Wraps
Managing Risk in Your Real Estate “Wrap” Portfolio
By Joseph Arlt
May 10, 2006

Let’s get something straight, right up front: I hate risk. While I was an M.B.A. student at the Wharton School, the “party line” was that if you wanted to increase your potential returns on investment (ROI), you had to take on more risk. My professors were talking about conventional investments that are traded on regulated exchanges. And from that perspective, they were right. Stocks generally carry more risk than bonds, Internet stocks more than blue chips or utilities, emerging market stocks more than U.S. stocks, junk bonds more than AAA corporate or Treasury bonds, and so on.

My professors were obviously not acquainted with our creative and unconventional real estate investments, – what my mentor John Burley calls “Level 5” investments or “wraps.” If they had been, many of those professors would have quit teaching and gone into real estate! When structured and managed properly, wrap transactions (lease/option or seller financing agreements to potential home buyers) provide huge ROIs with little risk.

Compared to my regular wrap transactions, all conventional investments seem to offer too little reward for too much risk. That’s because most conventional investments subject the investor to market risk, which can’t be consistently predicted or controlled. Level 5 real estate investors don’t have to worry too much about market risk. We generate returns out of thin air, either by “buying right” or by using creative financing techniques.

Level 5 investors can’t completely eliminate all risk, however. The key to risk management is identification. For a wrap investor, the primary risk is that monthly payments coming in will be insufficient to cover monthly payments going out. This overall risk can be broken into two main subcategories:

1. Default risk: Occurs when occupants do not make their monthly payments on a timely basis.
   
2. Inventory risk: Occurs when we must make outgoing monthly payments on vacant properties.
   

In analyzing the above risks, I will be referring to different time periods, which I’ll define as follows:

The short term: The time remaining until your outgoing payments are considered “late.”

The medium term: The time it takes to return the property to performing status.

The long term: The time until the property either cashes out or is owned free and clear.

When a property is not performing, we like to say that we are experiencing a “short-term cash flow situation.” That’s because we know that in both the medium and long terms, everything will be fine. The occupants will either catch up their payments (and pay us some nice late fees), or the property will be taken back and new occupants will be found, whose down payment/option fee will get us back to even. And in the long term, the property will either cash out, providing a nice capital gain, or we’ll someday own it free and clear.

That having been said, the fact remains that those outgoing monthly payments must be made on a timely basis, no matter what. To quote a line from the movie Apollo 13, “Failure is not an option!” Your lenders don’t care about your medium or long-term prospects. They want their money now. And your reputation won’t be helped much by a bunch of late payments.

There are also many important psychological reasons why you must be able to make your payments each month. We become real estate investors due to the financial freedom the lifestyle provides. But you won’t feel “financially free” if you’re staying up nights worrying about how you’re going to make your payments. And this fear will manifest itself throughout your business dealings:

• You’ll write less offers as you begin to unconsciously fear (rather than hope) they’ll be accepted.
  
  
• You’ll be ineffective with both potential sellers and money partners, who will sense your fear and question your abilities and financial integrity.
  
  
• You’ll be seen as desperate by potential buyers, who will not be swayed by your new “hard sell” techniques.
  

So how do you avoid these risks? By treating your real estate portfolio like… a portfolio! When you’re first starting out, this will be much less of an issue. You’re just trying to pick up a few properties and get things rolling. But once you get to ten or so I highly suggest you start acting like a bond or stock fund manager.

Fund managers have long known the benefits of diversification. Let’s say you’re a growth stock fund manager, and that your core holdings are typically S&P 500 type stocks. By adding a few smaller cap NASDAQ stocks you can add a little “spice” to the portfolio. And by adding a few good utility stocks, you can add some safety, in that these stocks might “zig” when the rest of the market “zags.” By diversifying things a little, a good fund manager can create a safer and better-performing portfolio.

You can use the same principles in constructing your real estate portfolio. I’m a firm believer in getting to know specific neighborhoods and specializing in them. But I’m also against “putting all your eggs in one basket.” You need to walk a fine line between the two. Neighborhoods can decline rapidly and unpredictably, and for reasons or events no one could have predicted. If everything you own is in one small area, you could conceivably end up with a bunch of vacant properties no one wants.

In general, a wrap investor’s exposure will depend on a combination of the following:

• The percentage of occupants who pay late or default
  
• The time it takes to remarket a property
  
• The time it takes to take back a defaulted property
  
• The size of down payments received relative to the outgoing monthly payments
  
• The amount of monthly profits relative to the outgoing payments
  

I’ve formulated a procedure for measuring a portfolio’s exposure to default risk, which I call “Safety Scoring.” I believe that the procedure, once understood, will have a major impact on how investors analyze current and potential wrap properties. We’ll discuss safety scoring, and its implications and uses, in the next issue.