The High Cost of Risk in Real Estate Investment
The amount of potential loss should be every investor’s first concern. Why? Because recovering from a loss becomes mathematically more difficult as the investment declines in value. For example, when an investment declines 20%, it has to appreciate 25% to break even. When that same investment declines 40%, it has to appreciate 67% to break even. And when that same investment declines 60%, it has to appreciate 150% to break even. All of the aforementioned give no consideration to the significant affect that leverage has on recovery of principle from an income property investment.
The following chart is perhaps one of the most important visuals that investors will ever see. It shows the percentage amounts of appreciation that are needed to break even against the corresponding percentage declines of 10%.
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What is investing? Webster’s unabridged dictionary says to invest is “to put (money) to use, by purchase or expenditure, in something offering potential returns, as interest, income, or appreciation in value.” That said, all types of investing can be be put into two categories; (1) real (minimal risk) and (2) fad (high risk).
The difference between real and fad investing is the difference between substance and form. Real investing is based on substance; fad investing is based on form. Real investing is the actual matter of a thing as opposed to an appearance or shadow. When you compare these two categories of investing to operating businesses in a capitalistic society, the profit-and-loss statement becomes the lynchpin that separates real investing from fad investing. The profit-and-loss statement is the key document that real investors use to analyze a business. The bottom-line(s) from the profit-and-loss statement is what real investors use to determine the value of a business.
Real investors hold the past, present, and projected results of the profit-and-loss statement accountable for deciding whether to invest or not to invest. Fad investors rationalize that failures within the profit-and loss-statement are acceptable; then they devise a whole series of methodologies (none of which have anything to do with value) for determining value.
Why is it important to know the differences between real investing and fad investing?
1) The investment community of our country is moving from a state of fad investing to real investing. The greater fool theory has been tested and failed again. Lenders are coming back to earth. They are looking at the borrower’s ability to meet payment obligations and the collateral securing the loan. Investors are looking at real operating earnings, not the excuses.
