A lot of people want to invest in real estate but don’t know what to invest in or how to start. So today, we’re continuing our passive investing series with Lon Welsh by zooming out to look at different investing strategies and how to select the right one.
We’re going to do this by walking through the Investor Decision Tree that Lon made. This is a great flowchart that helps investors decide where to start based on their time, experience, capital, and other unique factors. We’re going to explain how the Tree works, and go through it using three common investor avatars.
For more information on passively investing with Lon’s company Ironton Capital, check out the webinar here.
- Listen to the podcast “#389: Guide to Choosing the Best Real Estate Investing Strategy for YOU” Denver Real Estate Investing Podcast
- Watch the YouTube video (at the bottom).
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the podcast or video.
Why Do I Need an Investor Decision Tree?
Lon wrote his first book on real estate investing in 2009. The first chapter of the book is “What Should I Invest in and Why?” After teaching classes on real estate investing for 20 years, he knows this is the first question every would-be investor has. There’s an enormous amount of confusion when it comes to real estate investing, and you don’t want to start off on the wrong path.
The goal here is to give investors peace of mind after going through the tree that they’ve made the right choice of where to start and why they’re starting there. I can attest to this personally: I read the book about five years ago, and the decision tree helped me immensely. Go to the website for the free download of the tree plus the newly updated chapter explaining how to use it.
Three Types of Investors
To show you how to work through the chart, we’re going to walk through it using three common avatars of people who want to get into real estate investing.
Investor 1: A Busy, Established Professional
This type of professional is someone very specialized in their field, like a doctor, lawyer, architect, or business owner. Generally speaking, they have a high income, are usually mid-career, have a family, and are busy professionally and personally.
Lon has met lots of people like this; they’re frustrated with the stock market and know that real estate provides diversification for their investments.
The first question for them: Do you have the time and desire to become an active investor? This investor type is usually so busy they don’t have time for an extra hobby. And remember: everything in real estate is a hobby because active involvement requires a time commitment. Even if you hire a property manager (an excellent idea), it’ll still take your time and attention to achieve good results.
For this investor, passive investing is the right choice.
Next, we ask: Do I need access to the funds? Most of these successful professionals already have six months of living expenses in the bank, a maxed-out 401K or IRA, and an after-tax stock brokerage account. Liquidity isn’t a concern for them. They’re willing to trade immediate access to the funds for a better return.
Then, we ask: Are you an accredited investor? As we discussed in Episode 2, accredited investors must make $200K annually individually, $300K as a married couple, or have assets of $1MM or more to invest (not counting their primary residence). If you are not accredited, then look at a Real Estate Investment Trust (REIT), which has no accreditation requirement. There are over 1000 REITs to choose from, and there’s one for every type of asset class: self-storage, office space, apartment buildings, and more.
If the investor is accredited, then we ask how much they have to invest. If the amount is $100K or more, then it’s most optimal to invest in a fund, like Ironton Capital.
Alternatively, they could look at syndications, where the general partner purchases a large asset, selects the project, does all the work, and guarantees the loan. In this case, the limited partner only needs to provide the funds. In exchange, they get less of a return. For many investors, the most challenging aspect of syndications is finding one. Most people don’t know syndicators, and if they do know one, they likely don’t know the right questions to ask.
In this case, a fund is a great choice because there’s no need to pick a syndicator (that is a lot of the value added by the Fund manager!).
Investor 2: A Young Professional with Less Money But More Time
This is a common type of investor that Lon and I work with. They have the time to become a real estate investor and want to pick it up as a hobby. They can tie up some cash in their investments.
Here, we ask: Do you have an average or better credit score? If you want to be an active investor, you are guaranteeing the loan and need a good credit history to be approved.
Then, we ask: How much do you have to invest? Typically, these investors have between $50K-$100K to invest. In this example, we’ll say they have $75K.
Next, we ask: Are you comfortable or have a desire to work with contractors to do renovation work? If you’re one of the niche people who have success with contractors and want to do more, you can go down the Fix and Flip route. Most people who have tried a home renovation project didn’t have a great experience and don’t want to go down that path.
