The greater the risk, the greater the reward, right? This old adage applies in many aspects of life, and real estate investing is one of them. The question, though, is what amount of risk is appropriate?
The reality is, the chance to purchase physical assets provides many investors with a sense of comfort. Plus, the fact that the real estate market has rebounded from the Great Recession of 2008 and has reached all-time highs lately makes this industry even more appealing to investors. Still, these investments may come with several risks that your passive investors should consider, rather than simply paying attention to the anticipated return.
Here’s a rundown on how to make your passive investors aware of potential real estate investment risks without ruining your chances.
How stable and long-lasting is a commercial real estate property’s stream of income? That’s what ultimately drives its value. For instance, if Apple signs a 20-year lease with you, the price tag of this lease is much higher than the total amount of money you’d generate in an office building featuring many smaller tenants.
However, to make your passive investors aware of credit risk, show them recent news reports about Sears’ financial struggles. Sears used to anchor malls back in the 1990s, but these days, it is going through the bankruptcy process. The truth is, even tenants who are the most creditworthy can end up going bankrupt, so this is a risk that’s important for passive investors in commercial real estate to consider.
Demonstrate to investors how you’ll deal with renter turn around in a lucrative way so that, if this ever happens, they know you can recover easily.
The greater the amount of debt you have tied up in a real estate investment, the greater the risk associated. In this situation, investors would be wise to demand more in return.
The thing about leverage is that can certainly help to propel a project forward quickly, in addition to increasing returns if everything is going well. However, if the loans associated with a project happen to be under stress—for instance, the return on the asset is not sufficient for covering the interest payments—an investor tends to lose large sums of money quickly.
The Leverage Rule
In light of the above, a good rule of thumb is not to let leverage exceed 80%. A return on an asset should primarily be generated from the real estate property’s performance—not through excessive reliance on leverage. So, be sure to instruct your passive investors to exercise caution when it comes to the amount of leverage used for capitalizing an asset. Also, remind them to ascertain that they receive returns that are commensurate with that asset’s risk.
Structural real estate investment risks aren’t related to a real estate property’s structure; rather, they have to do with the financial structure of an investment, as well as the rights provided to participants.
You need to tell your passive investors what their rights are based on their positions in a joint venture, like a limited liability company—for instance, whether they have a minority or majority holding. This will determine how much they’ll have to pay the person managing the company when the real estate asset is sold, as well as how much profit they’ll receive from the deal.
Also, how much equity is the manager investing compared with the limited partners? If limited partners are involved in deals with advantageous profit splits with the managers, and if the managers have a lot less cash invested in these deals, the managers are incentivized to take more risk. Make sure that your passive investors understand this structural risk concept before moving forward with a deal.
To make your passive investors aware of liquidity risk, ask them how they’ll exit an investment if they need to. Use two completely different cities to make your point about this type of risk.
For instance, dozens of investors might show up to place bids in a large real estate market like Houston, no matter what the market conditions may be like. Meanwhile, a real estate asset located in the city of Evansville in Indiana won’t draw as many market participants. This is an important consideration because it may be easier to get into the Indiana investment, but it will also be harder to get out of it.
Idiosyncratic real estate investment risks are related to a certain property. Point your private investors to the current example of Wrigley Field to help them to understand a particularly important type of idiosyncratic risk: location risk.
Buildings behind this famous Cubs baseball field in Chicago have been used to host privately held rooftop parties. However, these assets are becoming bust investments because a brand-new video board will totally block their views into the field. Meanwhile, property values around The 606—Chicago’s high line— are rising.
Additional Idiosyncratic Risks
Other types to consider include construction risk. Construction makes a project riskier by limiting the ability to collect rent or profit during the construction period. In addition to construction risk, there are environmental risks, which may include workforce and political risks, budget overruns, and soil contamination.
Yet another type of idiosyncratic risk to factor in is entitlement risk. Entitlement risk is where a government agency that has jurisdiction over your project will not issue the necessary approvals for your project to move forward.
Real estate investing does come with multiple risks, but if you and your private investors weigh the risks and the rewards wisely, you can enjoy great returns from one deal to the next. Learn more about finding and making great apartment deals from my and Theo Hick’s book, Best Ever Apartment Syndication Book.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.