ANALYZING A POTENTIAL DEAL: Why ROI is Not the Only Variable to Consider

1Would you be happy if you found an investment that would return 40% a year? Most investors would say yes to this question.  Now, does your opinion change if the chances of you losing your money were 50%? What if the investment size offered was only $5,000 but you had $500,000 to invest?

Often when I teach a class or put out some information on our blog or other online forum, I get asked what my investment criteria is, or what someone should be shooting for when making an investment decision.  This is a question that I never answer.  It is not that I don’t want to; it is because I cannot answer it.  There are too many variables to consider when making a decision.  Of course we are shooting for high safe returns, but what is high and what is safe?   Everyone has their own ideas and comfort when it comes to both of these.

Pine Financial Group works with hundreds of private investors.  Most, if not all, understand the security in what we do and have a high level of comfort with the risk.  Sometimes I talk to a potential investor about investing with us and they cannot get their arms around it, or they see it as a risky investment.  For example, a doctor that my family has been seeing for over 10 years has known what I do since I started doing it.  I 2approached him once about working together, and he quickly shot me down.  We have talked about what he is invested in, and it was clear to me that he basically has a zero tolerance for risk.  Someone like this needs to do whatever it takes to preserve principal, so they focus on that and little else.  What ends up happening is they invest their money in the bank paying less than inflation.  On the flip side, I know investors that invest millions into business and real estate that are purely speculative.   I think there is a balance somewhere in the middle, but each investor will need to balance their tolerance for risk with the expected returns and just try to find the best way to accomplish their goals.

As a real estate investor, it is really easy to get super high returns, but with those returns comes higher risk, more work, and sometimes less profit.  All of which should be considered.  Let me give you an example of what I mean.  I am a hard money lender that loves to loan 100% of cost, meaning our loans are no money down if the deal fits into our criteria.  Assuming you are an investor finding great deals, you can borrower all of the money to buy and fix up your investment, meaning the return on your dollars is through the roof (often times several hundred percent to infinite).  I would never talk you out of borrowing money from us, but the downside to this is that we are more expensive, so it will cost you more to do the deal.  Sure your returns are extremely high, but the profit per deal goes 3down.   This again is something to consider.  If you have a lot of money to invest, and it is just sitting in a bank earning close to zero, you might want to put more money into a deal and get a cheaper loan.  That way your profit is higher.  This could also be true if you are not finding as many deals and need to maximize profits per deal.  Most of our clients are finding a lot of deals, and would rather focus on volume to increase their overall bottom line, and not on maximizing profits on each deal they do.

As you grow as an investor, you will learn that there really is a sweet spot to maximize returns without taking too much risk.  Assuming you stick with it, eventually you will outgrow any sweet spot that exists and you will be forced to invest for lower returns, just to get the money working.  A great example of this again is in real estate.  This is an extreme example, but is something that we are seeing today.  Hedge funds typically have a large amount of money to invest.  Recently, hedge funds starting buying rental properties.  Because they have so much money, they cannot afford to cherry pick deals.  Therefore, they are buying large packages, typically for a much lower return than someone who is looking to buy just one or two of the best deals they can find.  As you grow, you will find that it is harder to keep larger amounts of money invested.

Here are some items you may consider as you go through your analysis on any type of investment.4

  • Cash on cash return. (Return on Investment, ROI).
  • Return on the investment without financing. (How well does the investment do as a cash investment?  This is a common way to look at commercial real estate.)
  • How passive is the investment?
  • How risky is it?
  • How well do you understand it?
  • How liquid is it?
  • How will you manage it?
  • What impact does it have on your taxes?
  • What is the minimum and maximum investment amount?
  • What is the potential?  (Best case, worst case, likely outcome analysis.)

5I know many people that have a low tolerance for risk and don’t end up doing anything, so I wanted to share this.  I know a lot of people and their financial habits because of what I do.  I talk to people about their investments nearly every day.  The fact is, more wealthy people choose to take on risk than those that do not. Yes, they lose money occasionally, but they typically make more than they lose and make more than they would have by not investing.   I am not saying go crazy and start investing in risky endeavors.  What I am saying is, if you are too scared to invest in anything or not willing to look at and learn about investment options, you cannot expect to be wealthy.  It is much easier to invest for wealth than to work for it.