In today’s world, it is hard to escape the headlines. Inflation has surged to a 40-year high. Recession signs are looming. And everyone is wondering what the next few months will look like for the United States.
But recessions are not new, and we should not expect them to never happen.
Looking at the stats, we have had 12 recessions since World War II. During these recessions, the economy contracted an average of 2.5%, unemployment has risen 3.8%, and average corporate profits have fallen 15%. And while it takes two quarters of declining GDP to call a recession, the average recession length was ten months, making much of a recession a hindsight event. So how are you to adjust your portfolio holdings in response to a recession?
This is where investing based on principle comes into play.
The Conversation Changed My Life
When I started investing in real estate years ago, one of my mentors taught me that you should not always be swinging for the fences for returns. My mentor said you should ensure any asset you invest in possesses a core set of attributes, so you can establish multiple ways of preserving capital and making a return.
Today, I have a simple spreadsheet where I evaluate every single asset before I invest to make sure it abides by these four basic principles of conservative investing.
1. Capital preservation – This is where you invest in an asset secured by a hard asset like real estate or business (syndication investing blends both ideal assets together!). Ideally, the asset’s valuation should be based on its net operating income or expected gross income. You also want to see sale and rent comparables higher than the subject asset. Lastly, you want to make sure enough cash reserves are being held for the assets to cover CapEx and operational expenses for several months upwards towards a year. If you are not forced to sell in a down market, you have not lost!
2. Cash flow – This is where you have multiple units of cash flow to harvest on a regular monthly basis (multifamily doors, storage units, hotel rooms, car wash customers, etc.). Ideally, cash flow should start from day one and there should be a business plan in place to grow it (no buying negative cash flowing businesses!). In addition, you want to make sure that the operational expenses are low enough so there is plenty of margin for you to remain responsive to the business environment.
3. Equity growth – Equity growth can come in the form of natural market appreciation, forced appreciation, or debt paydown. When considering market appreciation, you want to ensure that the asset is positioned on the path of progress in a growth market. Forced appreciation (my favorite equity growth lever) occurs when the operator has a business plan that increases the income, decreases the expenses, and adds additional income streams to the property to drive net operating income growth and the value of the property.
4. Tax Benefits – Lastly, look for what assets the IRS allows you to take tax benefits on. Examples of such benefits are depreciation, accelerated depreciation, bonus depreciation, and 1031 exchanges.
Principles Into Action – What Works & What Does Not
I would be remiss if I did not show you how investing by principle works. Let’s put these principles into action to evaluate common investments that you may have in your portfolio right now.
Cash – It is no secret that cash is losing to inflation by 9.1% as of July 2022. What is worse is that not only are you losing out on capital preservation, but you also have no way to take advantage of cash flow, equity, or tax benefits when holding cash.
Gold – Even gold is down ~2% YTD in July 2022. Gold is touted to be an investor’s hedge against inflation. Historically, it has done just that by preserving capital as inflation occurs. However, you cannot cash flow gold, take advantage of equity growth, or get tax benefits when holding gold.
Cryptocurrency – Many investors call Bitcoin “digital gold” and that it would hedge inflation and preserve capital as inflation ran rampant. Instead, cryptocurrency has lost 56% of its value since the beginning of the year. In addition, you cannot cash flow cryptocurrency, nor do you get any tax benefits holding it.
Paper assets – Paper assets include stocks, bonds, and mutual funds. If you are tracking the S&P 500 as of July 2022, you are down about 18% year to date, however; you have not technically lost capital until you sell your shares. (“How long can you hold on?” is the question.) Moreover, paper assets do not cash flow well and largely do not provide tax benefits (aside from municipal bonds, or tax loss harvesting).
Now that we have discussed what is not working, let’s apply these principles to one of my favorite investments… passive real estate:
Capital preservation – An investor owns shares in an LLC that holds and operates the land, the buildings, and a business with monthly communication and quarterly financial reporting to stay informed.
Cash flow – For our current investments, an investor can expect a seven percent plus preferred return. In addition, an investor can expect to see a 5-15% cash-on-cash return depending on the asset type and the year of the hold.
Equity growth – For our exits to date, our investors have seen a 25% IRR (internal rate of return).
Tax benefits – An investor can expect to see accelerated depreciation, and bonus depreciation to drive year one passive losses to help shield income and capital gains.
Of course, there are a few other principles that I include in my investing process, however, just evaluating investments by these four core principles alone helps me hedge my risk and allows me four separate ways to make money no matter what the market is doing.