Why LPs tend to underestimate risk

Welcome back and happy Sunday!

Over the years, I’ve noticed a very clear trend where LPs underestimate risk in LP positions.

Today, I’d like to explore why I think this trend is prevalent and why its assumptions are flawed.

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First, let’s get the basics out of the way.

It’s healthy to look at your upside (otherwise you’d never consider investing), but the downside needs to be carefully vetted.

This is particularly true in real estate estate investments where the upside is nothing like venture capital and loss of capital lasts far more than you think.

Here’s my thesis:

• Most LPs aren’t experienced investors

• Most LPs own a home, which has performed decently as an investment (complicated topic to call it an investment, but that’s for another post) in recent years

• When presented a pitch from a GP, many LPs immediately think of their home’s performance over a long period of time and connect that (typically subconsciously) to their LP investment decision

Here’s why this logic is deeply flawed:

• **Leverage - **I think this is the largest difference, by a wide margin.

• Single family homes are bought on 30 year mortgages which significantly decreases market risk as long as you can pay your mortgage on time.

• LP positions are typically tied to an asset which holds debt with 3-5 year debt maturities. This means that the macroeconomic environment can play a significant role in what happens - “simply paying your mortgage” isn’t enough when that maturity hits

• While it’s generally true that the value of (most) real estate increases with time, debt is an incredibly important factor that’s often overlooked in the comparison

• Liquidity - the buyer pool for single family homes is far greater, making the asset far more liquid. Both liquidity and cash flow definitely matter, and at some point you might as well put your money in treasuries or public stocks (including REITs which typically finance themselves conservatively)

• **Control - **another factor people forget about is the fact that you have control. If something isn’t going according to plan, you can always sell. With an LP position this isn’t the case - you’re fully trusting the GP to hold the asset until it’s the best time to sell.

If a GP is using a comparison to the single family housing market as the main reason for you to invest, I think it’s safe to say that this might be a “yellow” flag. Some others I keep seeing online are:

• real estate is tangible, don’t you want to own a piece of something?

• stock market is down and so is your retirement, invest in real estate instead because it’s much safer

• everyone needs a place to live, invest in multifamily!

Also, here’s a meme for all of us who have to put up with these misleading posts! :)

I love investment comparisons, but if you’re going to make them ensure they’re portraying both investment options fairly

As always, I hope this is helpful and I look forward to your feedback!

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