A Dire Warning for Real Estate Investors: Don’t Trust the Market!

In This Article

Q: Do you trust “The market” for your real estate profits?

A: Those who trust “The market” are at the mercy of the market. 

I think this is folly. Hopefully, many of you agree. 

Here’s what I’m talking about… 

The real estate syndication realm is awash with new operators showing their investors dazzling returns. Profits that would astound investors from Wall Street to Main Street. 

And these syndicators are raking in massive profits along the way as well. I know many operators who were in high school during the Great Financial Crisis and working W-2 jobs just a few years ago who have joined the multi-millionaire club in this current rush to riches. 

But this scares me to death.

You see, the same “Market” that made them and their investors rich could also destroy them. The streets of history are littered with such casualties. 

Here’s how it looks in the real estate world…

The value of a commercial real estate asset is based on two variables: 

1. Cap rate
2. Net operating income

Value = Net Operating Income ÷ Cap Rate

If this formula is unfamiliar, check out this post. 

The cap rate is the market’s evaluation of the value of an asset. It is based on the interest rate, a risk premium, the desirability of that asset type, the location, and more. Factors outside the operator’s control. 

And of course, the net operating income is the gross operating revenues minus expenses. And this is largely in the control of the operator. 

As you can imagine, a seasoned operator focuses on the latter. They see intrinsic value hidden in an asset. They acquire the asset and do their magic. They put their team and technology to work to raise the income and create value for investors. 

Seasoned syndicators don’t count on “The Market” to do the heavy lifting.

(If The Market cooperates, their investors get a double win. But their “hope” lies elsewhere as we’ll see.) 

But rookie syndicators trust the market to do the heavy lifting. They hope for various circumstances to line up perfectly to turn a profit. Factors like: 

• Continually compressing cap rates
• Continuous low interest rates
• The end of eviction moratoriums and other pandemic fallout
• The continuing rise of inflation

Take away one or two of these factors, and their house of cards comes tumbling down. Because trees don’t grow to the sky. And hope isn’t a sound investment strategy. 

Newbies trust the uncontrollable market for their profits. 

Pros trust the market, too. They trust the market to lower their profits. 

Seasoned pros assume the uncontrollable market will lower their property values. Pros focus instead on the more controllable acquisition process and Net Operating Income. 

They trust their talent, team, and technology to create profits in any market. And they plan to hold assets through market ups and downs to provide investors a more stable and predictable source of true wealth. 

Warren Buffett’s folly?

Do you remember the late ‘90s tech bubble? Investors made billions in this runup in tech values. I can see some similarities between what is happening today, though the excesses were even more extreme then. 

Buffett seemed out of touch. He and his Berkshire Hathaway investors missed out on stupendous profits as the dot-com bubble ballooned to staggering heights. 

Buffett was only in his late ‘60s, but he was called senile. At his annual billionaire’s retreat in Sun Valley, Idaho, his colleagues wondered if he’d lost his touch. 

Buffett addressed the group, assuring them he was well aware of the differences between investing and speculating. He was happy staying on the course that had served him so well over many decades.  

In his 2000 letter to shareholders, Buffett stated this: 

“By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates) … Speculation is most dangerous when it looks easiest.” 

Of course, we all know what happened. The bubble burst…and Buffett emerged as the hero…yet again. 

Check out this graph showing the NASDAQ’s rise and fall. 

Wikipedia described it this way: 

The dot-com bubble, also known as the dot-com boom, the tech bubble, and the Internet bubble, was a stock market bubble caused by excessive speculation of Internet-related companies in the late 1990s, a period of massive growth in the use and adoption of the Internet. 

Between 1995 and its peak in March 2000, the Nasdaq Composite stock market index rose 400%, only to fall 78% from its peak by October 2002, giving up all its gains during the bubble. 

During the crash, many online shopping companies, such as Pets.com, Webvan, and Boo.com, as well as several communication companies, such as Worldcom, NorthPoint Communications, and Global Crossing, failed and shut down. Some companies that survived, such as Amazon.com and Qualcomm, lost large portions of their market capitalization, with Cisco Systems alone losing 86% of its stock value. 

So, are you saying we’re in a bubble, Paul? And what can we learn from Mr. Buffett? 

I am not saying we are in a bubble. 

But I am saying that we need to learn from Mr. Buffett here. Buffett didn’t care about the price of NASDAQ or the billions his pals were making speculating. He didn’t care that his portfolio had underperformed the market for years or that people were calling him senile. 

Buffett cared about sound investing fundamentals. He cared about the same thing he had since he acquired Berkshire Hathaway in the mid- ‘60s. 

His goal was to invest in undervalued companies with sustainable businesses and products managed by competent management teams. That didn’t change because the market changed. 

Buffett wasn’t relying on THE MARKET to tell him how and where to invest. 

And I don’t think we should either. 

We can count on the market for one thing: to be the market. Just like the wind blows wherever it wishes. It is not in our control. 

Good sailors reach their destination in any weather. They are not dependent on wind or waves or temperature. 

A dozen recommendations for investors who believe this post 

If you are a Syndicator… 

Don’t overpay for assets. 

Don’t count on the market to make a profit. 

Don’t believe “it’s different this time.” 

Don’t count on the next decade to be like the last. 

Don’t overleverage with the belief that you can be just like the last guy who did it and repeat their success. 

If you want to speculate, do it with your own cash. Don’t drag investors in and call this speculation an investment.  

If you are a passive investor… 

Don’t invest with any syndicator until you’re sure they’re not a speculator. 

Don’t put all your eggs in that one basket. Diversify. 

Don’t swing for the fences. Slow and steady wins the race. 

Don’t invest before conducting careful due diligence on the syndicator and the opportunity.  

Don’t invest in overheated deals in overheated asset classes in overheated markets. (Remember, hope isn’t a sound investment strategy.) 

Don’t trust the market to generate your returns. Do trust a great operator with an excellent track record, a veteran team, and proven processes. 

Final thoughts

It’s possible to trust the market as a commercial or residential real estate investor or in any other asset type. Did you hear about the great Dutch tulip bubble of 1634 to 1637? 

Trusting your acquisition and operating skills will serve you well in any market. But please don’t count on the market to do the heavy lifting for you. 

BiggerPockets exists to help you grow in your analysis capabilities and make wise investment decisions, so you won’t have to rely on the unpredictable market. This includes bolstering your skills to navigate good markets and bad, plus connecting you to great investment managers and opportunities. Has this post helped you clarify these issues?

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.