Now we can sort the investing options by desirability. They can buy a small house or condo and do a short term or long term rental. There’s even the option of doing a short term rental sandwich, wherein you rent a condo long term and operate it as a short term rental. This requires the approval of the landlord, but can be a permissible strategy.
There are a lot of options for this type of investor, so use this decision tree as a starting off point. Talk to Lon or me to help figure out your strategy. It’s often not clear at the beginning which is the best choice for you, and strategies evolve over time.
Investor 3: An Experienced, Active Investor with a Robust Portfolio Who Wants to Shift Their Strategy
This investor owns rentals (perhaps many rentals) and is a busy professional or perhaps a full time investor. They have an active portfolio of long term or short term rentals and their net worth is building. However, they’re getting busier and want to shift their investing strategy.
We meet a lot of investors like this. They’ve been investing for 5, 10, or 15 years and sometimes are burned out on it. It’s not as easy to find active investments today because prices are steadily going up. We start at the top of the decision tree with a focus on the next investment: Do you have the time or desire to be an active investor for the next project? The answer here is no.
Next, we ask: Do you need access to the funds? At this point, the investor has a rainy-day fund and a sizable portfolio, so they don’t need the liquidity. They probably have good passive income from those existing assets.
Then, we look at the passive investing options: REITs, syndications, or funds. REITs have some powerful features: they’re liquid, so you can sell on short notice, and you don’t need to be accredited.
Are REITs a Good Investment Right Now?
However, Lon thinks REITs are not likely to perform well over the next five to seven years. The cash flow in any investment property is influenced by the difference (spread) between the cap rate and the interest rate. To illustrate, imagine you can purchase a rental home for $500,000 that has a 6% cap rate. That would generate $30,000 of NOI, net operating income, before your mortgage (if any). (NOI = Purchase price * cap rate).
For example, in 2021, you might have bought a rental house on a 6% cap rate and borrowed at 4% interest rate. That makes your spread 2%. This is likely a profitable investment.
It is possible that as interest rates increase, cap rates will be steady. As interest rates go up, if cap rates are steady, there’s not enough spread to make money. Today in summer of 2022, if you are buying a 6% cap rate rental home and your mortgage is at 5.5%, you only have a 0.5% spread. That’s not likely to be profitable enough for your target returns.
It’s also possible that the cap rates could increase with rising interest rates. Imagine the market decides the cap rate should be 7% instead of 6%. If our example house still generated $30,000 of NOI on a 7% cap rate, the value declines from $500,000 to $428,500. (Price = NOI / Cap rate… so $30,000 / 7% = $428,500). Income assets decline in value when cap rates go up. They increase in value when cap rates go down.
For this reason, REITs–which often depend on appreciation for a large part of their return–may not generate attractive returns for the next few years.
If a tenant moves out or the building needs renovation work, the investor may need to subsidize that cost. It will take three to five years for cap rates to go up, and when that happens, the value will go down. Then, it will be a race to see if you can raise rents faster than cap rates can eat up the valuation.
Many commercial assets will not see a lot of appreciation over the next five years. At this phase of the market cycle, REITs are not an attractive bet.
In a syndication or fund, investors are buying a distressed asset that needs to be repaired or built from the ground up. That approach is more appropriate for this time of the market cycle.
Should I Invest in a Syndication or Fund?
The answer to this question is that it depends on your personal situation. If you have a broad social network that brings you into a relationship with a syndicator, then it can be an exciting and viable strategy. Most people, though, don’t know that many real estate professionals. And if they do know one, they likely won’t know what questions to ask.
For example, if a syndicator is building townhouses, and you don’t have experience with site selection, zoning, General Contractor bidding, or estimating the value of the project in two years, you won’t know all of the questions you need to ask to assess the project.
Lon has broad experience with different real estate projects and feels comfortable asking and answering all of those questions. Ironton Capital is like a mutual fund of syndications and makes sure the projects are broadly diversified across asset classes, geography, and different strategies.
Start Forming Your Investing Strategy Today
To start creating a strategy that works for you, download the Decision Tree and chapter here.
Remember to check out the Ironton Capital webinar that walks people through all of the investments they offer. Learn about the different projects and decide if it’s the right investment for you.