Invest to Win

On Saturday afternoon, a friend of mine called me and said “You don’t have to watch the Illinois game.” I said, “They lost right.” He said, “They were up 25-7 and the quarterback had 175 yards passing in the first half. He ended up with 190 yards passing for the game because they kept running the ball to milk the clock.” I said. “They were playing not to lose.”

I think all fans hate it when teams play not to lose. Every sports fan wants their team to continue pouring it on, go for the jugular, forget the prevent defense!

Then again late night Saturday I was sitting at a No-Limit Texas Hold’em Poker tourney. I had done fairly well to become chip leader with 9 players left. I began to tighten up. I had all these chips and I didn’t want to lose them. An hour later I was the short stack. Wow! How did that happen? I was playing not to lose. I had lost my aggression and was folding almost every hand. Luckily I came back and won the tourney.

What does this have to do with investing? I hate to say this but many investors are investing not to lose. When it comes down to investing, one’s first thought is usually, “Am I willing to lose this money or can I afford to lose this money.” While these are both very responsible questions, they stem from a mindset that limits your potential.

I’ve fallen into this mode. I was very active in real estate over the past 3 years. When the market turned late last year, I sort of went into a shell. I had done so well until then that I began to fear losing my equity and net worth. That mindset was reinforced by all the media bubble-talk, and it made me sit on the sidelines the past 8 months. I am a firm believer that you can make money in any market. I had let my fears get to me.

Yesterday I was sitting and Barnes & Nobles reading the new Kiyosaki & Trump book and came across this passage (from Why We Want You to Be Rich):

One day, during a brief meeting in his office, Donald simply said, “I invest to win. Don’t you?” With that statement the defining difference appeared. He and I invest to win, while others invest not to lose.

We have talked here about the advice, “Save money, get out of debt, invest for the long term (generally mutual funds) and diversify.” Late that afternoon, Donald and I discussed how we did not focus on saving money. In fact, we are both millions of dollars in debt – but good debt. We do not diversify, at least not in the context that most people use the word diversify. And while we are both long term investors, we do not invest in mutual funds, at least as a primary vehicle. Why? Because we invest to win….
Most other financial experts are telling people to play it safe, to live below their means. They are telling people that investing is risky and that they need to save and avoid losing. The experts aren’t focused on winning. They’re focused on not losing.

This just reaffirmed what I’ve been thinking. Maybe it’s a sign. Three different situations, same result. With that, I put an offer in for that duplex in Tucson.

Cap Rates

What is a cap rate? A cap rate (or capitalization rate) is the net operating income divided by the price of a property. If you have a $100,000 property and its net operating income is $10,000 the cap rate for this property is 10%.

What does this mean to you? How have cap rates affected the current real estate boom?

If you pay cash for this property, your cash on cash return will be 10%. How does this tie in with interest rates? Simple math will tell you that if you can borrow money at 9% and buy property with a 10% cap that you have a 1% spread. The maximum return that you can get from a situation like this is infinite. The less you put down, the greater your return is (red line).

What if interest rates were at 10% and your cap rate was 10%? Well, then your return on this property will be 10% no matter how much you put down (blue line).

And what if interest rates are greater than cap rates? Well you will have a negative return until you put enough down to break even. If interest rates were at 11% and your cap rate was 10%, it would be around 10% down or $10,000 (green line). What’s interesting to note is that your return will never go above 10% no matter how much you put down.

Cap Rates Chart

Now you can see why there was a real estate boom in the past 5-6 years. Interest rates were below cap rates and investors could borrow as much as they wanted. In fact, the more they borrowed, the better their return. As more people jumped on the real estate bandwagon, prices went up and cap rates came down. Eventually the cap rates became lower than interest rates. From the chart, you can see that your cash on cash return is limited to the property’s cap rate if your interest rate is above it. So why were people still buying? The answer is potential appreciation. With real estate prices rising so fast, people were ignoring the fact the fundamentals did not make sense. They were content with a 3% cap rate and negative cashflow because of the appreciation potential.

And that was all fine and dandy until about 8 months ago. The appreciation train derailed and now they are stuck with these 3% cap properties and 9% investor loans. In times of no appreciation, we must stick to the fundamentals.

Intro to Real Estate Investing

Real estate investors have become a cliché during the past 3-4 years. It seems like everyone you talk to is a real estate investor or knows someone who is. What makes real estate investing so popular? In the past few years you could do no wrong with real estate. With profits in the five and six figure ranges, one profitable real estate deal would exceed most people’s yearly pay.

On Risk and Effort
However with great reward comes great risk. That risk can be mitigated and controlled if you are investing correctly. Unlike paper assets, buying real estate is not a simple process. You cannot just log into your brokerage account and point and click. It also requires additional work, sweat equity or even more money.

How You Make Money
You make money in two ways, cashflow or capital gains. This is the same as buying high yield stocks or buy low and sell high. When it comes down to the math, real estate investing is pretty easy.

For cashflow, buy property in which the rent will cover all your monthly expenses (mortgage, taxes, insurance, management, HOA, maintenance and repairs). For capital gains, buy low enough to resell at a price that covers all your expenses (holding costs, realtor commissions, closing costs and repairs). Purchased correctly you can get both cashflow and capital gains with your investment property.