Passive Investor Tips is a weekly series hosted by full-time passive investor and Best Ever Show host, Travis Watts. In each bite-sized episode, Travis breaks down passive investor topics, simplifying the philosophy and mindset while providing tactical, valuable information on how to be a passive investor.
The future is impossible to predict, so the best actions we can take as investors are to do our due diligence, be conservative in underwriting, and know that potential returns are never promised or guaranteed. In this episode, Travis discusses three categories of risk when it comes to investing and why it’s so important to determine your risk tolerance before diving in.
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Travis Watts: Welcome back, Best Ever listeners, to another episode of Passive Investor Tips. I'm your host, Travis Watts. I have a really good episode for you today, a very important one, considering what's going on in the world, and the economy. We're talking about the truth about commercial real estate - the risks and the rewards. Disclaimers as always, never financial advice; not telling you or anyone else what to do. Please do your own homework, due diligence, and seek licensed advice.
With all of this top of mind, this channel is very focused on passive income investing and commercial real estate, and while there are of course a lot of episodes about the benefits and why you might choose this asset class, there are also many risks. So I figured, as a full-time commercial real estate investor myself, spending years and years in investor relations and investor education and talking to thousands of investors, I might have a few pointers and things that I can help out with in terms of risk.
I think the reason that a lot of people don't make episodes like this is frankly it doesn't make for the most popular video, that's gonna get the most clicks... But since that's never my primary concern, I figured let's put popularity aside and do this episode. And the funny thing about it is people will do more to avoid pain than they will do to gain pleasure. So let's go ahead and dive in.
The first topic that I want to start out on is the fact that many new investors to the commercial real estate space may be looking at projections, projected returns, projected pro formas for these different offerings and deals, and you might be like me in 2015 thinking "How is it possible that I could potentially get a high double-digit IRR return being a hands-off investor?" I remember thinking this because I came from a background of doing single family homes and managing everything myself, and it was like a full-time job. And I remember looking at some of these projections thinking, "I get lower returns than this, and I have to do all the work. So this seems a little too good to be true." But I sit here today, after doing 50 plus of these deals as a limited partner, to tell you that there's two key words we all have to keep in mind, and that is potential returns. Never a promise, and never a guarantee.
So it's important to keep in mind that the truth is nobody knows exactly what's going to happen in a particular deal when we look five years into the future, to use that as an example. So the best we can do is project potential returns, and we can be conservative in our underwriting and in our assumptions.
Alright, so let's move into the three primary categories of risk. This is just my personal opinion, based on my own past experience, but number one is the risk of the general partner or the investment firm that you're working with. I always ask myself the question "Can this person or this group realistically pull off this business plan?" And I try to seek some proof to that answer, such as, "Are they experienced? Do they have a track record? Do they specialize in a particular niche? What is the reputability of this particular team?" And to me, this really is number one, and probably the biggest risk, because if this firm or person or group can't actually pull off this business plan, then those projected returns mean next to nothing.
And the second main category of risk is the risk of the market itself. Where's this particular property located? Is the employment diversified? Are there lots of different sectors of employment in the area? How's the crime statistics in that area? What are the average incomes in that particular area? School ratings, for example. So you always want to look for markets that are growing and expanding, rather than contracting. And I can tell you from firsthand experience that markets play a really big role in the potential outcome of a deal.
And the third main category of risk is the risk of the deal itself. How is this particular deal structured? What type of debt are they putting on this piece of property? Are the projected returns truly conservative? And what's the age and condition and classification of this property? Is it an A class, B Class, C Class, D class?
Due to the nature of syndications, what they are and how they work, one primary benefit is that investors from all across the nation can diversify their portfolio and invest out of state where they don't live. But I will send out a word of caution - I always suggest visiting these properties in-person if you can before you decide to invest as part of your due diligence. Not a lot of investors do that, but every chance I get to do that, I absolutely do.
So in a quick recap, there's three primary categories of risks - that's the operator, the market and the deal itself. So now let's look at some subcategories of risks as well... Number one being the market timing. So real estate markets go in cycles. So you've got recession, recovery, expansion, and hyper-supply. Now, this is not to suggest that there's just one or two areas of this cycle to invest in. I'm a firm believer that there's good deals to be had in all segments of the market cycle. I'll give you a quick, practical example. No matter if we were in expansion, in hyper-supply or recession, if my neighbor comes to me and says, "Hey, I'll sell my house to you at 40% off", I'm a buyer. I'm buyer in any market cycle. So you have to be a little opportunistic and just put an emphasis on where we are in the market cycle to better your potential chances of making a profit.
