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Author, activist, and distinguished real estate developer Don Peebles once said, “To change our position in life, we must first change how we think.”
Easier said than done, right?
For even the most seasoned owner/operator, ensuring a successful outcome takes considerable work. This means investors must periodically take a step back to evaluate their current strategies, especially regarding passive real estate investing.
Here are the top five reasons investors might lose out on growing their wealth with passive real estate investments.
Most real estate opportunities can look great on paper, but it’s during the problem-solving and post-closing execution that critical mistakes can occur. So, it can be important to pick a sponsor that is a reliable operator with a proven track record. When assessing a sponsor and their track record, ask questions such as the following:
The best real estate operators have methods for gaining ownership of properties that don’t follow the original recipe. This means that acquiring land or property that performs poorly isn’t necessarily a red flag. Owners/Operators discover more during the bad times than the good ones. An important consideration is what was learned and how the sponsor minimized the chances of it happening again because the best owners/operators can see opportunities where others see pitfalls.
Leverage, or using borrowed money, is another risk for investors to consider when evaluating a passive real estate investment. It’s a big concern, especially with the federal funds rate being at its highest since 2001. Understanding the debt structure for every real estate transaction is an absolute must. Ask if the interest rate on the loan is fixed (same throughout the loan term) or floating (changes with market trends). If floating, are there safety measures such as interest rate caps or reserves to mitigate the risk of further rate increases? What is the loan-to-value (LTV) ratio? How about the debt-service coverage ratio (DSCR)?
Maximizing leverage on real estate acquisitions might result in higher returns, but it also comes with increased risk. Additionally, there are creative ways to add mezzanine debt or preferred equity to reduce the initial equity investment and boost the investment yield. This is one example of why chasing the highest return is never the best. However, an opportunity with sensible borrowing will most likely provide a superior risk-adjusted return.
Like with most investments, there is an inherent risk that comes with real estate. Property values could decline, rental rates could fall, vacancies could increase, and macroeconomic conditions outside the sponsor’s control could adversely impact the asset.
Good sponsors identify risks with every transaction and proactively manage them throughout the life of the investment. BAM Capital spends copious amounts of time underwriting opportunities and conducting due diligence.
It’s important to walk every unit, audit every lease, create detailed market surveys of the competitive set, and understand the surrounding demographics and supply/demand fundamentals. A sponsor conducting this level of analysis and due diligence during the acquisition process dramatically enhances the investment’s downside protection.
Attentive owners have the company’s track record and financials reviewed by an independent, third-party accounting firm. There are several reasons for this as auditing financial statements and investment performance is important for various stakeholders. Investors must consider the following:
Ultimately, trust is a key component when investing in real estate with a sponsor and takes the guesswork out of the equation for investors.
It’s important to realize when a real estate sponsor has bit off more than it can chew based on past performance and whether the projected return is proportional to the execution risk.
Execution risk is the blood, sweat, and tears a sponsor will endure to execute the business plan and achieve the desired investment return. It encompasses wide-ranging factors that affect an investment's successful completion and profitability. These factors include market conditions, construction/renovation risk, operational issues, resident turnover, etc.
BAM Capital acquires institutional-quality multifamily communities, not transitional assets that rely on substantial renovations to justify significant rent increases in subpar locations. Each of BAM Capital's acquisitions has delivered “opportunistic” yields primarily due to BAM Capital’s vertically integrated platform, operational expertise, and intimate market knowledge.
Being a passive investor in real estate is a great way to grow wealth and achieve financial freedom.
Still, like with any investment, it's important to conduct due diligence and understand the risks before investing. This means knowing the sponsor, understanding the debt structure, seeing the downside risk, and being aware of the execution plan relative to the investment return. Experienced passive investors are as vulnerable to the five mistakes listed above as those just starting.
But, by avoiding these mistakes and seeking the best risk-adjusted return—not simply the highest return—partners can invest confidently and protect their wealth.
Visit bamcapital.com/bestever today to learn more.
About BAM Capital:
BAM Capital is not providing personalized investment advice, and nothing contained in this article should be construed as investment advice or an endorsement of any investment strategy or investment product. The information contained in this article is general in nature and does not take into account the specific investment objectives, financial situation, or particular needs of any reader or investment opportunity. Before making any investment decision, readers should seek advice from an independent financial advisor to ensure it is appropriate for their individual circumstances.
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.