RISK. We are all too familiar with this four-letter word that strikes fear into the hearts of many investors. But, when it comes to passive real estate investing, it’s essential to find ways to minimize it.
When you invest, the goal is to create income to see your assets grow. But of course, it’s impossible to ignore that there is a downside, which means there is always the potential for you to lose money. The truth is, any sort of investing comes with risk. That is why the key to investing is to identify the risk through careful research and due diligence.
As doctors, we’re experts at weighing risks and benefits. We use a risk-benefit analysis to determine the best course of treatment for our patients, understanding that no treatment is without some potential downside. The same can be said for passive real estate deals, syndications, and funds.
So where are the risks in passive real estate investing?
In this article, we’ll explore five simple steps you can take to minimize risk and maximize returns. By understanding the risks and taking proactive steps to mitigate them, you can invest with confidence and achieve your financial goals.
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”. Remember, risk and return are typically correlated, and it’s up to us to determine the right balance for our portfolios.
Here are 5 simple steps you can take to minimize your risk in passive real estate investing…
1. Know The Sponsors
The most important risk to consider is who is operating or running the deal. Deals live or die by who is running them.
It’s like undergoing surgery – you want the one who is holding the knife to be the best surgeon, to ensure a great outcome. A bad sponsor can ruin any deal, but a good sponsor can help you get through a deal that may not perform as well and eventually achieve a favorable outcome. After all, you are relying on the operator to carry out the business plan and manage renovations, daily operations, and ultimately the potential sale of the property.
To assess a sponsor’s track record, you need to ask some critical questions.
- How many deals have they been in, and how many have they excited, meaning they’ve gone full cycle?
- What were some of their best and worst deals, and how did those deals perform?
- Did they ever lose money, and what happened in that situation?
Losing money on a deal is not necessarily a red flag. It’s possible that even the best companies may experience losses. What’s important is what they learned from it, how they resolved it, and what they’re doing now to minimize the chances of it happening again.
Sometimes, being with someone who has experienced difficulties and learned from them can be beneficial. You can leverage their past experiences and mistakes to achieve your desired outcomes. By understanding the sponsor’s track record and learning from their mistakes, you can minimize the risks and maximize your returns.
2. Mitigating Market Risk
Another crucial factor to consider before investing in passive real estate is understanding the current market. What steps are the sponsor taking to mitigate risks and ensure that investors don’t lose money when the market hits a downturn or upturn?
If you don’t get satisfactory answers to these questions, and you’re not comfortable with trusting your hard-earned money to them, it’s best to move on. There are many syndicators, operators, and sponsors out there that you can find who will be a good fit for you and whom you can trust with your money.
Investing in passive real estate should be a well-thought-out decision. By understanding the current market and the measures the sponsor is taking to mitigate risks, you can make an informed decision that aligns with your investment goals and risk tolerance. Don’t rush into any investment without proper due diligence to ensure that you’re comfortable with the sponsor and the investment opportunity before making any commitments.
3. Financing the loan of the deal
The financing of a deal is a crucial aspect to consider when investing in passive real estate. We all remember the 2008 recession, which was started by bad loans in the real estate market that could not be repaid. This ultimately led to a domino effect, which ultimately affected the entire economy.
The biggest risk in any deal is debt or financing, also known as leverage. You need to understand the debt structure, whether it’s short-term or long-term, fixed or variable, and the clauses or expectations for refinancing in the future.
For example, here are a few questions to ask…
- Is the loan a short-term loan or a longer-term loan, is it a fixed interest rate or is it adjustable?
- What happens when a loan matures? Or when it comes due?
- How long did they plan to hold the property?
- Do they plan to refinance the property at some point?
- What are the loan payments like?
- What is the worst-case scenario if the sponsor is not able to refinance the loan, will they sell at a loss?
Higher leverage might result in higher returns, but it also comes with higher risk. So, while a deal with high returns might seem attractive, it’s crucial to evaluate the risk involved. Conversely, a lower return deal might have less risk and be a better fit for you.
You must fully understand the loan and its structure before moving forward with any investment. Whether the loan is interest-only or amortized over a long period, the terms can vary. Take the time to understand the pitfalls and risks associated with financing the deal.
4. Determine the Market You Are Investing In
Understanding the market you’re investing in is a critical aspect of passive real estate investing. This includes understanding the neighborhood, city, state, or region and how properties perform in different areas. It’s important to identify the market drivers that will cause the property to continue to do well over time. This involves looking at factors like population growth, job growth, local economy, big industries, and other characteristics that drive growth in the area.
Different types of real estate have their own unique drivers for growth in the area. For example, apartment buildings require a good amount of migration and population growth, while self-storage or retail buildings have different characteristics and drivers for growth. It’s essential to understand the market for each type of real estate and why a certain area might be good for investment.
Real estate is often considered local or even hyperlocal, and it’s crucial to understand the specific location of the property. You can use Google Maps to determine what that particular location offers. Ask sponsors what makes that area special and why it will perform better than other parts of town.
Environmental risks are also an important consideration when investing in real estate. It’s essential to understand any potential environmental hazards, such as flood zones, hurricanes, tornadoes, or other weather-related risks. It’s vital to ask about the worst-case scenarios and the insurance that covers some of these environmental issues to avoid getting stuck in a bad situation.
Investing in passive real estate involves evaluating market drivers and understanding the potential environmental risks to make an informed decision that aligns with your investment goals and risk tolerance.
5. Understand the Concentration Risk
Finally, when it comes to passive real estate investing, it’s important to understand and mitigate concentration risk. Are you all in one property, in one area… or have you been able to spread your risk or mitigate it by investing in multiple areas?
Putting all your eggs in one basket is never a good idea, and diversification is the key to success. Diversifying across sponsors, asset classes, and risk profiles can help smooth out returns over time and minimize risk. Just like investing in stocks, it’s important to have a diversified portfolio of passive investments that allow for returns throughout multiple market cycles.
Personally, I diversify my investments, through using different sponsors or operators, each with their own strengths and areas of expertise. I also invest in various geographical locations across the United States, including the West Coast, South, Midwest, and East, as each area has its own unique characteristics. Additionally, I invest in different types of real estate assets such as apartment buildings, self-storage, office buildings, and some retail and development projects. This allows me to invest across different asset classes, which are known to perform differently over time, especially during different parts of the economic cycle.
In this blog post, I go into detail about how I made my bulletproof portfolio.
For my family and I, striving for ultimate security and financial freedom means having a diversified portfolio of investments that generate returns across multiple economic cycles is key. It’s important to note that I don’t concentrate all of my investments in a single year or property and just let it ride. Instead, I prefer to invest across all parts of the cycle, whether real estate is hot, doing okay, or even when it’s not doing well. It’s during times of overall market worry, such as today, when real opportunities arise.
In conclusion…
Investing in passive real estate deals can be a great way to grow your wealth and achieve financial freedom. However, it’s important to do your due diligence and mitigate risk before investing. This includes understanding the sponsor, the market, diversifying your investments, and being aware of concentration risk. By following these tips, you can minimize your risk and invest with confidence.
Remember, investing in real estate is a team sport, and there are resources available to help you learn and invest successfully. Check out the Passive Real Estate Academy for more information and support. Make sure you join our waitlist to receive the best offer when we launch our next Cohort!!!
With the right approach and mindset, you can achieve your financial goals and build a portfolio of successful passive real estate investments.
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