How to protect yourself from the risks of real estate

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Spoiler alert: all investments come with risks. Real estate investments are no different.

So what are the risks of real estate syndications (passive group real estate investments)?

Keep the following in mind as you consider your next passive investment in real estate.

Which Is Riskier: Active or Passive Real Estate Investments?

I would argue that real estate syndications come with lower risks than buying rental properties directly. Here’s my logic.

To begin with, active real estate investors need to develop all the skills required for real estate investing themselves. They need to learn how to find good deals on properties, such as driving for dollars or learning how to buy foreclosure homes. They need to learn how to negotiate with contractors, how to oversee their work and keep them on-schedule and in-budget. Which says nothing of pulling permits and hassling with inspectors.

Then they need to learn how to secure investment property loans and financing. And learn how to become a landlord, assess market rents, market vacant units, screen tenants, sign lease agreements, and legally store security deposits. They need to collect rents and enforce their lease contracts and go through the eviction process. The list goes on.

Passive investors don’t need to hassle with any of that. They outsource all those skills to a full-time professional real estate investor.

That doesn’t mean they absolve themselves of all responsibility, of course. They still need to review the deal and the sponsor’s track record to mitigate the risks outlined below.

But as a passive investor, you don’t need to become an expert yourself. You just need to hire the right expert.

Risks of Real Estate Syndications

Passive real estate investments still carry plenty of risk. At the “risk” of scaring you off of them completely, keep the following in mind as you vet syndication deals.

1. Rising Interest Rates

We’ve certainly seen plenty of this going around over the last few years. And it’s knocked out plenty of real estate syndications along the way.

Higher interest rates add real estate risk in several ways. First, many syndicators (AKA sponsors, operators, or general partners) borrow a floating rate loan when they buy the property. When interest rates rise, so too do their monthly payments. Sponsors can (and should!) buy interest rate caps to put a ceiling on their monthly payments, but not every sponsor had the foresight to do so before rates started rising.

Second, many commercial real estate loans come with short terms, often three to five years. If interest rates happen to be high when the loan expires, that leaves sponsors in a pickle: refinance at a high interest rate or sell in an unfavorable market.

Why an unfavorable market? Because higher interest rates typically cause higher cap rates.

2. Rising Cap Rates

Capitalization rates, or cap rates in real estate, represent how much a buyer is willing to pay for a certain amount of net income. You can think of it as the income yield that buyers will accept.

The cap rate formula looks like this:

cap rate formula

The higher the cap rate, the less the buyer is willing to pay for the same income. Lower cap rates mean the buyer is willing to accept a lower yield, and pays more for the same property.

Thus, higher cap rates are great for buyers but bad for sellers.

If cap rates rise, property owners can choose between selling now for a lower profit (or a loss), or waiting for better market conditions to sell. But if interest rates remain high, and their loan term is expiring, owners may feel forced to sell in a bad market — potentially for a loss.

3. Stagnating Rents

Cap rates aren’t the only part of the equation that determine a property’s value. Rents also matter, as buyers value commercial properties based on their net operating income.

But what happens if rental rates fail to rise? Or worse, fall?

Granted, rents rarely fall, even in recessions and real estate bubbles. But they can stagnate, as many real estate experts fear happening in 2024.

Stagnating rents don’t just mean steady-but-unimproving cash flow. They mean shrinking or even negative cash flow, because expenses don’t dip. Costs like landlord insurance, property taxes, and labor all keep rising.

That not only makes the property unappealing to hold long-term, but also harder to sell. Lower net rental income reduces the value of the property, potentially leaving the property unprofitable to either keep or sell.

4. High Vacancy Rates

The same logic applies to high vacancy rates: they reduce the net operating income. That lower cash flow again makes it ugly to hold and ugly to sell.

Fortunately, syndicators and property managers have more control over occupancy rates than market rents. They can offer lease incentives or improve the property to make it more attractive to renters.

But those come with costs, of course. No such thing as a free lunch and all that.

5. Sharply Higher Expenses

All sponsors forecast rising expenses with every year that goes by. But that doesn’t mean they always forecast the extent of those cost increases.

For example, in 2023 many sponsors reported enormous insurance premium hikes. Think 40–125% rate hikes in a single year. Woof.

