I think one of the most important things for real estate investors to be educated on and aware of is what they are getting themselves into when they decide on a particular investing strategy.
For the record, I don’t think any strategy is the wrong way to go. I only think a strategy is the wrong way to go if you chose it naively with no idea what you’re getting yourself into. And in those situations, it may not actually be the strategy that is wrong… It may just be that the strategy is wrong for you.
With anything in life, and especially with investing and entrepreneurship, education and self-awareness are huge.
If you’re educated about what really goes into an investing strategy and you have self-awareness surrounding your goals, skills, and interests, and you can weigh those things against each other, you will be miles ahead of the crowd.
The Definition of Investing
If I pull up the handy Google and ask for the definition of the word “invest,” this is what I get:
Invest: 1. Expend money with the expectation of achieving a profit or material result by putting it into financial schemes, shares, or property, or by using it to develop a commercial venture.
I want to highlight two words in there—expend and money. Notice it only specifies money. So if I buy some stock shares with my money, then that fits this definition. The only thing being expended is money.
The Definition of Working
If I pull up the handy Google and ask for the definition of the word “work,” this is what I get:
Work: 1. Activity involving mental or physical effort done in order to achieve a purpose or result
2. Mental or physical activity as a means of earning income; employment
3. A task or tasks to be undertaken; something a person or thing has to do
Activity and tasks are the key words for me in this one. So this one is me doing something, or putting a mental or physical effort in, or what have you. Most of us are pretty familiar with this term.
Now, I’m not sharing these definitions with you because I’m trying to be condescending or explain the terms to you—I know you know what these words mean. I am including them because they very clearly show the difference in the two terms at an extremely universal level.
In one of these scenarios, money is being invested. In another one of these scenarios, effort is being invested.
Investing and Working in Real Estate
So why am I harping on these two words? Well, it’s simple. Investors oftentimes don’t seem to understand the difference when it comes to their real estate investments.
Let’s go back to buying a stock share. Is that working, or investing? All day long, that’s investing. Why? Because the only thing you are putting into it is money.
What about your nine-to-five job? Is that working or investing? No doubt, that is working. Why? Because what you are putting in is effort. (I realize some people may need to invest money into their “work” but that is a different context from what I’m talking about here.)
Those two examples are very obvious. But what about real estate investing? Where do things fall in this industry?
Well, we actually start to enter a gray area.
Let’s use flipping a house as an example. If you go into real estate investing and you decide to flip a house, is that a straight investment?
Most people seem to think so. But let’s breakdown the tasks involved with flipping a house:
- Purchase a distressed property
- Fund rehab materials
- Perform rehab
- Sell property
If we were to pull down those obnoxiously haughty definitions of invest and work, do all of these components fit into the investing definition? Nope. I see them more broken down as follows:
- Purchase a distressed property
- Fund rehab materials
- Perform rehab
We can all agree that if you only purchase the distressed property and purchase the rehab materials and then sell the property, you won’t make any money. So in this case, the key to your profits is in the work. The money you invest lends its hand toward the profits and is an important part of it—but without the work, the profits won’t appear.
So at the end of the flip, when it’s all complete and you’ve successfully flipped the property to a buyer, you walk away with a chunk of cash. That cash is usually what people consider to be the profit from their investment. But of that cash, how much of it is a return on your actual investment (i.e. the money you expended into the project)? And how much of that cash is essentially payment for the work (or sweat equity) you put into the project?
If you work a job, you are typically paid for your time and effort. You likely get paid per hour—even if you’re on salaried pay at your job, you are still worth a certain amount per hour. So you just did all the work to rehab and sell this property. For those parts of it, some of that financial return/profit is really just payment for your time and effort—just like any other job.
So how much of that profit is a return on your monetary investment (which is what investing is really about)? And how much of it is just payment for your time?
A common and fun term you might have heard is sweat equity. Sweat equity is defined as “an interest or increased value in a property earned from labor toward upkeep or restoration.”
