When It’s This Easy to Make Money, A Bubble is Getting Ready to Pop

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My friend, Ron, is a single-family developer on the East Coast. Ron has spent decades successfully developing subdivisions. He told me this shocking story the other day. 

He was planning to build 2,200 square foot homes on about 40 lots that he had developed, hoping to sell these homes in the range of $350,000. They were nothing special but near a beach, so that helped.

He saw a new house on the market in a subdivision across the street. It was only 1,500 square feet and sold for over $400,000 last spring, so he was very encouraged. He was surprised when it hit the market a few months later for $625,000. And it sold!

He was even more surprised when it hit the market again for $820,000 last month. It went pending quickly, and he told me the other day it actually sold for $20k over the asking price at $840,000. 

Remember, this is for a 1,500-square-foot house that isn’t beachfront. 

When it’s this easy, something might be wrong. 

Do the Numbers Matter Anymore?

Another friend of mine is an outstanding multifamily syndicator. He told me about a multifamily property that is particularly challenging for his team. 

Before I go on, I want to say he is one of the best multifamily syndicators I know. He’s got an excellent property management team, great marketing, great systems, and he usually doesn’t make mistakes with acquisitions. Well, this was one mistake. 

He told me his net operating income was barely covering his debt service. His debt service coverage ratio was dangerously low. Because he uses floating rate debt, his interest rate was in the 2% range. 

His property management team had done all they could but could not get the rent bumps they projected and the needed increases in net operating income. 

This was not a great investment. Then it became one. 

My friend got an offer 50% higher than he paid for this asset. The new buyer, probably a less experienced syndicator, has a floating interest rate at approximately more than double my friend’s, at roughly 5%. 

Think about this—how in the world is this going to work? How is it going to end for the investors? 

I don’t understand how the math works or how they got a loan, but that happens in times like this. In times that precede a market top (a bubble bursting), debt flows freely, and syndicators gobble up every bit they can.  

The only way this could even work, in my mind, is if the buyer got extremely low LTV debt and is hoping, praying, and counting on inflation to rescue him and his investors. 

But that’s not the point of this post. The point is that my friend got out of a terrible investment with a very nice profit. 

Once again, when it’s this easy, something might be wrong.

Lessons From Munger

Charlie Munger, the legendary curmudgeon investing partner of Warren Buffett and Vice-Chairman of Berkshire Hathaway, said, “It’s not supposed to be easy. Anyone who finds it easy is stupid.” 

If Warren and Charlie invested in real estate, I think they would be selling right now. That is unless they could locate assets with significant intrinsic value that could be harvested. I’ve written on this, and my firm has staked our future on it: “There Are Still Deals Out There (for Now)—Here’s Where to Find Them.”

This is not limited to just these two examples. I hear examples like this all the time. I mean all the time. 

And it is not limited to a few asset classes. I’m hearing stories like this in multifamily, single-family, self-storage, mobile home parks, and more. 

This type of behavior almost always precedes the top of the market and a bubble that eventually bursts. 

I will admit it’s possible that massive inflation could save many of these speculators. But do you really want to count on that? I mean, do you really want to be in a position and put your investors in a position where things outside of your control have to go your way to make things work? 

If you are collecting fees and will get paid regardless, you may be tempted to charge forward. But I am pleading with you to reconsider that for the sake of your future, your reputation, and especially on behalf of all the people who are counting on you. 

This is not the time to play double or nothing. When the market is at unprecedented levels, then the margin of safety is the smallest (and, in this case, perhaps negative). 

This is the time to avoid risk and wait for blood to run in the streets (from others’ mistakes). If you keep playing double or nothing, you will eventually land on nothing. Then what will you have left to double? 

Speculators sometimes end up driving a Maserati and living in a mansion. But some of them wind up delivering pizzas. There is nothing wrong with delivering pizzas, but I am guessing you are involved in the BiggerPockets community because you want more. 

We all know that low risk leads to low returns. Correspondingly, we assume that high risk leads to high returns. But that’s not true. High risk leads to the potential for higher returns. And also the potential for low returns or total loss. 

Don’t gamble with your wealth. And certainly, don’t gamble with others’ wealth. They deserve better than that. So do you and your family. 

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