How to Make Smart Investing Decisions Using the Four Quadrants

In this article

Making decisions without a plan rarely produces quality results. The same is true for making real estate investment choices. You need to be analytical throughout the investment process, starting by educating yourself on real estate investing and various options available, then deciding what type of investment suits your goals best.

What are the four investor quadrants?

In order to make intelligent decisions about real estate investing, you should understand the types of investment choices that are out there and match them with your long-term plans. My partner, Mike Zlotnik, has developed the Investor Quadrant methodology, which we share with our investor community.

The quadrants go from left to right in numerical order, with quadrants one and two on the top and quadrants three and four on the bottom.

The left side of the quadrants focuses primarily on cash flow and not as much on growth, while the right side is focused predominantly on capital growth and less so on income.

The upper row of the quadrants is the investment grade and hence tends to include moderate- to low-risk types of investments, while the bottom row of quadrants includes speculative-grade and applies to higher-risk investments.

When evaluating any project, the first step is to determine whether it is income- or growth-focused, followed by determining the investment risk level. This process allows you to place each investment into one of the four categories, which in turn helps you decide whether this is the type of investment that suits your particular financial needs.

Let’s review each of the four quadrants in greater detail to break down the process for classifying each type of investment.

---

---

Quadrant 1

• Includes institutional-quality deals
• Investments fall into low- to moderate-risk categories
• Deals offer cash flow from day one
• Examples include performing notes, first-lien mortgage notes, or super conservative leverage equity deals

Quadrant 2

• Includes institutional-quality deals
• Investments fall into low- to moderate-risk categories
• Deals offer limited to no cash flow initially
• Examples include non-performing notes or moderate leverage value-add deals

Quadrant 3

• Includes speculative-quality deals
• Investments fall into higher-risk category with a higher degree of uncertainty
• Investments initially project higher cash flow and concentrate on generating income
• Examples include second-lien performing notes, high leverage value-add deals, or mezzanine debt fund

Quadrant 4

• Includes speculative-quality deals
• Investments fall into higher-risk category with a higher degree of uncertainty
• Investments initially project limited cash flow and concentrate on multiplying value down the road
• Examples of such deals include development, major re-development, land speculation, and heavy value-add projects with low or nonexistent initial cash flow

---

How to adjust for risk

Keep in mind that all projects have risks, and you need to understand how to calculate returns that are adjusted for probable risks. In order to achieve that, you need to subtract the risk discount/loss reserve from the projected return.

The high-level guidance for risk adjustment or loss reserve ranges around 1-3% (average is 2%) for investment-grade projects and 5-20% (average is 6-8%) for speculative-grade projects. As you can imagine, the speculative-grade deal risks are much higher, and thus also offer higher projected returns.

It is not uncommon for these guidelines to vary significantly depending on factors including market fluctuations, sponsors, project-specific risks such as insufficient capital risk or higher construction cost, and many others. The values below are used specifically for illustration purposes to explain the methodology and the risks involved.

The table above illustrates examples of potential risk discounts for each of the four quadrants and the risk-adjusted returns based on such discounts. As you can see from this example, the risk discounts associated with the speculative-grade projects may be a lot higher and the returns may end up being lower than the returns for the investment-grade projects. Therefore, a lot depends on your investment portfolio, your short- and long-term goals, and your investment risk tolerance to potentially generate much higher returns.

There are no set-in-stone values, and the intent here is to give you general guidance to understand the various investments, associated risks, and realistic expectations of the potential returns and losses.

How to use the quadrants to help invest

Your question now is most likely, “Which one is best for me?” Only you know what is best for you. But these can help you determine your portfolio-building strategy.

If your main objective is capital preservation, then you are most likely a conservative investor looking for investments with lower volatility. You would likely benefit from a well-diversified fund that invests in a variety of projects.

Keep in mind that diversification may apply to geographic locations, investment strategies, or real estate asset classes. So, each fund may incorporate one or two or all three of these diversification strategies. The more diversification strategies are implemented within each fund, the higher the actual hedge against volatility such fund offers.

Some examples of single-strategy funds include funds focused on multi-family or mobile home parks. When it comes to individual asset syndication deals, the risk is also higher than in a fund due to the diversification reasons that we just discussed. If anything goes wrong with this single project, then you are likely to not receive any dividends or potentially lose some or all of the principal funds you had invested. In a fund, the risk of all or even most projects failing is fairly low, and hence the volatility is a lot lower than that of a single-asset investment.

Let me use a specific example. Let’s say that two individuals, Ella and Frank, have $200,000 to invest. Ella decided to invest all of it in a fund that diversifies across all three investment strategies, while Frank invested in four different single-asset syndications. Guess which investments have lower risks and a higher hedge against the investment’s volatility? You guessed correctly—Ella’s.

We frequently use these investment quadrants to teach our investors how to make better-informed investment decisions, and hopefully they shed some light on the investment methodology for you as well.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.