    In general, residential real estate investing seems to have the following R multiple distribution pattern:

    many transactions with a low average reward, and

    many transactions with a low average loss, and

    a few transactions with a high average reward,

    then, (for most with leverage)

    very few transactions (maybe only one) with an asteroid size loss.

    Over time, this distribution sucks some people in (who haven't experienced the losses) and it keeps other people out (who have experienced the losses). Some of the data I have gathered (see below) might be helpful to both groups.

    I have 33 years of R-multiple data (though I didn't think in terms of R for the first 23 years). While incomplete and approximate, this residential land, for-rent residential property and for-sale residential property data is still very useful. Depending on how one classifies market conditions, the data includes 2-5 market cycles. I gathered it from a few banks, several builders, developers and my own firms. The timeframe for each R-multiple is one year or less.4

    Assuming R = 20% of initial value, here are the percent of transactions and the correlating R multiples -

    (click to enlarge)

    Interestingly, during the last down market of 2007-2011, land didn't do as poorly on a historical basis, but for-sale houses did worse.

    I reference these figures as a base case5 for evaluating investment opportunities. Can you see the dramatic differences that the market type makes in the R multiple distributions? Traders who understand Tharp Think will realize that the different market types require different strategies and different position sizing rules (or "policies" for institutions) to reach the same objectives. However, few real estate investors apply this kind of thinking to their business.

    Conclusion

    Taking a trading approach to residential real estate will provide an investor with a number of edges. Understanding some relatively simple principles like risk, risk adjusted returns and market types can be a huge advantage for the small minority of people who apply them to their investing.

    In the second part of this article, which will appear in next week's newsletter, we'll continue exploring a trading approach to real estate investing by focusing on: how to adjust to changing market conditions, some typical real estate investing methods, the method I have used successfully for years and how you might find similar opportunities.

    Footnotes:

    It is also probably much more useful than more "sophisticated" measures of risk. But that is a discussion for another day.

    They didn't call it R, but they used the concept. They often use a term called "reserve", short for a loan loss reserve, based on the idea that various asset classes have had quantifiable histories of loan losses.

    Only the most experienced or conservative consider recourse loans in their risk calculations. Most others simply don't think about it much. A recourse loan is typical: it means the borrower, and often guarantors, are liable to repay the loan, whether the income and sale of the property does so or not.

    If anyone has any other R-multiple experience with real estate, or something similar, I'd love to hear from you.

    My own performance has been much better for land, much worse on rental properties, and better on for sale homes.

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