Think Passive Real Estate Is Safe? Here Are 9 Hidden Risks That Could Cost You

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You can’t eliminate all risk from investments. After all, the zombie apocalypse could strike tomorrow and probably wipe out your entire portfolio. But you can reduce risk, even among high-return investments. In fact, these are precisely the investments you want to minimize risk for—your Treasury bonds don’t need it. 

I love real estate syndications as high-return investments. They’re completely passive: You don’t have to worry about financing or contractors, permits or inspectors, tenants or property managers. You don’t have to become a landlord, yet you still get all the benefits of real estate ownership, including cash flow, appreciation, and tax advantages. 

If you find terms like “real estate syndication” or “private equity real estate” intimidating, don’t. They’re just group investments, where a professional investor takes on silent partners to help fund the deal. You effectively become a fractional owner in a large property like an apartment complex, mobile home park, or industrial or retail property. 

So which risks should you watch out for when screening potential investments? Here are nine to keep in mind.

1. Sponsor Risk

Before looking at specific investments, start by evaluating syndicators (also known as sponsors, general partners or GPs, and operators). 

An experienced, skilled sponsor who puts their investors first can find ways to salvage deals that go sideways. Inexperienced or loose-scrupled sponsors can find ways to mess up even good deals. 

While you should ask sponsors many questions, a few to start with include:

• How many deals have you done in your career? How many of those were sponsored syndication deals? 
• Of those, how many have gone full cycle? What kinds of returns have you delivered for your investors?
• Have you ever lost investors’ money? Have you ever lost your own money on a deal? 
• Have you ever done a capital call?
• Tell me about some deals that went sideways on you and how you responded.
• What’s your niche strategy, and why did you choose it? 

Do not invest with any investor that you don’t feel 100% confident in. If you don’t feel a “hell yes!” attitude about a sponsor, consider them a hard no. 

2. Debt Risk

Plenty of syndication deals have fallen apart over the last two years due to risky financing. Too many syndicators borrowed short-term or variable-interest loans, only to find themselves in trouble when interest rates shot upward. They ended up with weak or negative cash flow, perhaps unable to refinance at today’s higher rates. 

When we vet deals in our Co-Investing Club, one of the first things we look at is the debt structure. We ask questions like:

• What’s the loan term?
• What’s the interest rate? Is it fixed or floating?
• If it’s floating, is the sponsor buying a rate cap or rate swap or some other protection against rates rising further?

We turned down an investment last year that was financed with a two-year bridge loan. I’m not willing to gamble on interest rates and cap rates dropping within the next two years. 

Instead of that deal, we invested in a deal where the sponsor assumed a fixed 5.1% interest loan from the seller. Clinching the deal: It had nine years remaining on the term. 

I don’t know what the market will do in the next two years. But I’m pretty sure that at some point over the next nine years, there will be a good market for selling. 

3. Market Risk

Markets constantly change and evolve, driving upward or falling down. They rarely sit still. 

If cap rates rise, income property prices drop. That’s great for investing in new deals and bad for your existing real estate investments. 

Recession risk falls under the umbrella of market risk. In a recession, rent defaults rise, as do vacancy rates. Both hurt the net operating income of the property and, therefore, both its cash flow and its value. 

You can’t control cap rates or recessions. Markets move, sometimes in your favor and sometimes not. But you can invest conservatively in properties that cash flow extremely well, with long-term, low fixed-interest loans. 

As a final thought on market risk, all real estate investments are local. When people talk about “market risk,” they may worry about the macroeconomic market and broader economy. But what really matters to real estate investors is the local market: local cap rates, vacancy rates, and rents and expenses. That’s what impacts your real returns on that particular investment. 

Fortunately, you can invest passively from anywhere in the world, in any city in the country. I certainly do, from my current home base in Lima, Peru. 

4. Concentration Risk

I don’t know what will happen in any given city or state or, for that matter, in any given asset class (multifamily, mobile homes, retail, industrial, etc.). That’s precisely why we go in on these deals together: to spread small amounts of money across many different properties, regions, and property types. 

I own an interest in around 2,500 units in two dozen properties in 15 states at last count. In most cases, I only have $5,000 to $10,000 invested in each property. 

That means I don’t need a crystal ball. I don’t have to predict (gamble?) on the next hot market or asset class. I simply keep investing in different properties in different regions every single month as a form of dollar-cost averaging.

Because let’s face it: Any given local market could shoot up or drop unpredictably. You avoid that risk through diversification: spreading smaller eggs among many baskets.

5. Regulatory Risk

Local cities and states impose their own landlord-tenant regulations. Some are investor-friendly, and others tilt heavily toward protecting tenants at the expense of property owners. 

Properties subject to tenant-friendly regulations come with extra risk. It takes far longer to enforce lease contracts and evict defaulting or other renters in violation. I’ve seen evictions take 11 months in tenant-friendly jurisdictions!

In some markets, owners are forced to renew troublesome tenants even when their leases expire. They can’t non-renew lease agreements.

That doesn’t mean we never consider investments in anti-landlord markets. But we prefer nonresidential investments in those markets. For example, we’ve invested in a short-term cabin rental business in Southern California—in an unincorporated mountain town supported by tourism. There is zero risk of short-term rentals being banned or eviction nightmares when these cabins only support guest stays for up to a week. 

6. Cash Flow Risk

I touched earlier on the risk of local rents stalling or even dropping. That can pinch cash flow. 

Your cash flow can also get crunched from the other direction in the form of rising expenses. Look no further than the skyrocketing insurance premiums of the last two years or sharply higher labor costs. 

So, how does our investment club protect against cash flow risk? We look for deals with conservative projections, including low rent growth and high expense growth. If the numbers still work out, even assuming hard market conditions, you have some wiggle room if things go awry. 

7. Construction Risk

When syndicators plan to add value through renovations, they need a great team to actually swing those hammers and get the work done on budget and on schedule. 

Who’s doing the work? Is the construction team in-house or hired out? Either way, how many times has the sponsor worked with this team on prior deals? 

If it’s the sponsor’s first rodeo with this crew, watch out. 

8. Property Management Risk

The same principle applies to property management. Who’s going to manage the properties day to day? Whether the property management team is in-house or hired out, how many times has the sponsor worked with them before? 

Poor property management is a recurring theme in syndication deals that go south. Our investment club looks for deals with proven PM teams to reduce this risk.

9. Partner Risk

In larger syndication deals, you sometimes see a primary sponsor and several supporting sponsors. Make sure you understand who exactly will manage the assets, and focus your vetting on them. 

I’ve seen a deal where a supporting partner sponsor had a strong track record, but they weren’t the lead sponsor or in charge of asset management. The lead sponsor bungled the deal, leaving others to clean up the mess. 

This brings us full circle back to sponsor risk and making sure you understand exactly who you’re entrusting your money with. 

Final Thoughts

If you account for these nine risks when you invest in passive real estate projects, you can slash your risk even while earning 15%-plus returns. You can also manage risk by investing in real estate debt instead of equity.

A few months ago, our Co-Investing Club invested in a rolling six-month note paying 10% interest, secured by a first-position lien under 50% loan-to-value. Property prices could go up or down, as could interest rates, and we’ll still feel secure. Granted, that’s not the 15%-plus plus annualized returns we typically aim for as a club. But the short, flexible term and incredible collateral leave us feeling confident about the risk. 

You’ll never nix risk entirely. But you can mitigate and manage it by finding those asymmetrical returns paying well with modest risk. 

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