The definition of the term really brings together this idea of having to work in and for your investments. There still is an investing component: the increase in the value of the property once you do the work on it, which is likely greater than the amount of profit that is really just paying you for your work. But work is required in order for it to come into fruition.
Understanding the Spectrum
As I’ve already suggested, there is a spectrum for which investing strategies require no work and are just straight investments (monetary only) and which ones require significant work—and everything in between.
On the far end of the no-work-required investments, you can think about investing in stocks (non–Real Estate) or notes (Real Estate).
On the far end of the work-required investments, you can think about wholesaling. In fact, I would argue that there isn’t an investing component at all to wholesaling. Instead, wholesaling is 100 percent work. You aren’t earning returns on any money you invest. You only earn “returns” for your time and effort because you are working. You may have to invest some money to get your wholesaling business going, but that’s not money you invest in the sense of straight investments.
If I were to create a very short list of investing strategies, ranging from no work required to maximum amount of work required, I might come up with:
Notes/REITs/Syndications > Rental Properties with Property Managers > Landlording > Rehabbing
With all of these, what you are looking at is how much time you have to work on the strategy in order to make it work. And therefore, what portion of your profit is from the investment itself, and how much is payment for the work you put in?
Here’s an Example
Let’s look at buying a turnkey rental property with property managers verses BRRRRing a local property that you will landlord.
You buy a turnkey rental property—the rehab is completed by someone else, the tenants are already placed, and property managers manage the property once you own it. You pay $100,000 for it, which is roughly market value on the property.
You buy a distressed property to BRRRR (buy-rehab-rent-refinance-repeat). Next, you rehab the property, place tenants in it, and then you are the landlord. Originally you bought the property for $50,000, and you did a $30,000 rehab. So you spent $80,000. The new value is $100,000. You now have $20,000 in immediate equity.
The bulk of the return/profit on each property will come in the form of equity in the property—and cash flow, once it’s rented.
On the equity side, it’s clear that the BRRRR property has $20,000 more than the turnkey property. So you’re up $20,000.
On the cash flow side, both properties, in theory, bring in the same amount of cash flow. The returns are then technically higher on the BRRRR property because you’ve invested less money in it. If you are looking at the cap rate or the cash-on-cash return equations, the denominator on the BRRRR property is lower because you put less cash in—so that makes the return higher.
For help on running and calculating rental property numbers such as cap rates and cash-on-cash returns, check out Rental Property Numbers so Easy You Can Calculate Them on a Napkin.
Let’s pretend the cash-on-cash return on the BRRRR property is 12 percent. Meanwhile, it’s 8.5 percent on the turnkey property.
In both cases—equity and cash flow—the BRRRR property wins the race. On the most basic level you have $20,000 in equity on that property and you are making 3.5 percent more cash flow per month.
Now let’s think backwards. Roughly how much time is, or was, required for each property?
The turnkey rental property really only ever required you to spend time on due diligence during the purchase—and then managing the manager once it’s up and running. I’ll say you spend roughly 15 hours during the escrow period doing due diligence. Then once you own it, you spend no more than five hours annually dealing with something involving the property manager or filing insurance claims or something. That is less than half an hour a month.
The BRRRR property requires you to: find a property, negotiate the property, and then rehab the property. Finding the property and negotiating it may take you 15 hours. Rehabbing the property, at roughly a $30,000 level, may take you 60 hours. Then once you own it (and since you are the landlord) I’ll estimate five hours per month tending to the property.
On the equity front, that $20,000 profit on the BRRRR required 75 hours of work. I would also argue that in addition to the 75 hours of work—whether that be doing the physical labor yourself or tending to contractors—there is also a level of headache, thought, and stress in conjunction with the work.
On the cash flow front, an added 3.5 percent of cash flow is in exchange for 4.5 hours of increased labor (landlording) over the .5 hours for managing the property manager. Headache, thought, and stress are also likely in conjunction with the work.