And the second subcategory of risk - I kind of lumped two things together here; I'd say interest rates and political risk, because they kind of go hand in hand. So I'll share a quick story of what's happened here starting in 2022. The Federal Reserve began to aggressively increase interest rates. And the thing about commercial real estate is you don't often have a 15 to 30-year fixed-rate debt term like you might find on a single family home. Long-term debt in the commercial space would be considered seven to 10 years, and a lot of people do floating rate loans and bridge debt, and this is very short-term temporary debt that can adjust... And that's what we're seeing here in 2023, is a lot of groups bought properties with three to three and a half percent interest rates, and then their debt term is coming due, and interest rates might be, say, 7% now. So you always have to look at proper debt structure. Again, back to the primary categories, when I mentioned the deal - what kind of debt are they putting on the property? If it is floating rate, then you'll want to see an interest rate cap to limit risk, ideally for longer-term, or if it's fixed rate, that would be ideal for past deals, but now moving forward, who knows what interest rates are going to do? They might stagnate, they might taper down a little bit... But at least you know if you can cover your debt service with a high interest rate, then it may be worth considering the deal.
And in terms of political risk, the Federal Reserve is one subcategory of political risk, but you also have things like -- when we have election years and we have new presidents coming in, they often will disagree with the previous presidency, and they often change up the tax code. So if something big were to happen that directly affects real estate, like let's say they eliminate the ability to do a 1031 exchange, or they reduce the tax benefits that you may potentially get from real estate, then this can cause huge upheaval in the space. The other thing is market risk in terms of political risks. So let's say you're investing in a tax-free state, like Texas or Florida, and let's say a new governor comes in and says, "Hey, we want to start doing a 5% state income tax starting next year." Well, that's gonna move a lot of people, businesses out, which could affect your multifamily properties.
Travis Watts: And the third subcategory of risk would be natural disasters: fires, floods, hurricanes, tornadoes, earthquakes... It's really important to have adequate and proper insurance on the particular deal that you're investing in. So always ask questions about insurance, how much they anticipate the insurance going up, by the way... And a lot of people don't know this, including some operators, but you can add additional terms to an insurance policy, such as if 8 or 10 units burned down because of a kitchen fire, we want to have a reimbursement of our lost rent for those particular units. So all of this, including adequate cash reserves in case the unexpected happens, can potentially allow the general partners to continue distributions even though a property may have been impacted by a natural disaster.
So in conclusion, all of these categories and subcategories of risks that we've discussed here on the episode so far is by no means an all-inclusive list. If you're going to be investing in real estate private placement or syndication, you need to read the PPM. And the PPM stands for a private placement memorandum. In there should be outlined all of the potential risks of that partnership. They can be lengthy, but you need to familiarize yourself with them, read through them, and ask your due diligence questions to make sure that this investment is the right fit for you.
So please keep in mind that all investing does entail a level of risk, and the real question is, what is your risk tolerance and what are you most comfortable with, so that you can find suitable investments that make sense.
So I want to leave you with three benefits to investing in commercial real estate, because after all, I am a commercial real estate investor, and after going through all of those risks and scary topics, you might be thinking "Why would you invest in this space?" And number one for me anyway, it's always been about passive income. I am a full-time passive income investor. And passive income can help you expand your lifestyle, it can help you have a backstop or a safety net to your active income, and it can provide additional diversified income streams to help supplement things like retirement, for example.
And the second benefit is tax advantages - commercial, residential real estate, or really any type of real estate here in the United States has potential great tax benefits. And governments give out tax benefits to citizens and businesses that help the government achieve what it needs to get done. So for example, if you invest in providing housing for people, or drilling for oil and gas, or investing in solar energy, these are items that the government has to rely on private individuals and private companies for, because frankly, they just can't do all of that stuff on their own. So in turn, they give you a tax benefit for investing in categories like that.
And the third benefit is equity upside. So most of the deals that I invest in in the real estate space have potential equity upside. So we buy a property, we renovate it, we raise the rents, and in turn, that can lead to a higher potential sale price. So for example, if we bought a property for $100 million in a real estate private placement, me and hundreds of other investors, and we go through the business plan and we end up selling it for $125 million, just for example purposes, the 25 million is the equity upside that I'm referring to. So as a limited partner, I can participate in some of those equity gains. And it's nice to have an added bonus on top of just receiving the passive income... Although I will caution you that it is again very difficult to predict what the equity might be looking five years into the future, because nobody knows what the world looks like or what the economy's doing in five years.
So again, in terms of the benefits - certainly not an all-inclusive list. There are many reasons to consider commercial real estate, and I only had time to cover a few in this short episode. But if you want to take a deeper dive, if you want to learn more, if you have any questions reach out to me - Travis Watts on LinkedIn, or Bigger Pockets, or @passiveinvestortips on Instagram and Facebook. Always happy to be a resource for you or anyone else you think could find value. You're listening to Passive Investor Tips right here at Best Ever. I'm your host, Travis Watts. Have a Best Ever week, everyone, and we'll see you in the next episode.
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