Saying "No" Is Just as Important as Saying "Yes"

One of my favorite business slogans was coined by Dr. Peter Linneman: “Saying ‘no’ is as important as saying ‘yes,’ only tougher.” 

Real estate finance is all about risk and opportunity, and there is never opportunity without risk.  Operating cost, vacancy, natural disaster, leasing, liquidity represent some of the risk. You could experience an unexpected increase in operating costs, which would decrease the building’s net cash flows below your expectations. Although contractual lease terms may alleviate some of the risk, you may not be able to pass these costs down to the tenant. And no matter how carefully you analyze these costs, I promise you that your forecast will be wrong. “Wrong” doesn’t mean meaningless, just that actual outcomes are not as certain as they appear on your beloved spreadsheet.

Contrarily, operating costs, terminal value, rental growth represent a non-exhaustive list of potential upside and growth. Thus, because a rental property has more potential upside, and more potential downside, than say, a 10-year Treasury Note, you should expect a higher rate of return on your investment.  Conceptually, the “right” expected rate of return is a reflection of the anticipated cash flow. 

Real estate investing doesn't begin with a podcast, or a book, it begins with a self-reflection, your desired returns and your risk tolerance.  Understanding expected future cash flows helps you understand why you may fail to meet your cash flow projections, and help you plan for if/when that happens. This, and able to say “no,” is what makes a great real estate investor. 

The only way to mitigate your risk, and thoroughly analyze an opportunity, is to know and continually study your market.  Publicly traded companies and large REITs have increased access to market information, but the single best way to know a particular market is to devote yourself to a specific product type and geography, and getting to the know where nothing happens without you knowing about it before it happens. There is no shortcut to understanding the market—plenty of publications sell “the next big thing,” and if you torture the numbers long enough, they’ll tell you anything you want to hear, but you can't replace being on the ground.  Is it alright to assume? Absolutely, but your bank account will be judged on the accuracy of your assumptions. 

Real Estate investment decisions ultimately depend on your expertise, balance sheet, risk preference, experience, and deal flow. For example, your proforma for four different opportunities may all show a 15% cash-on-cash return, but you need to quantify the potential upside with the potential downside, and reconcile it with your risk preference, to choose which opportunity best suits you. What differentiates the four properties is their risk profile—not their expected returns.

If you are investing in real estate, then you are taking real estate risks.  You must exploit your expertise, even if it doesn’t keep you as diversified as you would like. For example, if you have $100,000 of capital, and your project requires $100,000, you will not have enough money to be both diversified and execute on the project. This flies in the face of portfolio theory taught at every business school in the world, but consistent with exploiting your competitive advantage and maximizing your profits. We can’t do all the deals because we lack capital, manpower, and resources.  Therefore, you strive to determine which deals deserve a “no” because they do not most effectively use your skills or meet your investment objectives.