Do Higher Returns Equal Higher Risk?

“Price is what you pay. Value is what you get.” -- Warren Buffet

I've spoken with over 1200 high net worth investors one-on-one.

This question comes up a lot:

If an investment's return is higher, does that mean it has higher risk?

The answer is: Sometimes, but not always.

That's why it's really important that you look at what the downsides really are.

Look at the advantages and disadvantages of a particular investment.

You might find things that are not high risk have much higher returns than what you thought possible.

Let’s talk about it!

1. The Link Between Risk and Return

What is the link between risk and reward?

Some of the safest investments are short term treasuries or T-bills.

These often mature a few months out (or less) and backed by the federal government.

I have my own debate on why they are not the safest investment, but in general, their safety is common knowledge.

It is very possible you have negative real interest rates on t-bills due to inflaltion.

Then you get to things that have higher yield.

A similar type of investment would be a junk bond.

These are corporate bonds, aka: a company that's paying money for a loan.

It could be a much higher rate than a T-bill.

Why is that?

The company typically has had some financial trouble.

They had to borrow in the first place to get the bond.

There's a decent chance that they may not be able to repay it.

You can see the risk there.

I will say this: A lot of things are not so cut and dry.

It's not exactly what you see is what you get.

Think of an optical illusion like this one. (What do you see?)

When it comes to looking at deals, we don't always see them the way that they really are.

We have our own biases and backgrounds.

It is really important to note that when we're looking at different deals.

A question that often comes up: Is the market price for any assert efficient?

Is it accurately priced with all the risk packaged in?

There are a lot of people much smarter than me that believe that’s true.

There are also some very smart people that do not believe that.

Warren Buffet has a saying: “Price is what you pay. Value is what you get.”

You can go to the store and buy a $100 sweater on sale and pay $40.

That's really what good investing is!

Buffet himself says good investing is like trying to find a dollar and only paying 40 cents.

That might sound like a strange concept.

Not everybody can understand that.

You don’t always pay more and get more for it.

In some cases it's true, but in a lot of cases it's not.

We’ve seen the stock market value one stock at $100 one day and a week later that same stock is $10.

That's confusing, right?

Which is it? $100 or $10?

A person who believes in an efficient market would say that's all accurate.

Everything, including risk, was priced into those numbers.

The truth is the market is not efficient.

But there are deals out there!

If you're someone like me, I love getting deals.

We work in multifamily real estate investing.

The returns are substantially higher than things like the stock market.

Why is that?

A lot of times you have deals that are not liquid.

These deals can be value add where we're doing improvements on the buildings.

There is also one disadvantage of investing in multifamily real estate, at least in terms of syndicated deals.

Typically people's money is tied up for two to five years.

You can't just go in and trade it like a stock.

So there's a disadvantage to multifamily, but the returns generally are higher.

This doesn't necessarily always mean the risk is higher.

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2. Higher Returns with Lower Risk?

Higher returns can actually mean lower risk.

I'll get into an example shortly that will show you that it's true.

My background is investing in multifamily.

That’s our business.

You can use this with other investments as well.

It's really important that you look at the advantages, disadvantages, and risks of every investment you make.

There will always be great things about certain investments.

There will also be risks about every single investment.

Any investment that says there is no risk, you should turn tail and run!

Let’s talk about an example of why some things will have higher returns, but not be higher risk.

In multifamily investing we see much higher returns when compared to the stock market.

It's not uncommon for us to see 15% or higher returns per year.

If you look at the historical growth, you can see that in the performance of different investment groups, including ours.

How does that happen?

One of the differences between this and investing in REITs, is that we use something called a value add component.

We come in after someone moves out of an apartment and renovate that unit.

Usually often costs around $10,000 per unit, depending on the market.

After we renovate, we'll be able to raise rent by a couple hundred dollars.

The next folks who move in will have a nice new renovated unit.

This dramatically increases the value of the property.

You don't get that when you invest in rates or other similar things.

The returns will be higher with this type of investment typically when compared to other types of real estate investments.

Another benefit with multifamily real estate is that we're able to use leverage.

We're able to use debt.

Usually, we'll put 20-25% down, sometimes less.

If a property appreciates, the equity still is not a higher proportion, but we can dramatically increase the value.

An example of this is a large, 288 unit property we bought less than a year ago in Jacksonville.

The property was $27 million.

We sold the property for $37.5 million less than a year later.

