Why Risk Is the Most Inaccurately Assessed Factor When Investing

Put 10 investors in a room, and they’ll come up with 11 definitions of real estate or note investment risk—and far more ways to assess that risk. Then there’s the risk about which more experienced investors are wary—the risk of missing out on opportunities due to either lack of info or market changes they mistimed. Yeah, as if we can time the market, right?

Beginning around the end of 1975 ’til around Labor Day of 1979 in San Diego, there was no risk in buying residential income property there. Then, in October of ’79, the tune changed to a dirge. Interest rates went through the roof.

Think maybe I’m exaggerating? How ’bout a 16.5% FHA rate? A 21% prime rate? An 18-19% investment property rate? Then, as if all that wasn’t bleak enough for ya, how ’bout 14% inflation?! All that happened from the second half of 1979 to 1982, give or take.

But Wait—There’s More!

1981 made it far worse with a nasty recession. The feds then cut taxes everywhere, and the Federal Reserve gave us the medicine nobody wanted, but that was the recipe for a faster recovery. Fed Chairman Volcker then began to squeeze inflation by limiting the amount of new money coming out of the Fed. Strong medicine indeed. There were months when the annual unemployment rate, which reached 9.7% at one point, was sometimes over 10%.

Given all that bad news, imagine how well some investors were positioned in San Diego income property (residential) with single-digit fixed rate 30-year loans. The vast majority were able to weather the horrible economic years of the early ’80s, which lasted in my view ’til around the end of ’83 or maybe spring of ’84. But though things were far better in December of ’83 compared to the previous four years or so, they were still not super attractive.

For example, I put a client into a 7-unit apartment building in an excellent location. I found him an adjustable rate loan indexed to the 11th District Cost of Funds. He thought I was a magician ’cause the initial rate was below 12%! Starting at 11.75%, it was revisited every six months, adjusting to the COF Index. His interest rate on that loan decreased every six months for several years, something he got very accustomed to pretty easily.

Those who abstained from acquiring income property in San Diego before October of 1979 were sentenced to the sidelines for the next 4-6 years, depending upon their comfort zone. Meanwhile, those who did buy more property or pull cash out via refinancing at single-digit fixed rates before it all hit the fan were well positioned to take advantage of the repeat of the same rapid inflation in the second half of the ’80s. Those folks pretty much repeated what they’d done a decade earlier, which was trade up at least once, and for some happy investors, three times in just six years or so.

Yes, the appreciation was that pronounced.

Back then, risk was also potentially losing out on the “last chance” of gettin’ in before the music stopped for awhile. The same thing happened at the end of the ’80s with the onset of the infamous S&L Crisis, which left the market more or less moribund for several years.

Takeaway: It’s a mistake to look at risk only in the arena of property or note acquisition. The risk of not investing can sometimes be just as debilitating to one’s future retirement success. It falls under the heading “shoulda, woulda, coulda” and is usually part of a sad story told to grandkids. I’ve got a few of those stories myself.

A Common Example of Risk Myth

Everybody knows that buying non-performing first position discounted notes secured by real estate is far riskier than buying the performing note across the street. Common sense, right? Would you rather stay away from non-performing notes in first position secured by real estate or include them with your performing note portfolio?

Let’s do the math and you decide for yourself. Over the last 2.5 years or so, I’ve kept a running count in my head. The vast majority of folks come in believing the opposite of what they originally knew as settled fact.

Let’s look at a normal middle class neighborhood with two homes, identical in every way.
They’re both worth $150,000 and both have a $100,000 loan balance on a first position note with identical terms.
You can buy the performing note for $80,000.
The price for the non-performing note is $50,000.

Payments come in regularly and on time from the performing choice. There are no payments, of course, from the defaulted note. These projected note purchase prices are taken directly from my own recent experience THIS year. I took a quick average and went from there.

Which One Do YOU Want?

