How to Reduce the Risk of Investing in Passive Real Estate
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Giving a timeless piece of investing advice, Warren Buffett once said, “The first rule of an investment is don't lose money. And the second rule of an investment is don't forget the first rule. And that's all the rules there are.”
But how do you ensure that you don't lose money?Real estate investing involves risk. Any investment involves risk.
That's why careful research and risk assessment are essential.
It's impossible never to lose money, but you can reduce your risks with a few simple steps.
As physicians, we are used to taking calculated risks. We take risks in our day-to-day work at the hospital. We took risks to get to where we are now.
We stayed in school several years longer than friends to achieve our career goals. As we worked, we hoped that we would get through residency and pass our boards so we could pay off our six-figure student loans. And now, some of us take carefully calculated risks with our patients' lives each and every day.
Today I want to share the five things you need to do to reduce risk in a passive real estate deal. Don't pass over these steps to save time. You may save yourself a few hours, but you could also lose money if the deal goes south.
Five things to do before investing in passive real estate
#1: Get to know the sponsor's track record
It's been said that a great sponsor can salvage nearly any bad deal, but a poor sponsor can tank any deal, even a great deal. It's similar to if you were undergoing surgery. You'd find out all you can about the surgeon who will be holding the knife. You want the best surgeon in charge to ensure a successful operation.
Answer the following questions by researching the sponsor's track record:
- How many deals have they done?
- How many deals have they exited?
- How many years have they been putting deals together?
- What were their best and worst deals?
- Do they have a cash position in the deal?
- How are they compensated for their involvement in the deal?
- What's their involvement in the day-to-day operations of the property?
- What's their risk-mitigation strategy?
Of course, this is by no means a comprehensive list. It would be best to continue asking questions until you're comfortable and have little hesitation of putting $25,000 or $50,000 into the deal.
But if you have that gut feeling that there's just something that's not quite right, just move on. There are lots of syndication opportunities.
#2: Understand how the deal is being financed
All you have to do is think back to the origins of the 2008 financial crisis to realize the role financing plays in real estate. Bad real estate debt that couldn't be paid back created a domino effect that ultimately affected the entire economy.
Lenders have tightened up their requirements, so it's unlikely we'll live through this particular situation again, but you always have to be careful with leverage. It's a double-edged sword: leverage can multiply the rewards, but leverage can also multiply the losses.
However, it's good to know the type of loan and whether it's interest-only or if it will be amortized over a decade or two. With an amortized loan, the monthly payments will include interest and principal, and the loan will be paid off by the end of the amortization schedule. While an interest-only loan has lower payments, there could be a problem if the lender suddenly calls the loan.
Another metric to know is whether the loan to cost (LTC) or loan to value (LTV) ratio is being used. With a loan to cost, you divide the total cost of real estate that is purchased by the loan amount. Loan to value is the current market value divided by the loan amount.
Let's say there's a deal that costs $200,000, and you want to finance $150,000. That's a 75% relatively high LTC ratio. However, if the property's current market value is $400,000, that same $150,000 loan is now a more reasonable 37.5%.
Finally, you need to know what will happen with the loan payments if the loan is called by the lender or reaches the end of its term.
#3: Know the market in which you're investing
Besides producing passive income, investing in syndications lets you take advantage of markets you might otherwise not consider. Here in California, it's a challenge to find real estate that provides cash flow. That's not the case in the Midwest; my money goes further in St. Louis than it does in San Francisco.
As you're considering a deal, consider the market in which it's located. Is the population growing or moving away? Is there a significant industry that supplies stable long-term jobs for residents?
More specifically, what is the general location of the deal? Investing in an apartment complex on the east side of the city is not good if most of the jobs, stores, and entertainment venues are on the west. Likewise, a high-end apartment complex may not do well in a town that is primarily blue-collar homeowners.
#4: Consider environmental risks
Unfortunately, there's not much you can do to prevent Mother Nature from sending her weather-related disasters. You can, however, choose which ones you're willing to take a risk on.
From flood zones and fires to tornadoes and hurricanes, every region of the United States has some risk. Find out if there will be upgrades that mitigate damage to the building. See how large of an insurance policy will be taken out on the property. Ask what will happen in a “worst-case scenario” event.
Again, if you discover that you're not comfortable with an investment in Florida due to the risk of wind and water damage, that's okay. There's another deal out there…just keep looking.
#5: Assess your own real estate concentration risk
Finally, before you invest in a passive real estate deal, you need to consider your real estate holdings. You don't want all of your investment dollars tied up in a series of apartment complexes in Ohio or a portfolio of trailer parks. It's like how your grandmother used to say, “Don't keep all your eggs in one basket.”
You try to spread your risk among many companies or in an index or mutual funds in the stock market. It's a good idea to take a look at your current investments and decide whether or not you're too heavily concentrated in one asset class or not. If you are, are you comfortable with this?
While it's easy to stick with the tried-and-true, sometimes we might find ourselves heavily invested in one type of real estate. Everyone will have an opinion on it, but only you can decide what you feel is right for your portfolio.
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Disclaimer: The topic presented in this article is provided as general information and for educational purposes. It is not a substitute for professional advice. Accordingly, before taking action, consult with your team of professionals.