Two Rules of Real Estate Investing

The first rule of real estate investing is the preservation of capital.  The second rule of real estate investing is diversification.  These rules apply to all types of investments; however, too often, people believe real estate investing is excluded - not!  Becoming a real estate investor can encompass an active or passive role in day-to-day management.  Either category of involvement requires adhering to "the rules."

Like driving on a two-lane road, when we see the double yellow line dividing the highway we know it is there to keep us safe.  If everyone follows the rules, then we can travel the road in comfort, knowing people recognize the necessity of staying in their lane for our collective safety.  In real estate investing, veer away from the two rules of preserving capital and diversification will bring your portfolio directly into a crash-point during your journey, it's inevitable.  You can't ignore the rules without bringing peril to your door.

Real estate investing requires you to pay attention to the rules: preservation capital and diversification.

Interest Rate Risk Affects all Real Estate Investors

Sometimes real estate investors think they are immune to the same rules investors in other asset classes must follow.  The next paragraph, yes - still NOT true.  For example, interest rate risk.  Interest rates affect the investment world at large.  If you are a real estate investor with zero debt, interest affects you.  How?  Because other investors (other real estate investors included) have their access to debt and equity capital based on the availability of debt, required Debt Service Coverage (DSC), all affected by fixed or floating loan rates and access to new debt.

If real estate investors cannot borrow, all assets (including your free and clear real estate assets) have fewer potential buyers.  Severe changes in interest rates affect you and your ability to sell into a fluid marketplace with more prospective buyers - all because of an adverse change in interest rates.

We live in a small world.  You've heard before if that if America sneezes (economically speaking), Europe catches a cold.  It's incredible to think that our society is so inter-connected, isn't it?  If we didn't know that before, we certainly do now, from supply chains to global commerce.  Capital also moves internationally - economic events on the other side of the world can impact your duplex in Hoboken. Don't believe me?  Read my article: The Meaning of a Weak Dollar to Real Estate Investors.

Preservation of Capital is LifeBlood for Real Estate Investors

Preservation of capital is imperative because, without it, there are no future investment decisions to make. Having an allocation strategy helps assure your basket of investments maintains a reasonable level of balance between investment types, not becoming over-weighted in a single category.

Preservation of capital is a conservative investment strategy where the primary goal is to preserve capital and prevent loss in a portfolio. This strategy necessitates investment in the safest short-term instruments, such as Treasury bills and certificates of deposit. What is Preservation of Capital? -Investopedia

Real Estate Investors are Diversified in Times of Inflation

Real estate is known as an inflation hedge because real estate values usually keep pace with inflation.  Thus, real estate values do not erode with inflation.  Before you say "so what," consider, if 50% of your assets were in real estate and the other 50% is in cash.  In this scenario, after two years of 10% inflation, your real estate has the same buying power (at $600,000 valuation) while your cash has dipped to $400,000 - all while you did nothing different other than live through two years of 10% inflation.

Investment diversification means having an appropriate allocation strategy that encompasses an array of investment asset classes, otherwise known as diversification.  Are there more rules?  Yes, but none more important than these two.  Preservation of capital, diversification of investments; both rules apply to real estate investing.

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.  The Importance of Diversification -Investopedia

From my perspective, your home is not real estate (read my article Your Home is Not a Real Estate Investment.  The home you live in is a place to reside first and, perhaps, an investment second.  Think of it this way; if you had to sell all of your “investments” would your home be on that list?  Note, I did not say assets but investments. Therein lays the distinction.  We do not rely on our "home" for investment yield, nor would you want to sell it based on its investment performance. Thus, it is not an investment. When evaluating your finances, what does your real estate allocation look like when removing your home from the list of real estate investments?  Are you under-weight in hard assets?  Take a look.

The rule of 72 is a well-known rule of investing. The rule states that investments with a 12% rate of return will double your money in six years. Conversely, an investment yielding 6% will require 12 years to double the investment.  This simple rule, while effective in providing a framework for thinking about investing, precludes telling the entire story.  Whereas your return on investment is important, there are many other facets to consider when investing your hard-earned money.

Inflation.  A Real Estate Investors Friend?

The elephant in the room is inflation.  Inflation erodes investment value.  For example, the rule of 72 does not take into consideration the decrease in the value of the dollar from an increase in prices from inflationary occurrences.  When the price of something moves from $1 to $1.10 in one year while at the same time investments are yielding one percent there is a devaluation in your purchasing power.  In other words; your money has less purchasing power, less value.

Another influence on yield is poor decision-making by the investor or on behalf of the investor by advisers.  Additionally, as the world gets smaller, global economic events, or weather for that matter, can influence your investment returns.  Unfortunately, the "24-second news cycle" also impacts financial markets.  Moving money based on the flavor-of-the-day is more than just a bad investment policy, it is no way to live your life.

How do we solve the menagerie that is global influence and a whipsaw news cycle? By keeping your eye on the important stuff, by not getting lost in the minutia of what people consider important when all it really represents is cotton candy; something that takes your attention then disappears.

By keeping capital preservation and investment diversification as cornerstones to your money-matters strategy it is much easier to remain anchored and ignore the waves of incongruency that take over mass investor sentiment.  Keeping these two rules (preservation of capital and diversification) will allow you to remain grounded and save much pain by forcing your decision-making process to refrain from chasing shiny objects or making huge "bets" when a small bet is appropriate.  Keeping grounded doesn't mean you live in a cave or ignore the opportunity.  Keeping grounded means, you have a process in place for making investment decisions that have as it's hinged to the door preservation and diversification.

Its' always good to have another set of professional eyes reviewing your long-term investments and investment strategy.  Consult your trusted advisers, including a financial planner and an accountant.  There is strength in numbers, so it's best to have more than one advisor represented by two different firms.  You gain the advantage of two perspectives from people that are drinking different coffee (or kool-aid) from their respective organizations.

John Wilhoit is the author of the best-selling book on rent roll analysis: How to Read and Rent Roll. See also the companion guide to measuring the quality of rental income: Rent Roll Triangle.  Find JW's Podcast here.

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