Some people are born gamblers, always willing to invest their money on the long shot. Yet we seldom see real estate investments as a gamble.

Technology startups fail often and we know about them. We are less likely to hear about investment in real estate that failed, however, and one reason for that is survivorship bias.

In the book Mistakes Were Made, But Not by Me, Carol Tavris and Elliot Aronson discuss a “benevolent dolphin” problem. Every now and then there is a story about a shipwreck and a person being pushed toward the shore by a dolphin which saves their life.

The authors explain: “It is tempting to conclude that dolphins must really like human beings, enough to save us from drowning. But wait — are dolphins aware that humans don’t swim as well as they do? Are they actually intending to be helpful?

“To answer that question, we would need to know how many shipwrecked sailors have been gently nudged further out to sea by dolphins, there to drown and never be heard from again. We don’t know about those cases because the swimmers don’t live to tell us about their evil-dolphin experiences.

“If we had that information, we might conclude that dolphins are neither benevolent nor evil; they are just being playful.”

Not everyone shares their stories

Those who do well in real estate (and other businesses) share their stories with their friends and the media. Yet investment in real estate is risky, especially during a pandemic where economic recovery is slow and there is still a major recession.

Books on real estate success are written by the survivors in this field.

If you read a book written in the 1990s, you are likely to hear stories about the 1980s, sky-high interest rates and how being creative and hard-working made it possible to not just survive, but to thrive. Similarly, every decade new books talk about careful asset selection, diligent underwriting, etc.

The survivors write the story, not someone whose gone bankrupt!

Before the pandemic, we chose to focus on two asset classes that emerged as clear winners in real estate over the past six months – industrial and multifamily rental. It would be easy to say that we (Denciti Development Corp.) made good decisions because we had a “secret.”

Unfortunately, it is just not so. There is no secret and we are not immune to bad decisions.

That said, there are things we do that I would like to share, and it is this disciplined approach that brings better results than a simple gamble. “Ignorance is bliss?” No. Not in our business.

Gains and losses are non-symmetrical

If you start with a portfolio worth $100 and lose 50 per cent, you now need to earn 100 per cent to break even. Gains and losses are not symmetrical.

Over the past decade, real estate values have been seen going up across all asset classes. In cities like Vancouver, real estate appears to go down very little even during economic recessions. It is no wonder real estate attracts investors.

One benefit to real estate investors is that the ability to finance hard assets often allows for better leverage. Fixed-income assets can be financed on a Debt Service Ratio (DSR) and are subject to how much income is generated by the property.

Developers of real estate usually try to leverage construction loans to the maximum available amount of credit. This is because the profit margins on development are usually between 10 per cent and 20 per cent.

When you think about 20 per cent, you may say that is plenty. The reality is that, unlike other businesses which produce and sell their products quickly, real estate takes years to build and a 20 per cent return over a five-year period is not very much.

This is where leverage can help. By choosing an appropriate capital stack (debt and equity), the profits on equity can become lucrative.

Leverage is an amplifier

Leverage is an amplifier of the gains and losses asymmetry.

Say you have $100 and borrow $400 to purchase an asset for $500. If the asset goes up by 20 per cent and you sell it, you get back $200, great news – you doubled your money.

Unfortunately, the reverse is true too. If a developer who invested $100 and borrowed $400 to develop an asset with projected valuation of $575 (15 per cent profit) were to see a drop of 20 per cent, the value drops to $460. After repaying the lender $400, that leaves only $60.

This example shows that a 20 per cent drop on a 15 per cent profit margin led to a developer losing 40 per cent of their initial equity! Leverage is an amplifier of gain/loss asymmetry.

Return on equity vs. return of equity

It’s been said that compounding is the greatest wealth generator. That is true, as long as you do not lose money.

This is why we think the top priority is not the return on equity, but the return of equity. We work as hard on analyzing downside as on upside, if not harder.

For example, we often see higher projected returns for a condo development than for a purpose-built rental. Choosing to build rental property (when not required by the municipality) can be a hard decision for a developer and seeing less profit on pro-forma is not easy.

Yet, we think that people need more rental product and the risk associated with developing rental in the current environment seems lower than condo. With the increase in population, people need to find a home and many cannot afford condo prices.

There is also benefit in knowing that in some small way, we help people find a place to call home.

Unlike sailors who were pushed out to sea by the “benevolent dolphin,” we can find stories and lessons from mistakes made in real estate.

Asking questions, challenging assumptions and studying empirical evidence leads to creative solutions and better results. Using this approach, our advice would be to use more than one financial metric (such as IRR, NPV, RoC etc.) and only take on leverage appropriate to tolerate market fluctuations.

A disciplined approach brings better results than a simple gamble.