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For you old folks out there, do you remember that irritating commercial from decades ago? The one where the nasally guy is sitting in front of a big desk with a big-shot hiring manager turning him down?
The big shot says we only hire experienced people for this role. And then the pale, nasally guy turns to the camera, shrugs, then whines, “But how do I get that experience?”
It’s the age-old question when you invest in commercial real estate: “How much experience is enough? And how do managers acquire that experience if you’re not supposed to trust them until they have it in the first place?”
I’m in my third decade as a real estate investor, and I’ve invested with amateurs and experts. I’ve certainly been an amateur myself.
There’s nothing wrong with that. But if you’re a passive investor looking to invest your hard-earned capital, I’m guessing you feel the same way I do. You don’t want to invest with a newbie.
My friend Brian Burke discusses this in his excellent book, The Hands-Off Investor. He’s a pilot. He knows how to fly airplanes and probably knows what to do to avoid a crash. At least, I hope he does.
Brian reminds us that when we fly, we want to know that the pilot has a lot of experience, a great team around him, and a spotless track record. When I fly, I take that for granted.
I would never knowingly fly with a test pilot—someone still in training.
There are names for people who are paid to endure these risks. They’re called flight instructors. I’m not one.
Similarly, I don’t want to risk my hard-earned capital with an amateur syndicator or fund manager. If you’ve been saving up your money to invest, you’re going to want to be definite that you’re investing with a true expert.
This is a critical issue because the rising tide has lifted all boats for many years. But as Warren Buffett says, “Someday the tide will go out, and then we’ll see who’s skinny dipping.”
I don’t want to invest with a skinny dipper, and I’m sure you don’t either.
The problem is the rising tide blurs the line between true experts and lucky amateurs. I’ve discussed this in a previous post: Warning: The Decline of Real Estate Experts Could Crash the Market. Interestingly, the amateurs may even have a better track record over the last decade than the pros.
How could this possibly be?
It could be that they’re taking bigger risks. Larger risks pay off big-time in a bull market. Think about investors who invested on margin. When the tide is rising, they look like heroes. And they outperform those who took lower risks. But when the tide goes out, this can be devastating.
If you’re a passive investor, you could be the victim.
For example, amateurs will often get into as much debt as they possibly can. High LTV debt can mean that an investor’s equity goes much further and grows much more in good times. For example, syndicators with 80% leverage only have to raise 20% of the total capital in equity.
In some cases, a true expert might get 60% leverage on this exact same deal. Their returns would be significantly lower if things went well because they shared those profits with twice as much equity. Make sense?
It’s been easy to be nonchalant with due diligence because almost everyone has been winning for the last 12 years or so. But the problem is we won’t truly know who the best managers are until there is trouble. Until investing collides with a downturn in the economy. Then we will know who is genuinely investing and who is speculating.
Investing is when your principal is generally safe, and you have a chance to make a return. Speculating is when your principal is not at all safe, and you have a chance to make a return.
True investors can be boring, while many speculators are quite flashy. BiggerPockets put a stake in the ground a long time ago to try to help all of us partner with and invest with experts. Not gurus.
True investors sometimes have not only had lower returns, but they also fly under the radar. You might not have heard of them or have been bored if you watched their videos or read their blogs.
Paul Samuelson was America’s first Nobel Peace Prize winner in economics, and he said, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”
The Search For Investment Professionals
If you’re looking for experts, you will have to do a lot of due diligence—much more than a casual look. I like to invest with specialists obsessed with their asset class and provide the best safety and chance for cash flow and appreciation.
Warren Buffett talks about investing inside your circle of competence. This could be your own circle or the circle of those to whom you are handing your money to. Buffett says it’s not important how large the circle is, but it’s critical to know where the edges are.
Warren Buffett’s partner Charlie Munger has a friend named John Arrillaga. Decades ago, Arrillaga decided only to buy real estate within a one-mile perimeter of Stanford’s campus. It doesn’t sound like a great plan to me.
But Arrillaga became a billionaire using this strategy.
Was Arrillaga’s circle of competence real estate? No.
Was his circle of competence real estate in the United States? No.
Was his circle of competence real estate in California? No.
Was his circle of competence real estate in Northern California? No.
Arrillaga’s circle of competence was real estate within one mile of Stanford’s campus. If he became a billionaire doing this, what do you need to focus on to grow multi-generational wealth yourself?
If you have a great full-time job, a family, a life, or even a retirement, you might not have time to become an obsessed expert in anything in the real estate realm. That’s ok, but that’s when due diligence comes into play.
Who can you find that you trust implicitly?
Thinking about Buffett again, consider the Berkshire-Hathaway model. He’s only got about 29 employees in his headquarters, yet Berkshire is one of America’s 10 largest public companies.
He doesn’t pick the flavors for Dairy Queen, yet he and his investors profit from the choices Dairy Queen’s managers make. He doesn’t pick home designs for Clayton Homes, but they profit greatly from this investment. Buffett counts on experts, and he diversifies across dozens of them.
Buffett’s done pretty well for himself. $100 invested in Berkshire-Hathaway in the mid-1960s would be worth well over $3 million today. Buffett’s done this by finding and partnering with great businesses with fantastic managers.
What can we do to follow his lead?
Buffett is an expert at saying no. Buffett says, “The most successful people say no a lot. The very most successful people say no almost all the time.” “No” is a complete sentence. And “no” should be your default when making any direct or passive real estate investment. At least that’s my opinion.
Learning to say no could protect you from the tide that will go out sooner or later.
What Do You Look For When Passively Investing In A Syndication Or Fund?
There are a lot of important questions you need to ask. My company has a list of 27 questions and issues, and we take a deep dive before investing. Here are a few of the most important questions:
- What year did you first start owning and operating in this asset class?
- Can you share your track record with the hold time and net investor returns? Include your best deal, worst deal, money lost on deals, full-cycle deals, and active deals. What did you do when things went south (like in 2008)? How did you take care of investors, if at all?
- How much of your own money are you investing in this deal or fund? Are you investing under the same terms as I would be?
There are a lot of other questions you need to ask. Many of these and more are covered in Brian Burke’s outstanding book.
Remember, regardless of how well a manager has performed over the last decade, the true test of their skill often comes in times of economic turbulence. When everyone’s winning, it’s easy to be nonchalant. But you won’t really know who the best managers are until there’s trouble.
There’s trouble coming. There always is. Because economic cycles always rise and fall. No, it’s not different this time.
Don’t be fooled by speculators. Investing with professionals is one of the safest and most reliable paths to creating multi-generational wealth. Whether you are the expert or trusting someone else, I would not compromise on the issue of extreme due diligence and default to saying “no.”