the risk We’re 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, finding ways to minimize it is essential.
When you invest, the goal is to generate income to see your wealth grow. But of course, it is impossible to ignore that there is a downside, which means that there is always the possibility of losing your money. The truth is, any type of investment comes with risks. That’s why the key to investing is identifying risks through careful research and due diligence.
As physicians, we are experts in weighing risks and benefits. We use risk-benefit analysis to determine the best course of treatment for our patients, understanding that no treatment is without some potential harm. The same can be said for passive real estate deals, syndications and funds.
So where is the risk in passive real estate investing?
In this article, we’ll explore five simple steps you can take to reduce 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 never lose [money]. And the second rule of investing is to never forget the first rule. And there are all the rules”. Remember, risk and return are usually correlated, and it’s up to us to determine the right balance for our portfolios.
Here are 5 simple steps you can take to reduce your risk in passive real estate investing…
1. Know the sponsor
The most important risk to consider is who is managing or running the contract. Businesses run them or die.
It’s like surgery – you want the person holding the knife to be the best surgeon possible, to ensure a great outcome. A bad sponsor can ruin any deal, but a good sponsor can help you get through a deal that might not have performed well and eventually achieve a favorable outcome. After all, you are relying on the operator to manage the business plan and manage renovations, day-to-day operations and ultimately the potential sale of the property.
To evaluate a sponsor’s track record, you need to ask some critical questions.
- How many deals have they made, and how many have they exited, meaning they’ve gone full circle?
- What were some of their best and worst deals and how did those deals perform?
- Have they ever lost money and what happened in those situations?
Losing money on a deal isn’t necessarily a red flag. It is possible that even the best companies can suffer losses. What matters is what they learned from it, how they resolved it, and what they are doing now to reduce the chances of it happening again.
Sometimes, being with someone who has faced problems and learning from them can be beneficial. You can use their past experiences and mistakes to achieve your desired results. By understanding a sponsor’s track record and learning from their mistakes, you can minimize risk and maximize your returns.
2. Reducing market risk
Another important factor to consider before investing in passive real estate is understanding the current market. What steps is the sponsor taking to reduce risk and ensure that investors do not lose money during market downturns or booms?
If you don’t get satisfactory answers to these questions, and you don’t feel comfortable entrusting them with your hard-earned money, it’s best to move on. There are many syndicators, operators and sponsors that you can find who will suit 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 risk, you can make an informed decision consistent with your investment goals and risk tolerance. Don’t rush into an investment without doing due diligence to make sure you’re comfortable with the sponsor and the investment opportunity before making any commitments.
3. Debt financing of contracts
Financing a deal is an important aspect to consider when investing in passive real estate. We all remember the 2008 recession, which was triggered by bad loans in the real estate market that could not be paid back. This eventually leads to a domino effect, which ultimately affects the entire economy.
The biggest risk in any deal is debt or financing, also known as leverage. You need to understand the structure of the loan, whether it is short-term or long-term, fixed or variable, and the terms or expectations for future refinancing.
For example, here are some questions to ask…
- Is the loan a short-term loan or a long-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 do they plan to hold the property?
- Do they plan to refinance the property at some point?
- What is debt repayment 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 can result in higher returns, but it also comes with higher risk. So, while a deal with high returns may seem attractive, it is important to evaluate the risks involved. Conversely, a low return contract may have less risk and may be more suitable for you.
You must fully understand the loan and its structure before proceeding with any investment. Whether the loan is interest-only or abandoned for a longer period, the terms may vary. Take time to understand the pitfalls and risks associated with contract financing.
4. Determine the market you are investing in
Understanding the market you are investing in is an important aspect of passive real estate investing. This includes understanding the neighborhood, city, state or region and how properties perform in different areas. It is important to identify the market drivers that can make the property better over time. This involves looking at factors such as population growth, employment growth, local economies, major industries and other characteristics that drive growth in the region.
Different types of real estate have their own unique drivers for area growth. For example, apartment buildings require large amounts of relocation and population growth, while self-storage or retail buildings have different characteristics and growth drivers. It is essential to understand each type of real estate market and why a particular area may be good for investment.
Real estate is often considered local or even hyperlocal, and understanding the specific location of the property is crucial. You can use Google Maps to determine what a particular location has to offer. Ask sponsors what makes that area special and why it will perform better than other parts of the city
Environmental risk is also an important consideration when investing in real estate. It is essential to understand any potential environmental hazards, such as flood zones, hurricanes, tornadoes or other weather-related hazards. It’s important to ask about worst-case scenarios and 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 potential environmental risks to make an informed decision consistent with your investment goals and risk tolerance.
5. Understand concentration risk
Finally, when it comes to passive real estate investing, it’s important to understand and mitigate concentration risk. Are you able to spread or reduce your risk by investing in one property, one area… or are you able to invest in multiple areas?
It’s never a good idea to put all your eggs in one basket and variety is the key to success. Diversification across sponsors, asset classes and risk profiles can help smooth returns over time and reduce risk. As with investing in stocks, it’s important to have a diversified portfolio of passive investments that allow for returns across multiple market cycles.
Personally, I diversify my investments by using different sponsors or operators, each with their own strengths and areas of expertise. I invest in a variety of geographic 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 a variety of real estate assets such as apartment buildings, self-storage, office buildings and certain retail and development projects. This allows me to invest in different asset classes, which perform differently over time, especially in different parts of the economic cycle.
In this blog post, I detail how I made my portfolio bulletproof.
For my family and I, striving for ultimate security and financial independence means having a diversified portfolio of investments that generate returns across multiple economic cycles. It’s important to note that I don’t concentrate all my investments on one year or property and just let it run. Instead, I like to invest throughout all parts of the cycle, whether real estate is hot, OK, or even when it’s not doing well. It is during times of overall market anxiety, 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 independence. However, it is important to do your due diligence and minimize risk before investing. These include sponsors, understanding the market, diversifying your investments and being aware of concentration risk. By following these tips, you can reduce 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 Passive Real Estate Academy For more information and support. Be sure to join our waiting list to get the best offers 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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