I admit I am a bit fearful of writing this article. There may be a big hole in my thinking and I will look foolish. But the whole idea of The Real Estate Philosopher is to think up non-mainstream ideas and take a chance. And I have looked foolish before, but my wife still gives me a hug when I get home after work. So here goes…

I start with a wonderment, whether when real estate players are conservative, are they kidding themselves about the risk/reward profile of their investments?

I have written on the macro risk of confirmation bias, which misleads us to think that certain players are more brilliant – or more foolish – than they really are, i.e., the track record may mislead, and that the best way for long-term outperformance is diversification. This would include diversification over asset class, location, capital stack dispersion, etc.

This article partially challenges my own thinking.  This idea came to me based on reading about some syndicating sleazeballs who took advantage of doctors, dentists and – yes – lawyers ☺.

How do they do it?

Simple. They put the risk on the investor and the reward on themselves. Heads they win something, and tails they win a lot. And the investors don't really matter to these unscrupulous players. But I do wonder whether there is a way for honorable and intelligent players to be rewarded by taking on risk with a careful assessment of it.

Dissecting this…

The hardest things for a sponsor to get right now are:

  • Super high leverage from a lender
  • Equity with a ton of leverage under it

Lenders, as good stewards of their capital, of course shun LTVs higher than whatever their mandate is. And equity players, as good stewards of their capital, usually max out underlying leverage between 50% and 75%.

But step back for a moment and look around…

Stocks are going wild. Companies that have never earned a penny are worth tens, and even hundreds, of billions of dollars. Gold has skyrocketed. Data centers are the talk of the town. Chip stocks are insanity. We have a first trillionaire. The Wall Street Journal keeps mentioning houses selling for over $100M. And AI, quantum computing and much more are all over the place. The world is awash in capital. For the right sales pitch, money abounds.

No one knows for sure, but this could be the biggest economic transformation the world has ever seen – or the mother of bubbles that will burst soon. After all, the deficit is now $40T.

But us careful real estate players, we want none of that, right? We are conservative, since we know that when the insane world crashes down we will be just fine with our nice safe real estate investments, conservatively made.

But I am wondering if we are kidding ourselves.

If the world really blows up, who will be paying the rent on our properties? Perhaps we go down with the ship anyway if the bubble bursts.

So, now follow my thinking to its conclusion…

By being conservative, we are foregoing a ton of reward but possibly taking on almost the same risk that the more fearless players are taking.

If I am right, that means that instead of being Overpaid for Risk, we are being Underpaid for Risk.

So, where does this leave us?

It doesn't make sense for me to advocate wild speculation with investor capital. To be clear, I am not doing that at all. Indeed, I have contempt – and disgust – for those who do that kind of thing.

But I am wondering if boxing oneself into a "perceived-as-safe" risk/reward environment may result in a severe mis-pricing of risk.

How about this idea: blending risk profiles into diversification?

Say I am a lender that focuses on, say, construction financing. I give myself what I believe is a reasonable risk profile that says that, across my portfolio, the LTV will be 65%. However, some of the time I limit the LTV to 40% and sometimes I go up to 90%. When I go to 90%, I charge a ton for the leverage and get guarantees and other protections.

Alternatively, say I am an investor who says that, overall, I don't want my portfolio more than 65% leveraged ahead of me. However, some of the time I cap leverage at 40% and sometimes I go up to 90% ahead of me.

For both of the above, I wonder if my overall risk/reward profile is actually better than otherwise. I admit that although I was a math major 50 years ago, I cannot figure that out. But I can tell you that for either of the foregoing concepts I would have a line out the door of eager sponsors begging for my higher-risk capital and offering me the world for it.

Food for thought for sure…

Bruce Stachenfeld, aka The Real Estate Philosopher™