There are a couple of reasons why that happened.

Firstly, the market appreciated.

Secondly, we got a great deal on the property.

There are things outside of our control.

But we also had leverage.

We didn't pay for the whole thing in cash.?

Even though the property only increased by 20-30% in value, we dramatically increased the invested equity by 70-100%.

That’s pretty phenomenal!

Another benefit is the real inflation head that comes with investing in multifamily.

As seen in this chart, rent growth generally rises with inflation.

If you look at inflation, you're gonna see there's an inflation hedge built in.

That’s really great these days!

My opinion about inflation is that it's here to stay.

Being in inflation protected assets is really valuable.

With those advantages do come some disadvantages.

One risk is illiquidity.

You can't just go the day after you invest in a deal and ask for your money back.

In some scenarios, the sponsor could buy you out.

That does happen.

But in general it is more illiquid.

It's typically two to five years until you get your money back.

Or maybe the money is coming back, but before you get your principal.

Another disadvantage of multifamily is that it's very operator dependent.

If you have a great operator, your investment can perform phenomenally well.

However, If something goes wrong, the operator might not l know how to deal with it.

There's some risk with the person you're dealing with.

How reputable are they?

How comfortable are you with them?

If you want to learn more about this, we have some videos here and here that talk about vetting deals and operators.

The most important thing, especially in this type of deal, is who you're working with.

Another concern in multifamily are the loan interest rates.

What are the rates we're getting on the debt we have?

Is it fixed or is it flexible?

If you have an adjustable rate debt, or rates rise, you may have to go to the market and say you want whatever rate the lenders are going to give.

You could be at 3% and all of a sudden you've got a 5% or 6% rate.

That could really affect the deal’s performance.

It's really important with anything you invest in to have eyes wide open.

These advantages and disadvantages are all things you have to weigh out.

All in all, I don't necessarily look at all these things as disadvantages.

You just have to understand them.

Higher risk doesn't necessarily mean it's a higher risk of lost capital.

It just means the investment may look a little bit different than you’re expecting.

3. Finding Asymmetric Returns

Now we're gonna talk about asymmetric returns.

What does that mean exactly?

Asymmetric returns have a high upside with a low downside risk.

There's this great book called the Dhando Investor by Mohnish Pabrai.

The book talks about this idea of “Heads I win. Tails I don't lose much.”

Pretty much the picture of an asymmetric return, right?

When you evaluate your investments, it’s great when you have one with a very high percentage chance of going fairly well.

If it doesn't go well, it's important that you don’t have 100% of your assets in this investment.

You should be diversified.

The idea is that you have a lot of upside without the equal amount of downside.

You should look out for things where the benefits are substantially higher than the downside.

A lot of investments are that way.

Many people would say that they are diversified.

They've got stocks and bonds.

There's actually a lot of correlation between those things, which is a challenge.

If you own stocks or bonds – even if you own just single family real estate – those things can be very correlated.

If one goes down, they can all go down.

We've seen stocks go down 30-50% over a 12-month period multiple times.

I see bonds having a high level of risk when it comes to their interest rates.

If you have a bond that yields 3-5% and all of a sudden new bonds come out that yield much higher rates, it makes your bonds worth much less.

If you want places to evaluate your investments, attend networking events and conferences.

Speak with other investors.

Ask them not only about their best successes, but about their mistakes.

Have they ever lost money?

When did they realize the investment went bad?

Having these conversations will really help you grow.

The best investment you can make is in your own education.

So well done for you for reading this post!

You're educating yourself on how to be a better investor.

Remember the Warren Buffet quote from before?

“Price is what you pay. Value is what you get.”

I hope you find value in places where other people say there is none.

That's really how people become very wealthy.

They look for value and find it in places where other people say it doesn't or couldn't exist – or they just don't educate themselves to understand how that works.

If you're interested in learning a little bit more about multi-family, we put together this great video about the unfair advantages of multifamily.

Now I want to hear from you!

How do you evaluate risk in your deals?

What do you do to try to mitigate that?

Before you leave, make sure to check out our special report about investing. It compares the stock market to real estate, and it also includes how the pandemic affects your investment future.

If you are interested in investing with us, we are happy to answer any questions that you may have. Join our investment club today and we will be in touch!

Disclaimer: I am not your investment advisor. This is for educational purposes only. I am not giving specific advice on what you can do. I am simply giving my opinions.