Property management expenses, labor and maintenance costs, and property taxes can also rise faster than expected. All of these lower the net operating income, again pinching cash flow and reducing the property value. You know how that ends by now: sponsors have to choose between holding a property with low or negative cash flow, or selling at a loss.

6. Tightening Credit Markets

If banks and lenders tighten their lending standards, that can make it hard to refinance or sell even for properties that cash flow just fine.

Imagine a deal with an approaching loan expiration date. The sponsor reaches out to dozens of lenders, but none of them agree to refinance, because they simply don’t want to touch commercial real estate at that moment.

So the sponsor lists the property for sale. But who can buy it, without a loan? Perhaps a few well-heeled private equity groups or Wall Street firms — but they make lowball offers. Because they can.

Again, the syndicator finds themselves stuck between being unable to hold and unable to sell the property for a profit.

7. Delayed Distributions

So what happens if the above real estate risks impact a property?

In the best case scenario, distributions get delayed. Instead of starting in Year 1 (or whenever), they get pushed back to Year 2 or 3 or never.

You don’t collect the passive income that you thought would start arriving in your bank account. But it could be worse.

It could be a capital call.

8. Capital Call

If the general partner runs out of money to operate the property, they issue a capital call.

It falls to limited partners like you and me to bail out the sponsor, giving them more money. And hoping that we aren’t chasing good money after bad.

In the best case scenario, the sponsor uses that money to right the ship, and the property starts cashflowing again. They ultimately proceed to sell the property for a profit, and everyone gets their money back plus some returns.

In the worst case scenario, you lose both your initial investment and the money from the capital call. Not pretty.

If you refuse to put up extra money in a capital call, the sponsor could take one of several actions. Most likely, they dilute your equity share. Other investors added money but you didn’t so your fractional property ownership diminishes. Alternatively, they could cover your portion of the capital call with an involuntary loan, at unfavorable terms.

9. Loss of Capital

As touched on above, if a real estate syndication deal goes terribly wrong, you could lose some or all of your investment capital.

While I don’t see it as a common occurrence, it does happen. I’ve said it before and I’ll say it again: investments come with risk.

How to Mitigate Real Estate Investment Risk

Now that you’re thoroughly terrified, how do you avoid these nightmare scenarios from happening to you?

In a word, due diligence. Okay, that’s two words, but you get the idea.

First and foremost, look at the sponsor’s track record. How long have they been investing in real estate? How long have they been raising capital as a sponsor? What average return have they delivered for passive investors across all the deals they’ve completed? How many real estate market cycles have they lived through?

Then review their underwriting assumptions. How conservative are they? What kind of rent growth and exit cap rate are they assuming? What kind of growth in expenses, such as property insurance, taxes, and property management costs? How much are they setting aside as a cash reserve?

Pay close attention to the loan terms. How long is the loan term? At what interest rate? Is it fixed or floating? Did the sponsor buy an interest rate cap? Ideally, you want to see a longer-term loan at a relatively low fixed interest rate. The shorter the loan term, the greater the risk of the sponsor being forced to refinance or sell in a bad market.

Most of all, you reduce your risk by spreading your money among many deals rather than concentrating it in a few. In our Co-Investing Club, members can invest $5,000 in each deal, instead of $50,000–$100,000. The results will look like a bell curve: some will underperform, some will overperform, and most will perform roughly as forecast.

Diversify by spreading smaller amounts of money across more deals, and sleep easier at night.

Final Thoughts on Reducing Real Estate Risk

You may have your own opinions on passive versus active real estate investing and the risks associated with each type of investment. I’m not here to argue.

If you’re an expert real estate investor, then by all means, invest actively. You probably feel more comfortable controlling all the risk yourself, rather than outsourcing control to someone else.

But for busy professionals working a full-time job, who don’t have much real estate experience, you’re better off outsourcing the asset management to a professional investor.

You still need to vet the general partner and the deal. But once you wire in your money, you don’t need to worry about the day-to-day execution. That not only removes the labor, but also the stress of wondering how to handle challenges as they arise. Let someone else manage the emergencies. You have enough on your plate already.♦

How do you manage risk in your real estate investment portfolio? What role do passive real estate syndications play in your investment strategy?

About the Author

G. Brian Davis is a real estate investor and cofounder of SparkRental who spends 10 months of the year in South America. His mission: to help 5,000 people reach financial independence with passive income from real estate.

This article originally appeared on SparkRental and was syndicated by MediaFeed.

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