A friend of mine met an interesting real estate investor recently. The guy claimed that he escaped the entire market crash relatively unscathed. At first, I didn’t really believe it, but his strategy made a lot of sense. I thought that it was worth passing along.
Essentially, he flipped houses throughout the entire boom as many did. The difference between this investor and others is his discipline. Every time a property increased by 10%, he sold it. On the way down, he was equally disciplined. As soon as the market turned downward, he priced his remaining inventory below the market to liquidate them all. Sometimes, it’s better to take a known loss than face an unlimited downside.
Most real estate investors didn’t have this kind of self-control. In a way, it’s strange, because often, individual investors are far more disciplined in the stock market. Many of us have personal rules, such as “If I’m down 20%, I’m out of a stock… If I’m up 30%, I’m selling as well.” The most successful market traders strictly adhere to similar limits.
Recently, I read the excellent book, Market Wizards: Interviews with Top Traders. The book interviews dozens of multi-millionaire traders from the 1980s and asks them about their early years and their basic approaches to trading. The book is a great read as you can pick it up whenever. Every chapter is about a different trader. (The book includes an interview with Jim Rogers that may be of particular interest to our readers.)
Across the different interviews, one thing becomes clear: every major trader has defined rules on taking profits and limiting losses. In fact, almost every trader has a painful story recounting how they learned that exact lesson. There were no specific limits shared by all traders, but the point to take away is that you must have limits.
Limits and risk control are exactly what many real estate investors lacked. Risks were taken that no one would pursue in the stock market. Even focusing on real estate alone breaks a key investment rule: Never put all your eggs in one basket. Few would similarly invest in just oil companies or just fast food chains.
On the upside, there was a strange lack of limits as well. I knew a guy who made an incredible profit during the boom. He picked just the right property at the right time. His vision should be applauded, but his self-control should be a cautionary tale. As the housing market had already started to crash, he received an offer on his property for $2 million, a 500% return. But for some reason, he thought the market would go up even more. So he rejected it. Ultimately, the property was sold six months later for half a million dollars less. That’s still an amazing return, but he left half a million on the table only due to his lack of discipline.
No one would treat a stock the same way. Imagine being up 500% on a stock as the market began to drop. Instead of selling, you hope for 700% returns instead. That’s insanity! But there’s something about real estate that makes people go crazy.
Other risks, such as extreme leverage, would never have been utilized by individual investors in the stock market either. Few of us would borrow $500,000 and put it into the S&P 500. But for some reason, it was different with real estate. One could make the argument that real estate always went up. But then again, the same argument could be made for the S&P 500 in the past few decades.
The real estate market’s problem wasn’t necessarily too many investors; it was too many speculators and individuals who didn’t understand the risks. Even today, I know so many people who refused to take offers 15% below the peak of the market at the beginning of the housing crash. Now they would be lucky to get a price 30% below the peak. However, they would have been easily convinced to sell a nonperforming stock in a tough market.
Before jumping back into real estate, investors need to realize that this sector is not a magical fairyland where the regular rules don’t apply. Risk exists in every investment whether it’s the stock market, antiques, art, or real estate. Each sector does not have different rules.