If the performing note pays off in, say, 7 years, you’ve made a nice cash-on-cash return via the payments plus the profit of 20% at the payoff. (Yeah, I realize there is principal in the payments.) If, on the other hand, you opted for the defaulted note, here’s where you might end up.

You pay around $4,000 to foreclose, give or take.
You put new paint/carpets and do a light fix-up to the tune of $10,000 to make it sale ready.
Then there are the back taxes owed, around $3,500 or so.
You now have around $67,500 invested.
You sell it for the $150,000 market value with sales and closing costs of 8%.
That nets you around $138,000 or so.
You have $67,500 invested, which leaves you a profit of approximately $70,500.

This all happened in, let’s say, 6 months, give or take. I’ve done it in 18 days, and one took just over a year. Most of mine land in the 4-8 month window. For tax reasons, you’d almost prefer it to take 13 months, as then you’d be able to claim long-term capital gain treatment. Your tax rate at that point, at least for most folks, would be 15%.

But What if You Can’t Give That Home Away?!

That first happened to me in 1981. The only sales happening then were the ones with the buyer getting the seller’s permission to insert a syringe in their jugular just to begin negotiations on price. Forced to hold on to free ‘n clear properties, by 1984, we not only saw massive evidence of the national economy recovering in a big way, we saw local real estate values begin to go up again. The net income from the debt-free real estate soothed our wounded pride as we waited for values to hit whatever magic number we had in mind.

For me, it was 1986. Boom! We sold everything and came out smellin’ like a rose. ‘Course, we also acted as if we hadn’t been nervous as cats in a room full of steel plated rocking chairs.

But we learned a lesson.

Looking back to the recession in the early onset of the mid-1970s, the same scenario had played itself out. After our 1980s experience, we saw that same script used for foreclosures caused by the S&L Crisis in the early-mid 1990s. Though it took longer for that one, by 2002-ish, real estate values had gone up enough to have created a whole new generation of geniuses. 🙂

The most recent example has been ongoing for the last several years. Those who had first position notes on homes defaulting after the bubble burst/Dow crashed/recession hit found themselves lookin’ for renters, not buyers. Imagine having foreclosed in, say, November of 2010. Sometime between 2014 and now, you likely woulda sold and made a pretty hefty profit. Some did even sooner than that.

In all these scenarios, the investor opting for the non-performing note or land contract in first position came out appreciably better than if they’d bought the performing note across the street. Now, please don’t take from this that I’m against performing liens, as that’s the furthest thing from the truth. Roughly 65-70% of what I and/or my various investment groups acquire are indeed performing.

A rough range for performing liens to pay off is 3-9 years, though you can’t ever apply that range to a given note, not ever. They pay off randomly, period. The non-performing portfolio tends to turnover around 1-2 times yearly. Obviously, the exception to that are the above mentioned economic downturns. The truth is that in retirement, most prefer passive income from performing assets, not labor-intensive investments like what we’re discussing here.

Related: A Look at the Rewards, Risks, & Rules for Investing in Rural Rental Properties

My plea to the DIY crowd is to avoid the temptation of buying the non-performing notes/land contracts without experienced professional help. I know, I know, your eyes are rollin’ in the back of your collective heads as you read that. What most don’t or won’t tell ya is that it’s almost impossible to buy a defaulted first position note in your own town. I’ve been buying notes/land contracts since Ford was in office, and the only reason I could was ’cause I owned a brokerage, and other brokers called me with the opportunities that never really hit the public eye.

Also, NONE of those were in first position, and none were non-performing. This means you’ll be investing in something far away, usually at least 1,000 miles. The closest town in which I’ve bought a first position defaulted note/land contract was in Nebraska. No, really.

Takeaway: As you can easily discern, investing $50,000 instead of $80,000 for the same debt amount secured by the same value home on the same street is definitely not riskier than the alternative. Sometimes common knowledge is nothin’ but common myth. But don’t believe me, believe the math.

Do you agree with this assessment of risk in real estate investing?

Let me know your thoughts with a comment!

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