I'm in the middle of reading How to Make a Few Billion Dollars by Brad Jacobs. Actually - I'm in the middle of listening to it. I had a colleague at Goldman who used to give me a hard time when I said "I read something" and he found out that I "listened to it". So full disclosure - I'm listening to it.
Anyways - I was driving up to Seattle to tour a property we're in contract on, and Brad launched into his discussion on the four quadrants of investing. I thought the concept was great.
I immediately wanted to apply his Four Quadrants to real estate investing. It seemed applicable, and a powerful framework to think about investing in general (if you are an active investor, anyways). Too often I think people forget about this - or don't think about it at all - and make investments that are the definition of low potential return, high potential risk.
To my mind - it's all about asymmetric risk profiles, which is not a novel topic but I do think is fairly novel when applied to real estate. People understand the idea of an asymmetric bet, of course. An option contract on a stock that costs you almost nothing but has huge upside potential, for example, intuitively makes sense. You will lose X ($10) but you could make $1,000. That's a bet you can and should make.
By contrast, investing $1,000 for a $10 potential return but a potential wipe-out of your investment is a bet most people would not make.
Yet, in real estate, I think people often walk into the latter situation.
The raw difficulty with real estate is that things can always go wrong, sometimes catastrophically so. I've known of brand new buildings that suffered pipe freezes and horrible flooding. You certainly wouldn't anticipate a 2022 or 2023 construction asset to deal with those issues, and yet deal with it it did. Insurance covered this - but of course, insurance premiums are skyrocketing.
Viewed from this perspective - is anything actually "not hairy" in real estate?
But as I'm exploring in an upcoming book (scheduled release would be mid 2025 right now) great investors are still systematized in their investment approach. Real estate (with all its inherent chaos) should also have such a system around it. And I think Brad's 4 Quadrant system is a really good approach.
Here's a rundown as applied to real estate (in my opinion):
The Holy Grail - Low Risk, High Return
The obvious and most attractive investment. It's also a unicorn, especially in a competitive market - but they do exist out there. Some examples include what I think is the most alluring opportunity right now - a super distressed brand new building being sold for a song because the developer is at risk of going bankrupt, and you pick up something way below replacement cost, at a crazy good capitalization rate, and are poised to benefit from the market rebound in pricing and rents.
There's a reason entire mega-funds have been raised on this concept. It's a clean, high return, low risk deal. There are, of course, risks - but they are not that significant. You are unlikely to need capital investment in the building. You may suffer some market risks - i.e. the aforementioned recovery doesn't materialize, but if you have a good basis and long-term debt, you're probably going to do just fine.
I also think - for most of the past decade - that a traditional, walk-up style complex in the suburbs that was 1980s or newer vintage and had a clean-cut value-add plan (you invest X in the units, you will absolutely get Y for rent) fell in this bucket. That's a reason that value-add multifamily models took off over the last decade. There are enormous Firm's that did just this, and printed money for a long time.
Nothing lasts forever, though - and this model has recently been weakened, and probably doesn't fall in the "holy grail" category right now.
High Risk, High Return
Somebody will disagree with me, but I would put ground up development in this bucket. Potential for huge returns, but (to me) an unacceptably high risk of huge loss at the same time. I would contemplate putting development in the high risk LOW return bucket (for the LP) except that it can and does produce outsized returns so it doesn't qualify. My concern with ground up is the enormous potential for things to go wrong. To name two huge risks:
- Cost overruns (!), your GC goes bankrupt (!!)
- You have no idea what the market will look like when you deliver (look at developers delivering product today)
I could add in that the city for some reasons holds your project up on permits, which is a whole other problem. There's a reason I never did development, personally - these are some of those reasons.
Other investment types, in my opinion: an older vintage value-add deal (that has systems upgrades in place, possibly not - all depends on the basis), a value-add play in a "turn-around" market play, which could go really wrong but could also go really right, deep distress deals (depends on the reason for the distress).
Because I think the "clean, easy and super high return deals" are hard to find and mostly don't exist right now - most people can and probably should play in this space. The key here is to mitigate your risk as much as possible.
Low Risk, Low Return
The "bonds" of the real estate world. Buying a new build at a low cap rate with long-term debt and coupon clipping (at a low return) for decades falls in this bucket. Now - if you buy conservative, get a good building, have investors (or its your own capital) that are super patient - a low return deal can turn into something quite different over the long run.
The problem in this era is most people (i.e. investors - but also owners) don't take the long view. Everything needs to happen quickly. So a low risk low return building would be the aforementioned scenario. I'd also add "buying all cash" into this bucket. You have very little risk, because you have no debt - but your return profile gets crammed down a lot for lack of leverage.
Real Estate's returns without debt underperform most liquid, comparable assets.
Then again - I'm a real estate guy. I'd argue you should do that even if it underperforms. Here's why. Net of tax returns. You buy a building all cash, you earn a 5% cash yield.
