Why Most Real Estate Investors Can’t Scale Their Investments or Their Business.

[Don Konipol]

I keep coming across posters asking for advice on how to “scale” their investment or business activities.  What they’re missing is that they first need to ask “Is my business / investment process scalable?  Here’s, the hard truth I’ve found in 45+ years in the industry; the vast majority of real estate investors, practitioners and business owners do not have a scalable activity.  Sure, they may be able to grow to a very moderate size,  add a few units, or trade up to a larger investment, but as for real scalability: NO.

Why? Because their investments do NOT have a higher enough ROI adjusted for risk. After paying a competitive rate for the property management and ASSET management that the small operator does himself. So, what is required to scale?

First, most investors and owners of real estate related businesses are in one or more of the following situations

1- they're unable to duplicate their expertise that drives the ROI and they are at their personal max capacity as to time

2- they're obtaining high ROI by use of excessive leverage

3 - they're obtaining high ROI by taking excessive risk

4- they hit correct timing in the correct market, and this is not necessarily repeatable with any probability

In order for an investment or business to scale, we need the ROI (on a risk adjusted basis) to be sufficient to cover a PREMIUM risk adjusted return to passive investors; all expenses of managing the assets and the business, and a significant return to the "sponsor" providing compensation to him making the work, risk and time worth while.

Here's an example. Let's say your filed of expertise is purchasing c type apartment t complexes and upgrading them to b, then holding to stabilization and once stabilized offering for sale. Investors in these type deals look for say 12 - 14% annualized return. You normally handle the whole project yourself. And you're able to confidently predict an 16 - 18% annualized return COMPOUNDED ROI. Well, guess what? Your Not scalable! First, 4% of that ROI is because you're doing the
asset management” work yourself without direct compensation.  Second, as sponsor you want a 1 - 2% annualized return asset management fee AND 20% of the profits after the investors get their money back.  So a MINIMUM 22% Gross ROI is needed to “scale”.  

There are lots of REALLY GOOD investments and businesses out there - but that doesn’t mean they’re scalable. 

[Don Konipol]

Quote from @Jill F.:

@Don Konipol Hi Don, At the point where I am in my business, I am thinking (a lot) about improving and growing my business and profits. I'm not thinking of 'scaling' my business by becoming a 'passive investor' in someone else's business.

I've seen a lot of your posts and I'd be interested to know what you think differentiates those 'few' investors that do manage to scale their businesses from the 'most investors' that are unable to achieve a gross ROI that would generate acceptable profits for a sponsor and investors? Assuming that they aren't simply lucky in market timing, excessive in leverage, or excessively risky, why do you think that some companies and leaders ARE able to duplicate the ROI driving expertise and/or improve personal-business productivity in a way that allows scalability? What do you think they do differently?

Also, What do you consider growing to a moderate size?

The “moderate size” question is pure opinion. In investing, I’d consider a moderate size being $2 - 10 million in real estate with 50-60% leverage.   In a business, I’d say owner “net profits” (exclusive of any owner salary) of $200,000- $1 million.  But the answer for everyone may differ.

Here are the personal attributes I see in those able to achieve a higher than market ROI, enough higher to be able to "scale".

1- Knowledge of real estate principles, real estate law and real estate finance
2- Minimum 3 -5 years full time, or near full time experience directly related to real estate investing
3- Ability to utilize technology for increased efficiency, capacity, and accuracy
4- Excellent hired legal counsel and excellent hired marketing help
5- Established method(s) of obtaining consistently high QUALITY deal flow
6- Ability to manage and choose people who are NOT employees: Attorneys, Appraisers, Mortgage Brokers, Real Estate Brokers, Title Companies, Surveyors, Marketing Specialists, Accountants, Contractors, Consultants, Property Managers
7- A VERIFIABLE track record of success
8- Ability to identify, analyze, and negotiate a deal that can be “worked” for “enhanced” ROI
9- Some type of competitive advantage; for example for me it’s my ability to analyze and identify mortgage loans that are actually less risky than all other lenders believe (on the investing in debt side), and on the real property side it’s my ability to analyze”pull the trigger” with LESS information than other investors need,  combined with the ability to pay cash, or raise significant capital almost instantly as well as being able to obtain loans at the lowest prime customer bank rate with no recourse or personal liability.  Others investors drive extra ROI by thing like ability to reposition property for greater profitability and or less risk; ability to rehab property at less cost, ability to identify areas where gentrification is likely to occur, etc. 

Most of the failures I've seen when investors attempt to "scale" a non scalable business result in only moderate losses and temporary setbacks. However, I've witnessed cases where the investor went "all in", spending and losing many millions. A classic example is Vestin Mortgage back about 15 - 20 years ago. They were a hard money / private mortgage lender out of Las Vegas doing about $30 million annually. They then decided to scale, hired Joe Namath as a spokesperson (I know, right there that's the sign this was headed for disaster) and went around the country drumming up interest in investing in their newly formed REITs. They raised over $300 million in two mortgage REITs, however they didn't have the deal flow to invest 10% of it. Because the number of qualifying risk/return deals is just not large enough to handle that amount of money at one time. So they started doing the loans that everyone else turned down, ultra high risk development deals, second mortgages, land loans at ridiculously high LTV, loans where the borrower has none of his own capital invested, 85% of AFTER stabilized value loans. Their REITs were initially sold to the investing public at $10.00 per share. After one year the REITs were being traded at $.01 per share!. According to their SEC filing of the $300 million in loan they made, $299,300,000 was NON PERFORMING.

Just checked on Vestin Mortgage. Interestingly I saw they're still in existence with a stock price of $3,105 per share. However, this is smoke and mirrors. They've had 4 reverse stock splits, including the absorption of the first REIT into the second REIT. The reverse stock splits resulted in the holder of 24,000 shares purchased at the original offering now being the owner of 1 share. So for every 24,000 shares purchased at $10 per share or $240,000, the investor, 20 years later owns 1 share worth $3,105. Or each original $10 share is now worth $.0004, or four one hundreds of 1 cent.