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Three ways to protect yourself from yourself from Wharton Emeritus Professor Peter Linneman.
BRUCE KIRSCH: When you’re new in the business, if you end up being in finance, you spend what I like to call a lot of quality time in spreadsheets, sometimes late at night. And when you’re working in these things for a long time, and when you’re tired, physically tired, and your eyes are tired it’s easy to get lost in the numbers, because they’re all glowing equally bright from the screen. And when you print them out, they all look equally authoritative. And unfortunately when we’re working in software, such as Microsoft Excel or another platform, the platform is not going to tell us, it’s not going to raise a red flag necessarily if we do something wrong, because generally speaking these soft-wares are simply carrying out inputs or instructions that we have coded into cells as formulas. And so this is really dangerous, because if the program is simply carrying out your instructions, and your instructions, unbeknownst to you, are faulty, you’re going to get something coming out the other end which is faulty as well. And so how can students and people who are newer to the business, or newer to working in spreadsheets, protect themselves and avoid making these big mistakes?
DR. PETER LINNEMAN: You have to grasp what you were just saying, which is sort of the weakest link theory. You can get 999 numbers out of 1,000 right, but if the thousandth is wrong the math is distorted by the weakest link. So you have to understand that and believe that. Second to that is a bit of humility, which is, even if you’re very good, what are the chances that you don’t make a mistake as a human being 1 out of 1,000 times. So if there are 1,000 inputs into a spreadsheet, what are the chances you didn’t make a mistake on one of them, that’s if you’re very good. And if you’re starting, and it’s late at night, and you’re tired, and you’re pissed off at the boss, and you’re thinking about your boyfriend, and all these things that make people people, the odds get down to maybe 1 in 50 or one in 100. Which means if there are 1,000 numbers you’ve made 10, 20 mistakes, and they’re not going to cancel one another, they’re real mistakes.
So it’s first understand, and take to heart the weakest link. And second, have a little humility, and understand even if you’re very careful, even if you’re very diligent, you make mistakes. Now how do you see them? And I’ve done this and I’m sure you’ve done this, and when I was young I did the reverse of it, you walk in, and you say here’s the answer. And the answer is, let’s look on an IRR basis for example, and you say the IRR is 19.7. Well, come on, if your boss has been around, and is a real professional, they know that buying a property at a 7 cap with 50% debt, where the debt is at 5%, and the income’s growing 1% a year, and you hold it for four years, they know that’s going to be around an 8% IRR. They just know that. Why? Not Because they’re doing it in their head, although some of them may be able to do it. It’s because they’ve seen it enough times in the past, that that’s what the math is, and their brain just says when you show me a 22% IRR, it’s wrong. And the young person says, no, no it’s right, it’s right. You go, no, no, I know it’s wrong. I can’t tell the difference in my head, in that scenario I said, between, is it 8.2 or 7.8, but I can tell the difference between an 8 and a 12%, and a 16%, and a 20%, and I know this is wrong. Similarly if you buy something at a 10 cap and you believe the income’s going to go up 5% a year for five years, and you believe you sell it around the same cap rates you got in at, and you’re using 60% debt at 4% interest rate over the time period, you know that that’s going to end up in the 20, 25% IRR range. I don’t know exactly where, but if you walk in and tell me it’s an 8%, I know it’s wrong. So there’s this sense of getting used to, almost like an SAT test, where you say, OK, what would come next in the pattern. If it’s red, green, blue, red, green, what should come next. You get used to these patterns, and get used to does it make sense that this could be the pattern. So weakest link, humility that even the best of us make mistakes, and is it remotely believable that if I’m making 10% a year that I only get an 8% IRR. You go, no not unless I think the value is falling a lot, but I said, the value is going up a lot, so if I come back with an 8% return it can’t be right. So it’s that building in the sensitivity, and unfortunately most of us learned the hard way, by getting beat up a little bit all along the way.
BRUCE KIRSCH: Right, one thing that I’ve learned the hard way is, if it looks too good to be true, then it’s probably not true.
DR. PETER LINNEMAN: That’s exactly true.
BRUCE KIRSCH: I mean it’s kind of a funny approach of saying, all right, so you’re in your first job out of school, and you’re working for a company, and into your lap falls the best looking deal in the history of real estate in your city. I mean, what are the odds that this is just going to grace you with its presence, and nobody else has seen this thing. The odds are very, very, very low because the market is pretty efficient at the end of the day, in terms of people finding excellent transactions.
DR. PETER LINNEMAN: And in fact, that’s not just a valuable point in terms of looking at spreadsheets, that’s a good point in business. When you’re offered a deal that looks too good to be true, you’re offered a resume for somebody to hire that looks too good to be true, when you’re offered financing that’s too good to be true, look both ways a lot of times, and start really doing your homework, because in my experience, as you say, things that look too good to be true generally are not true. It could be a scam. It could be you’ve not gotten the true information. It could be all sorts of things. When your instincts tell you it’s too good to be true, you should be digging deep and fast to figure out what’s really going on.
BRUCE KIRSCH: Right, and I find personally that usually it’s one of two things. It’s either you’re forgetting to pay back your loan, or you forgot to buy the land. Something of that nature.
DR. PETER LINNEMAN: Or if it’s outside of the spreadsheet world, where it’s an opportunity you’re being offered, or an employee you’re being offered, you may be the target of a scam, or somebody who’s lying about their credentials, or their property, or something. It’s the old, if the London Bridge is for sale, you’ve got to ask why are you the lucky one who can buy it for nothing.