That underperforms money market funds!
Not so fast my friend - because your money market fund pays full freight taxes, and your real estate deal pays almost no taxes (thanks to depreciation & reinvestment in the property).
Even your "bond" real estate deal is a good bet.
High Risk, Low Return
The worst of all the buckets. Again - somebody will disagree with me, but I put fixing and flipping in this bucket. Your upside is relatively capped, especially because you're not a long-term holder (you're a trader), and your downside is fairly dramatic.
Think about it this way.
Your "investment cost" is the cost of the purchase, plus your "turn" costs. Those can (and do) balloon. You can mitigate this risk a bit if you are handy and do the work yourself, but then you're also "working" quite a bit to generate the return. Contrast this to owning and running a long-term rental property. It requires some work, but it's much more hands off. So it's active - and that, to me, is absolutely a cost.
But your return - especially because you're "flipping" the house so swiftly - is pretty capped. The market is X for sale. X but you have to deduct the cost of the brokers commission, as well as taxes you will pay on the gains. Ultimately you eke out a relatively small return in repayment for what I view as a high level of risk.
To play devil's advocate, the argument in favor of fixing & flipping is thus. Well, yes, Arie, that's true - but the velocity of money is what matters. It's a small return, but earned over a very quick window of time, and if I can do 100x that in 1 year, then it adds up to a big return.
Okay - well taken point. I still think it falls in this bucket but reasonable minds can disagree. Fix and Flip works pretty well in a rising home price market. But ask any fix and flipper how 2008 went and you'll hear lots of dire stories. (By the way - you will also hear dire stories from everybody else, lest you think it was just fixer & flippers that got hosed). But I bet you fixer / flippers got hosed worse.
Other deals that fall into this. I have become convinced that DEEP value-add plays more often than not fall in this bucket. Buying a building that requires a huge amount of investment in systems and non-economic improvements just doesn't add any juice to the return (except making the next buyer not deduct these costs from your sale price). I used to look at deep value deals and be excited. I've moved on.
Other Factors to Consider
As I wrote this article, it occurred to me - some investments actually move between categories based on other factors. Those factors are important. It's also the classic example of the invisible hand at work. If an opportunity is too good to be true (a holy grail, upper right corner deal) then the market will find a way to arbitrage that opportunity until it no longer exists (garden style, suburban value-add multifamily comes to mind).
But there are factors other than the invisible hand of the market at play here, that can transform a low-risk deal to a high-risk one, or vice versa. Here are three.
Your Debt Terms
If you think you've done an upper right quadrant deal, but you took on short-term balloon payment debt, you could have transformed your clean, high return deal into an upper left quadrant deal. Suddenly you've magnified your risk.
By contrast, if you buy a fixer-upper but finance it with long-term debt that is easy to cover with building cash flow, you could have seriously lowered your deals risk profile.
As with all things real estate, your debt profile is enormously important to how to view the risk or lack-of-risk of your deal.
Market Conditions
The reason the aforementioned suburban, garden-style value add deal worked for so long - way longer than the invisible hand should have permitted - is because the market really worked with it. You could refinance ad-infinitum with a low and steady rate environment, and rents just kept growing.
But beyond market arbitrage, the thing that really hurt this play is that the market changed dramatically. Rents stopped going up. Oversupply of new housing blew up in many markets. As a result, what was a low-risk play became a high-risk play, and it moved into the top left quadrant.
Operator Expertise
If you are investing with a sponsor (i.e. not doing it yourself) this is really important. A really solid operator with a proven system and organized organization can alleviate a lot of risks. Deals can go wrong, and be higher risk, just because of the operator risk. This is important. Steps to suss this out - how long have they worked with their contractor? How many deals have they done successfully? How have their actual costs done versus budget on past deals? How many buildings do they own in market?
This is a huge and micro-important factor in where a deal falls in the spectrum.
The Bonus Fourth Factor
Here's a fun one to add. All real estate deals have a risk of failure. It's the nature of putting equity to work. All of the above can line up perfectly and you can still lose money. So for you personally - don't ever put all your eggs in one basket. It's a recipe for something to break.
Diversify! Don't take on idiosyncratic risk. For the non-Wall Streeters - idiosyncratic risk is the risk you take from a single investment. If you invest in the S&P 500 your'e diversified across the entire US economy. If you only invest in Amazon, you have all the wondrous potential of Amazon, but you also have all the risk of just Amazon. You have idiosyncratic risk.
if you put all your baskets in one deal, you have all the risks (and return potential) of that one deal. You heighten the odds of a bad outcome.
That's why I always tell my investors to never put a lot of money in one single deal. Do the minimum, I say - and diversify over time. Kind of like dollar cost averaging in real estate. It's the smart move.
Let me know in the comments if you can think of other real estate deals and where they fall in the quadrants!
