The 3 Driving Principles Of Real Estate Investing

If real estate investing seems overwhelming or complicated to you, then this post is going to absolutely shatter those feelings and break down this entire industry in very simple terms. In this post I’m going to go over the 3 big principles that govern real estate investing that you can use forever in your investing journey.

Quick Notes:

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There’s a quote that applies to almost everything but especially real estate investing and it’s this:

When you first start to study a field, it seems like you have to memorize a million things. You don’t. What you need is to identify the 3-5 core principles that govern that field. The million things you thought you had to memorize are simply various combinations of those core principles.

Principle 1: Recovering From Losses Takes Longer Than Stacking Up Small Wins

You’ve likely heard this before but it is much more difficult to recover from a loss than it is to go a few deals in a row with minor gains.

If you invest $100,000 into a deal and that deal loses 20%, you get that cut down to $80,000

Meaning your next deal would have to gain 25% just to break even for the first deal’s loss. And be mindful that the difference between 20 and 25% isn’t 5%, it’s a 25% difference, meaning your next deal has to do 25% better than your projections of the first deal just to break even. Not to mention the time lost going backwards and then going forward.

That’s not to say never invest in real estate. All investment strategies have risk and if you invest in real estate long enough you will have a deal that loses money, but going into a deal your first thought should be capital preservation and asking yourself what is the downside risk of a deal like this.

That’s one strong selling point of syndications is your downside risk is limited to your initial capital contribution. Passive investors don’t sign on the loan, don’t put up risk capital which means paying for things like inspections and bank fees that can cost tens of thousands of dollars.

So when looking at a deal, your first thought should be: what is the total downside risk for you as an investor?

Because it will take longer to recover from loss than it will to just hit singles on your deals.

Principle 2: Risk & Returns Are Directly Correlated

As you see projected returns increasing your risk in that deal is increasing as well. Turnkey investors who buy something 100% ready to go and already leased out will take significantly lower returns than someone buying a fixer upper, and they should, the fixer upper or house flipping investor should get more upside because the risk is so much greater.

Whenever you take on a renovation project you never truly know what you’ll uncover until you get in and start doing the work. You can do inspections and have lots of experience on the team, but once floors start coming up and drywall starts coming out you can’t be certain what you find.

The investor who wants higher returns needs to be comfortable with taking on more risk. This will also help you analyze deals quickly, the deal with a 15% IRR should be inherently less risky than the one with 35% projection.

Principle 3: Cash Flow & Equity Gain Are Negatively Correlated

When it comes to cash flow and equity gains, when one goes up, the other typically goes down.

It’s why people who want to invest for cash flow can rarely find deals that fit their criteria in California or New York. These places see much higher equity gain so investors are willing to take less and less cash flow until cash flow even becomes negative.

I typically tell investors cash flow is more playing defense with your investment and playing for equity is offense. If you’re looking to grow what you have, look for equity, if you’re looking to preserve what you have, look for cash flow.

You can also balance these 2 however you’d like, and even in our deals we look for balance with equity and cash flow but we also know if we leaned 100% on equity gains we’d likely make more money but, just like principle 2 says, we’re taking on more risk by doing so.

That’s not to say high cash flow properties present no risk either. If a property has higher cash flow that typically means it’s going to be a bit further out from major cities or the most desirable areas in that city.

You’ll find the highest cash flow deals in tertiary markets/small towns or higher crime areas. The trade off in risk is usually those areas aren’t seeing big growth, and they may lack strong property managers or contracted labor.

Then, when you go to sell the property, your pool of buyers will also be smaller. These properties come with their own unique set of risks.

These 3 principles can help you break down the entire industry of real estate investing in either commercial or residential: Recovering from losses takes longer than stacking up small wins, risk & returns are positively correlated, cash flow & equity are negatively correlated.