I have a lot of people in Investor Club who lend to flippers. These notes pay pretty well–I hear over 12-15 percent on a regular basis. These investors ask why they would ever invest in anything with less return.
It’s a fair question but there is a very good answer. When you lend to people who flip homes, you are investing in a business NOT in an asset.
Investing in businesses is inherently riskier than investing in an asset such as real estate. As a guy who starts businesses, I know that instinctively.
I have had businesses that threw off 7 figures of profits one year then were in the red the following year. The multiple variables involved with businesses such as markets, competition, and management make it a much more volatile endeavor than investing in an apartment building where people have to live–hopefully you can see the difference.
It is also from my experience as a guy who starts businesses that I have noted that there is often hidden variables within a business that dictate their success that people from the outside cannot necessarily identify. With some of my businesses, this relates to my own instincts as a marketer and directing our marketing initiatives.
If I sell a business that relies heavily on my special skill set, the person buying it has to be able to make up for that special skill set or they may not see the same results.
Suffice it to say that that knowledge has kept me from purchasing businesses as investments. My conclusion is that I am better off starting businesses from scratch. The exception to this thought process is buying a larger business.
For example, a business with a $50 million revenue with management in place sold by a passive owner might be appealing. The problem is that a business like this might have a yearly profit of $10 million and therefore might cost me $50 million to purchase. I don’t have that kind of money–yet. It might be something we do as a syndication in investor club at some point however.
If you’re a savvy investor, you probably noticed that I used a multiple of 5X times profits to determine the cost of this theoretical business. For businesses, that would not be out of the ordinary.
Is that high or low compared to real estate? Well, D class apartment buildings (no money no credit crowd) might be trading at around 10X profits AKA a cap rate of 10–so that building with a net operating income of $10 million might be worth $100 million or more compared to the $50 million you paid for a solid business.
In other words, if you know what you are doing, buying businesses can potentially be very profitable. It is something that I have not done but almost certainly will do in the future.
My guest on Wealth Formula Podcast this week, Victor Menasce, has a lot of experience in this area. I invited him on the show to tell us a little bit more about buying businesses. Make sure to tune in–you never know when you might learn about your true calling as an investor!