What is a "Good" Investment? Wrong Question!

[Disclosure: This is not investment advice. Just sharing some valuable advice I gave someone to avoid a costly mistake they were about to make.]?

Another broker recently asked me for investment advice on a small property. At first, I refused to give him an answer because it comes down to a person’s specific situation, goals, age, and risk appetite. But after he pressed, I told him why I only invest in larger “value-added” apartments. I told him why I avoided the DIY trap of overpriced 1-4 unit properties that don’t pencil out on paper. Since others have asked me similar questions, I’ll condense my advice. “Eventus stultorum magister” (experience is the teacher of fools), so I’ll let you learn what I learned the hard way. It took a lot of education, a lot of networking, and a ton of humility to relearn everything I thought I knew. (Mindset is everything). What I thought was risky was conservative, and what I thought was conservative was risky.?

Here’s why I focus my efforts on larger multi-family:?

• Unlike smaller properties, you can “force” appreciation of the asset beyond what comparable sales would allow in the 1-4 unit space. E.g. if you improve a property’s operating performance by a measly $5,000 per year, the value of that at today’s capitalization rates is easily over $100,000. (Yes, you read correctly). Sure you can find deals in the 1-4 unit space. However, many of the competing “investors” paying ridiculous prices for small properties (i.e. speculators drunk on low interest rates) are only going to make money 5-10 years from now with organic market appreciation once they sell. Which isn’t bad per se, but it isn’t exactly leveraging all of the benefits of real estate.
• Multi family is more recession-resilient than other asset classes, as long as you are careful about the employment trends in that local market, and have good debt in place. Losing one renter in a 100 unit is 1% vacancy. Losing one renter in a single family home? 100% vacancy. Ouch.?
• You can add to your bottom line by making the asset nicer, safer, and more beautiful. There is a reason why tenants renew leases even if rents go up. Each resident might only spend $100 extra on rent but the related site improvements are worth $500 per month to the resident. When it’s done right, everyone wins. What many people don’t realize is that apartment investors have to increase the value to residents if they want to increase the value of the asset. This is why the good operators tend also to genuinely care about the resident experience.?Good operators tend to be good people.
• Depreciation on large multi family assets is nice (and on better time horizon than non-residential commercial). And, the bigger the building, the more it makes sense to depreciate more aspects of the asset earlier. While it seems unfair, the tax code is deliberately set up this way to encourage the private sector to provide housing so we don't have to have Soviet-style apartment blocks.?
• The long term trends look good: it’s basic supply and demand. I invest in the PNW because people want to live here, rents are really high, but it is harder to build new apartments. The “return on remodel” is thus higher. Why don’t I invest in “hot” markets (eg. FL, TX, TN) like all of those real estate podcasts say I ought to??Because those markets have more competition: you’re not the only one seeing the shiny object! The reality is, good operators can find great deals in “bad markets.” You bet on the jockey and not the horse.
• Value added apartments give you a balance of high alpha (returns), but at a much lower risk profile than single stocks (which are not terribly tax efficient). No matter what happens to interest rates, institutional capital will always want to park cash in stabilized apartments because of the stability and tax advantages. And if *&$% hits the fan, apartments generally have better longer term debt. Not the worst situation in an inflationary cycle…. ?

As I told this person, unless you find a really good deal, I would only invest in a 2-4 unit property if I lived in one of the units (and was much younger). What I really don’t like is when some residential brokers tell clients a property is a “good investment” when they clearly haven’t run the numbers to see that it loses money on a monthly basis. It could be "great" but you need to disclose to client that it's going to be a loss leader for a few years. It's one thing to have a paper loss because you are making improvements that will turbo charge the operating performance in the future to "force" appreciation. (You can use that passive loss against the future gain. But obviously talk to your accountant because this subject gets super complicated). But carrying a 1-4 unit property at an actual cash-on-cash loss on the vague hopes of organic appreciation and continued lower interest rates over a decade hold?

The reality is that conventional wisdom hasn't caught up with the increased options that investors have today:?partnerships, crowd funding, syndications, joint ventures, debt funds, etc. If your broker gives you investment advice make sure they are educated about ALL of the options. (Ask them what they invest in.) There are tons of options right in front of you once you define the asset you are looking for that is right for you (and not the people giving you advice). Sure, some investment vehicles require you to be an “accredited investor,” but many others don’t nowadays. Some require you to have a lot of capital; others allow you to put a toe in the water to gain some confidence and experience. Real estate investing is becoming more accessible and democratized.

The first step is to get really focused on what you want in an investment. Substance not form. Look inwards, not to others. The who, what, and how? That's phase 2.?