“Everyone has a plan until they get punched in the mouth.” — Mike Tyson
Is this deal a conservative deal?
That’s a question everybody wants to know the answer to!
Deals these days seem anything but conservative.
We’re seeing certain market rents rising 20-30% year over year.
Do you put that in your projections?
Do you say that’s going to happen in the future?
Warren Buffet says it’s only when the tide goes out that you see who’s been swimming naked.
The swimming naked part represents when things don’t go well.
When the tide goes out, what projections and other underlying factors have people put into the deal that will allow the deal to perform well?
If you haven’t tried to understand the deal, and approached it conservatively, you can get caught swimming naked.
Sounds very embarrassing!
When we have a downturn, it’s so important to be conservative when you look at it.
But don’t confuse being conservative with the political term!
Being conservative here means when you approach a deal, you’re looking at the best and worst case scenarios.
You’re trying to be more on the conservative side of both those scenarios.
Today, we’ll get into how you can make sure your deal is conservative.
We’re gonna go over it all in three easy steps!
1. What is a Conservative Deal
A conservative deal is when things don’t go well.
When the tide goes out, what does that look like?
There is a spectrum.
On one hand, if you’re too aggressive, you will get deals but you have the potential to lose money.
You’re basically saying the growth happening now will go on forever.
Whether you’re a passive investor or doing deals yourself, you have a chance to lose money because you’re being so aggressive.
On the other hand, you can be too conservative.
I’ve seen this happen many times.
People will wait until they find the perfect deal.
The problem is the perfect deal never really comes.
Or when it does come around, these super conservative investors will find something wrong with it to make the deal not perfect.
The sweet spot is in the middle.
You won’t be too aggressive or too conservative.
Some things will go well in the deal and some things will not go so well.
When we do our deals, we look at what is achievable.
With that kind of portfolio, we are looking at what’s achievable.
What do we think is a modest growth projection?
In our business, our goal is to under promise and over deliver to our investors.
We’d rather err a bit on the side of conservative, but we can’t be too conservative (or we won’t get any deals done!).
Of course, we also don’t want to be too aggressive.
We want to find that sweet spot.
There’s a principle called underwriting.
Contrary to its name, underwriting doesn’t mean taking a piece of paper and writing on the bottom.
Underwriting happens when you’re looking at your projections.
For a fee, underwriting can assess risks and help you make the most informed decision.
It’s the balance between being aggressive and being conservative.
You are making sure you know everything that could go wrong in a deal.
Let’s get into some red flags of not being conservative at all in your deals:
2. Example of Not Being Conservative
What does it look like when someone’s not conservative in a deal?
What are some red flags you should look out for?
There’s this amazing book by Malcolm Gladwell called Blink.
This example from the book is really striking:
It starts with a control group watching a 10-second video of a teacher teaching without audio.
After watching the video, participants had to rate how good they think the teacher is at teaching.
They then went to that exact class where the teacher was filmed, which happened to be a 10-week college course.
The people in that teacher’s class had hours with this particular instructor.
You want to know what happened with the two different scores?
The scores were almost identical!
Isn’t that amazing?!
Simply watching 10 seconds with no audio, you can potentially tell if a teacher is good or bad.
This is also true with real estate deals.
When you look at the smallest detail in a particular deal, it will give you a lot of information.
You may not have words for what you see, but you should trust your gut.
The questions you want be asking are:
Is this conservative?
What happens if things don’t go according to plan?
What’s the sense I get about this group?
We try to look for deals that will provide modestly good returns when we’re being conservative.
At the time of this video, that looks like around 15-17% annual return projections per year.
I’m not talking about any specific deal, but in general, that’s what we look for.
We try to find deals that fit within that frame.
If something has a 25% return per year, I might say the deal looks a little risky.
There’s also a couple of other things we look at.
We look at the group’s track record.
Cap rates are also something that’s really important.
A cap rate, or capitalization rate, is basically how much income you are getting from the property.
This is based on how much the property value is versus how much you’re paying.
Let’s say we bought a property with a stabilized cap rate of 4%.
