Managing investment risk is unavoidable, especially in passive real estate investing. Generally speaking, the higher the risk, the higher potential reward. The opposite is also considered true. Avoiding absolutely all risk is unrealistic, so your job as an investor is to determine how much risk is acceptable to you, and the things you can do to minimize it.
The risk tolerance level for you in your current situation might be completely different from other investors. You need to decide where it is, high or low, as this will guide you as you review investment opportunities. Are you an older investor closer to retirement and want steady, albeit conservative returns? Are you a younger investor who enjoys participating in more volatile property investment opportunities that offer extremely high profit potential? (After all, if you flop on a project early in life, you still have many years to get back on track.) Is it your goal is to build wealth as quickly as possible, investing in extreme value-add opportunities, or are you trying to add a steady stream of income in the hope of supporting you during retirement? I’m sure that you fall on the spectrum somewhere between these examples, probably leaning more toward the “safe” projects.
Once you have determined what type of investor you are, as illustrated above, it is now necessary to figure out what types of risks you are willing to endure, and properly managing investment risk.
Expect the Unexpected
Not very many people in my circle of friends and relatives have a truly accurate crystal ball. It can be difficult to see some things coming. Example: Who would have thought that a pandemic would have stricken to world economy in 2020? Unfortunately, some types of events just cannot be predicted or prevented. These include natural disasters like fires, flooding, earthquakes, or man-made disasters like mass shootings, oil spills, and ground water contamination from fracking. No matter how hard we try to mitigate risks, the one thing that we can count on is that stuff happens. As we consider making an investment, we have to ask ourselves how we will overcome the unforeseen. Does the sponsor you might be investing with have a cushion in their underwriting that can help the project recover if something bad happens?
Most of us recognize that there are uncontrollable risks, those caused by economic factors such as inflation, interest rates, geopolitical events, unemployment, and other things outside of your control. There can be economic volatility in very local areas all the way up to worldwide. Often, macro-economic trends have an impact at the local market level.
In 2020, we began to see some widespread migration patterns emerging from the necessity for employees to work from home due to the pandemic. Because of this, many populations declined in the bigger cities and increased in less expensive suburbs or rural areas. This trend is expected to continue and will have an impact, one way or the other, on the viability of many investment projects.
As you grow your investment portfolio and begin managing investment risk, it is wise to consider investing in different geographic areas or multiple markets in order to help limit the impact of a decline in any single investment.
Many areas throughout the United States have experienced setbacks stemming from large employers going out of business or outsourcing jobs overseas. If a certain city relies on a single business or large employer, the area is at the mercy of that employer. For example, if a military base is the only employer in town and it has to close, all the people in the area might lose their jobs. Housing prices would plummet, demand for rental properties would fall, and the city’s economic well being would suffer a local depression.
Alternatively, when a large employer sets up a large distribution center, office complex or factory, there can be a positive local economic impact. Local employment goes up, discretionary incomes can rise, and demand for housing increases.
Ideally, your investment should be in one of the areas that do not have exposure to single-employer ecosystems. It’s almost never a good idea to put all your eggs in one basket. In order to manage that risk, the area needs to have a diverse set of employers, industries and sectors. Be wary of areas that don’t when managing investment risk.
I’ve discussed some very high-level risk categories, but that’s not all you have to worry about. What about risks associated with a project itself?
Ask these questions:
- How likely will the operating and labor costs rise to unexpected levels?
- Will there be future hikes in property taxes?
- Is the property reaching functional obsolescence?
- Has the sponsor’s underwriting truly taken into account the possibility of excessive vacancies and demand fluctuations?
- How will the syndicator’s team address deferred maintenance and capital improvements, and does it make sense with their business plan?
- Has the sponsor established adequate cash reserves that can carry them through the bad times?
- Will the sponsor be mitigating risk by carrying the appropriate insurance policies?
There are many things to consider in managing investment risk and before handing your money over to a real estate sponsor’s deal. Base your investment decision not on how they make you feel, but what the numbers tell you. Do not allow emotion into it. Look at all the facts. A good real estate syndication team will provide essential research and market data to support the investment. But… Verify. Ask questions. Make sure that if something bad happens that there is a plan for it.