​Gold, Silver, or Gilded

To begin, I need to lead with an important point that all real estate investors should know:

No real estate investor strikes gold with every investment. If they say they have, they’re either lying to you or represent a statistical anomaly equivalent to being struck by lightning while simultaneously being eaten by a shark.

The most common cliché taught to us from the time we start to understand the concept of struggle is that failure, and learning from it, is the key to being successful. For those who need further help internalizing this concept, examples are used ranging from Abraham Lincoln’s unsuccessful bids to obtain political office to Michael Jordan being cut from his high school basketball team before going on to become arguably the greatest player of all time. Failure is a learning exercise, failure is a tool, failure is a risk in every action we take that can yield a result beyond the ordinary we encounter in our lives.

Failure exists as a necessity, else everyone would be successful.

As you are reading this, you are probably finding it hard to disagree, which is why it is so abundantly frustrating to me that so many real estate investors don’t always seem to understand the concepts of risk, reward, and failure.

As with most investments, real estate is a great concept to be discussed, researched, and envisioned as a long-term route to self-sustaining wealth. Thankfully, we live in an era where the abundance of accumulated knowledge from thousands of investors from around the world can be shared daily, and therefore the initial barriers to investment education have been lowered. However, like with any investment, there will always be some information that cannot be made available to the buyer. This fluctuating risk is theoretically – and quite often practically - inversely proportional to return on investment (or ROI). Without risk, there would be no reason for every person with available capital to attempt to be a real estate investor, driving up prices, lowering ROI, and making the point of real estate investment moot.

As an economics student at the University of Rochester, one of my professors constantly talked about life as a Game of Imperfect Information. This concept states that there is no way for any party to have full and instantaneous knowledge of all market conditions, the utility of their actions, and cost functions. Therefore, we are operating under imperfect information, constantly attempting to obtain more knowledge to identify the costs and benefits of our actions and their potential results. This concept, as you probably have already inferred, has direct application to real estate.

When viewing investment opportunities, I usually immediately split them into two categories: silver and gilded. A silver investment is one where you have obtained enough information up front to solidify its place as a solid investment opportunity. This information can be gained in several ways, with examples being full profit-and-loss statements provided by the sellers (which are less common than they should be), viewing the property firsthand to check for mechanical defects, or necessary aesthetic upgrades. While it isn’t always possible that all risk has been mitigated before a purchase, enough upside exists based on the information gathered that a profit can still be made in the long-turn to outdo any potential problems that come up during ownership.

In contrast, a gilded property is one in which the information needed to mitigate large-scale risk is unobtainable for one reason or another. This is most commonly found in foreclosed homes or any time an investor attempts to enter a new market, as a myriad of issues could exist that are not foreseeable until the drywall is torn down or the first permit application is submitted. With that in mind, that increased risk generally means an increased potential ROI, offering a better investment than the standard “silver” investments discussed earlier. The potential could be there, but to get there you must chip through that initial layer of metal to see whether that golden opportunity being offered to you is truly gold, or merely a gilded stone you must figure out a way to squeeze your initial investment out of.

In a real estate investment career, it is excruciatingly difficult to avoid gilded investments entirely. In the rush to build a portfolio, the information gathering process may be rushed due to expected ROI, with crucial facts overlooked that ultimately increase up-front expenditures or long-term maintenance costs. On other occasions, an investment may be made in an area expected to appreciate rapidly that instead loses value due to either an economic downturn or an unforeseen outside event.

The reality is this: you will not know whether that glittering opportunity you first found was you striking gold or striking out until the property is sold or transferred out of your name. The sheer amount of potential risk is huge, but that’s what makes those monthly rent checks, fat profits from a flip, or that final check from the closing of that dilapidated wreck you sunk all your money into thirty years ago and turned into the nicest house on the block so unbelievably sweet.

I’m not trying to say that you shouldn’t take a risk with a property, whether it be your first flip or buying an auction property sight unseen because the neighborhood allows for a supposedly “guaranteed” return. All I’m saying is that to strike gold in the long-run with a real estate investment, you need to accept the fact that failure is a possibility, to make sure you do as much research as possible before pursuing an all-in investment, and that if you are persistent and learn from your mistakes, your hard work and capital will pay off.