The current bullish real estate market has resulted in a considerable increase in the net worth of older real estate investors plus a whole new crop of real estate moguls. This proliferation of increased net worth has produced a stream of media stories describing these new real estate moguls, their histories, and methods. As one might expect, those real estate investors who used higher leverage in their investment strategy produced significantly larger profits. Most of the recent real estate moguls appear to place high-leverage as the tool of choice for achieving a successful real estate investment program. Before this concept of high-leverage takes hold, we believe a sound evaluation of its risks should be reviewed.

An old story (which I will embellish) about a newly married couple spending their honeymoon in Las Vegas provides an effective summary of these risks. Like the one-armed bandits whose lights, bells, and whistles don’t turn on (because the players didn’t win), this is the type of story you don’t read about.

When the newly married couple crossed the threshold of their honeymoon suite, the new bride suggested that her husband find something to do while she prepared herself for their first evening together. The understanding husband stepped outside their suite, stuck his hand in his trouser packet, found a five-dollar bill, and decided to proceed to the roulette table and try his luck.

The roulette table has 72 numbers: half are red, and half are black. Aside from the 72 numbers, there is a zero and a double-zero. When a player selects either red or black as a choice, a winner is paid even money. Our new groom felt the roulette table’s most interesting and fairest opportunity was betting on either black or red. He took out his five-dollar bill, exchanged it for a five-dollar chip, and promptly placed it on the red. Red won, and our groom had ten dollars.

At this point, two gentlemen approached. The first offered to lend him ten more dollars to bet if he would sign a non-recourse note at 8% interest, due when he finished gambling. The other gentleman offered him a ten-dollar investment for a one-third interest in his entire gambling activity. Both proposals sounded reasonable to our groom, so he agreed. He then placed thirty dollars (his ten plus the twenty from his new associates) on the red. Red came up again, and our groom now had sixty dollars.

The croupier asked what his pleasure was, and before the groom could answer, the lender and the investor each offered the groom sixty more dollars under the same conditions as before. The young groom accepted, and he now had $180.

Eight consecutive times in a row our groom bet red, and eight consecutive times in a row red came up. On each bet, and under the same terms, the lender and the investor offered, and the groom accepted higher and higher amounts of money. After the eighth consecutive win, there was $2,799,360 on the table, a large crowd around the table, and the gambling casino owner looking on.

The croupier asked what the groom’s pleasure was, and before he could answer both the lender and the investor each offered $2,799,360. The groom accepted, and that meant the next bet on red would be $8,398,080. The croupier now looked to the owner for direction. The owner nodded okay. The bet was placed, and the little silver ball spun round-and-round. This time it came up black.

The lender now had $3,359,230 worth of non-recourse notes with an 8% coupon and no security, and the investor had an agreement to own one-third of an entity with no assets. They each lost $3,359,230.

The groom, feeling he had been gone long enough from his bride, returned to the honeymoon suite. Upon entering the room, his bride asked, “How did you do?” He responded, “I lost five dollars.”

Epilogue

It was later discovered that the money the groom used from the lender and investor was not theirs. The lender and investor were each using other people’s money, and they were collecting fees for managing that money. The clients from both the lender and the investor were retired people who stated that they told their money managers they wanted safe investments and a dependable yield. After the clients of the lender and the investor reviewed their money manager’s activities, each group of clients filed a class-action law suite. After one-year of interrogatories, document review, and depositions from experts on both sides, the cases are still pending.

Summary

The story of our groom highlights a number of important investment principles, some of which are:

The amount of money invested doesn’t change the degree of risk. Even though our groom was making progressively larger bets, he was at equal risk (100%) for every bet. This principle applies to all those real estate speculators who flip their highly leveraged equity from from one property to another without a well thought out exit strategy plan. There are seminars all over the country with promoters offering sure fire schemes using minimal equity and maximum leverage. Bottom line, for all investments, whether a five dollar bet on a roulette table or the purchase of a multi million income property, there has to be a well thought out plan from start to end. Once the plan is complete, carefully choose your associates. They should be dependable, capable and honest. Anything less will increase your risk and liability.