I was talking with a potential investor from the Bay Area the other day. He has $1M to invest and is looking to create a tax-efficient diversified passive-income portfolio. He’s deciding between investing with experienced operators as an LP and purchasing a small multifamily asset in San Francisco that he would own and manage directly.
In my opinion, the best approach to owning investment real estate is simple; invest capital across a diversified set of cash-flowing deals (or funds) with best-in-class operators, collecting checks each quarter, while seasoned professionals oversee the execution. Amateur investors with no direct real estate experience tend to think they’re capable of owning/operating investment real estate (while maximizing value), but here are a few reasons why they can’t compete with real estate professionals:
- Investment opportunities are highly relationship-driven and amateurs don’t have access to the best deals, capital sources, or various 3rd party service providers.
- Amateur investors don’t know enough about the complexities of deal-structuring and what motivates sellers. Experienced operators apply a sophisticated, flexible approach to deal structuring that aims to benefit both buyer and seller to arrive at a deal.
- Quality operators understand execution is paramount to completing a successful deal.
- Amateur investors don’t have access or knowledge of the data sources relevant to real estate investment in their particular sub-market/asset class.
Real estate is a complex institutional asset class requiring the right mix of relationships, experience, and creativity to be successful. However, many individuals think they can successfully own/operate real estate. A recent article in the NY Times explained why we think we’re better investors than we are, which can be applied to real estate investment.
Behavioral finance research has shown that individuals are lousy investors. Despite the growth of low-cost index funds that track market averages, amateur investors continue to actively buy and sell securities. Despite evidence that they’re unlikely to beat the market, many investors continue to buy and sell. The reason, it turns out, is because most people do not realize how little they know about subjects. We all have the tendency to overrate our abilities, knowledge, and skill. This is true in real estate investing as well. Just because you’ve lived in an apartment or worked in an office doesn’t mean you have the ability to purchase and operated a multifamily property or a boutique office property.
Investors are generally optimists. We wouldn’t venture into a new investment if we think we’re going to lose money. We are evolutionarily programmed to believe things are going to work out. A bias toward optimism can explain why amateur real estate investors with no real estate investing experience think they can compete with experienced real estate shops. Guess what, you can’t!
Once one has decided that owning/operating real estate is a good investment, they typically ignore information that points to the contrary. Many individuals think buying a home is a great financial investment despite the endless data showing that it isn’t. The confirmation basis can trick anyone into thinking the opportunity they came across is a great investment. Experienced real estate investors, on the other hand, weigh all information equally and combined with their “gut” instinct, which they honed over 20 years, make informed decisions.
Investors always underestimate the downside. Before you buy a deal, think, if the deal went bad, what would you be saying to yourself right now about how or why you should have foreseen it?
Even investors who have failed in the past continue to jump back into investing. When investments go wrong (or right), we tend to blame or credit the wrong things and thus maintain our faith in ourselves. Oftentimes deals work out because you happened to hit the right timing in the cycle, not because you’re a great real estate investor.
Real estate is an inherently attractive asset class and should be part of all investors’ portfolios, yet can be perilous for an inexperienced real estate investor to pursue. More specifically, investments are oftentimes too large, too time consuming, or too complex. Experienced real estate operators bridge this gap for investors by providing the requisite knowledge, experience, and relationships to successfully invest directly in real estate.
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