We’re projecting to sell it at a 5% cap rate.
This means we are projecting that it may be less favorable for us to sell in five years than it is right now.
That’s a conservative metric.
You’re being a little bit more conservative as you look forward.
If somebody goes the other way and says they’re buying the property at a 4% cap rate and will project to sell it at a 3% cap rate…
They’re basically saying things will get even hotter.
That’s not necessarily being conservative, right?
You’re assuming things you can’t control will get better.
Nobody has a crystal ball.
Nobody knows what those figures will look like.
The other thing we look for is rent growth.
Right now, nationally, we’re seeing ridiculous rent growth.
In some of the markets we’re in, Jacksonville and Atlanta, we’re seeing 20-31% national rent growth.
It’s absolutely insane!
However, we’re not going to use that metric every year going forward.
We feel it’s unsustainable and we want to be conservative.
We’ll use a figure like 3.5% percent going forward.
Just because things have gone well doesn’t mean they will keep going well.
We don’t want to be swimming naked.
We want to make sure we’re very conservative.
The deal will perform whether the conditions are favorable or they slow down a bit.
To close us out, we’re going to talk about some things to look for in a deal.
3. What to Look for Now
What should you look for in a conservative deal?
I’ve been quoting Warren Buffet a lot, but he has another word of advice that works really well here.
He talks about the idea of a margin of safety.
If things don’t go according to plan, what sort of guideline do you have?
What kind of contingencies do you have?
Real estate deals, and most deals in general, don’t always go according to plan.
They go better in certain areas and they go worse in others.
You gotta make sure you have things set up in a way that accounts for those pitfalls.
I’ve seen an operator hand over pretty modest returns.
They said they had potential upsides they didn’t put in the numbers.
One was a building with a bunch of storage, but we could potentially convert it into other units.
That would lead to a lot more income.
Another thing happened during the early pandemic when governments were giving out COVID relief to landlords.
The operator said the previous landlord didn’t apply for this money.
There was over $100,000 in aid they could apply for that they didn’t include in the numbers.
The things they hadn’t included in their official projections are contingencies that are potential positive outcomes.
That’s something you want to see!
Another thing to look for is the team themselves.
What is their track record?
Have they done other things?
Do they have references from other investors, or any testimonials?
Is there somebody I can talk to?
What’s the communication been like?
How’s the performance been?
When we work with our group of investors, we try to really under promise and over deliver.
We try to be conservative.
We have that margin of safety.
We are modest on projections when we’re looking forward.
Another thing you really want to look for is the business plan.
Does the business plan make sense?
Is this group doing what they say they’re going to do?
If their business plan and approach doesn’t make sense, you shouldn’t invest.
If it’s something like: “We’re going to come into this brand new property and raise rents to the moon!”…
That doesn’t make much sense, does it?
If their plan doesn’t make sense, you probably shouldn’t partner with them.
A lot of this is trusting your gut.
The more deals you see, the more you analyze, the more you’ll get a sense for what a good deal looks like.
Another thing we look at is something called stress testing.
Don’t worry – it doesn’t mean taking a test while stressed like you did in school!
Stress testing is basically what happens if the occupancy drops.
If the occupancy drops from 95% down to 70%, is the property still cash flow positive?
We did a recent deal where it was 66% breakeven occupancy.
The occupancy could drop down to 66%, the rest being 34% vacant, and the property would still breakeven.
Those are things that are really helpful when you look at a deal.
If something doesn’t go according to plan, everything will still work out alright.
The conclusion of all this is to have very realistic expectations.
You should always try to see what could go wrong in a deal.
I always try to ask operators what could go wrong and what they’re concerned about.
If they don’t have an answer, I would just turn your tail and run.
There are always things that will not go according to plan.
It’s really important to account for those.
If a deal sounds too good to be true, it’s probably because it is too good to be true.
Now I want to hear from you!
What does a conservative deal look like to you?
What’s something I missed that you find really helpful when you look at a deal to assess whether it’s conservative or not?
Let us know in the comments below and we can start a conversation!
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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.