{"id":177848,"date":"2024-09-27T10:41:33","date_gmt":"2024-09-27T16:41:33","guid":{"rendered":"https:\/\/www.biggerpockets.com\/blog\/?p=177848"},"modified":"2024-09-27T10:42:13","modified_gmt":"2024-09-27T16:42:13","slug":"the-extra-downside-protection-i-look-for-in-investments","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/the-extra-downside-protection-i-look-for-in-investments","title":{"rendered":"The Extra Downside Protection I Look For in Investments"},"content":{"rendered":"\n

The last two years have felt like a slow-motion car crash in <\/span>commercial real estate<\/span><\/a>. <\/span><\/p>\n\n\n\n

That goes for <\/span>office space<\/span><\/a>, of course, but it also goes for <\/span>multifamily<\/span><\/a> and other commercial property classes. Look no further than this <\/span>piece by BiggerPockets<\/span><\/a> if you need a refresher. Two regional banks went under because of the industry\u2019s woes in 2023. <\/span><\/p>\n\n\n\n

But even in one of the worst stretches for commercial real estate on record, many operators and passive investors have continued earning solid returns. Since 2022, I\u2019ve invested in nearly 30 passive real estate deals as one more member of SparkRental\u2019s Co-Investing Club. Of those, only one has imploded and resulted in a loss\u2014and it was one of the first deals we invested in as a club. <\/span><\/p>\n\n\n\n

One advantage to getting together with a group of other passive investors every month to vet deals is that you get better at doing it <\/span>and<\/span> quickly. This year, I\u2019ve shifted how I think about risk. <\/span><\/p>\n\n\n\n

As you continue (or start) investing passively in real estate, consider this framework for looking at risk.<\/span><\/p>\n\n\n\n

Why Standard Vetting Isn\u2019t Enough<\/span><\/h2>\n\n\n\n

I used to approach vetting from a classic sponsor- and deal analysis perspective: Get references, look at track records, look at competitive advantages and expertise, run the numbers on the specific deal, etc. <\/span><\/p>\n\n\n\n

We still do all that, of course. <\/span>Check out this article on the <\/span>nine passive investing risks<\/span><\/a> that<\/span> we check first when <\/span>we look<\/span> at sponsors and their deals.<\/span> <\/span><\/p>\n\n\n\n

Those will help you immediately eliminate most bad operators and deals. That one deal I mentioned that completely fell apart? We would have dodged it with a closer look at the risks outlined in that article. Of course, that was 20-some deals ago, and we\u2019ve all learned a lot since then.<\/span><\/p>\n\n\n\n

Even so, two <\/span>of the<\/span> sponsors behind that deal were big-name sponsors\u2014one enormously so. Both enjoyed sterling reputations at the time. Everyone we talked to about them gushed about how great they were. They had sparkling track records to show off to potential investors. <\/span><\/p>\n\n\n\n

I <\/span>have certainly<\/span> learned that reputations and track records only take you so far when you\u2019re vetting operators. On top of more thorough vetting, I now also want to see something extra. <\/span><\/p>\n\n\n\n

\u201cSomething Extra\u201d Downside Risk Protection<\/span><\/h2>\n\n\n\n

I\u2019ve increasingly come to share Warren Buffett\u2019s view that the only rule that matters in investing is never to lose your principal. <\/span><\/p>\n\n\n\n

Every time I look at <\/span>private partnerships<\/span><\/a>, private notes, syndications, or some other <\/span>type of passive real estate investment<\/span><\/a>, my first question is, \u201cDoes it offer any special downside protection?\u201d Is there some extra barrier in place between me and losing money? <\/span><\/p>\n\n\n\n

Put another way, what would <\/span>have to<\/span> happen for my investment to lose money\u2014and how confident am I that such a scenario is vanishingly unlikely?<\/span><\/p>\n\n\n\n

There\u2019s no such thing as a completely risk-free investment (and anyone who says otherwise is selling something). Aliens could invade Earth tomorrow and disrupt every investment on the planet. But you can look for extra protections that create extremely low odds of lost principal.<\/span><\/p>\n\n\n\n

Examples of Downside Risk Protection We Like<\/span><\/h2>\n\n\n\n

So, what do these extra protections look like for different types of passive investments? Here are a few case studies.<\/span><\/p>\n\n\n\n

Private note case study<\/span><\/h3>\n\n\n\n

I\u2019ve mentioned them before, but there\u2019s a boutique house-flipping company that our Co-Investing Club has invested with several times now and <\/span>really<\/span> likes. <\/span><\/p>\n\n\n\n

First and foremost, they check all the typical boxes. They\u2019ve done over 300 flips and currently do 70 to 90 <\/span>a year<\/span>. They also <\/span>currently<\/span> own over $15 million in rental properties, with over $6 million in equity. You can\u2019t do that <\/span>kind of<\/span> volume without getting all the common mistakes out of your system. <\/span><\/p>\n\n\n\n

That doesn\u2019t mean every deal turns a profit. <\/span>Again<\/span>, at that volume<\/span>, you\u2019ll have the occasional dud, but <\/span>their<\/span> win rate is in the 93% to 95% range each year.<\/span> <\/span><\/p>\n\n\n\n

Because they must move fast on buying deals and need so much flexible capital, they offer private notes paying 10% fixed interest. Investors can terminate the note at any time with six months\u2019 notice.<\/span><\/p>\n\n\n\n

These notes <\/span>normally<\/span> come with two strong downside risk protections. First, the company\u2014which again has over $6 million in equity in its rental portfolio\u2014signs a corporate guarantee. <\/span>Second, the owner <\/span>himself<\/span> signs a personal guarantee as a multimillionaire <\/span>pledging<\/span> his <\/span>personal<\/span> assets.<\/span> <\/span><\/p>\n\n\n\n

That\u2019s pretty unusual in itself and <\/span>great<\/span> downside risk protection. But to get even better protection, our investment club negotiated with <\/span>him<\/span> to secure our note with a sub-50% LTV lien against one of his free-and-clear properties. If something catastrophic happens, we can foreclose to recover our money. <\/span><\/p>\n\n\n\n

See why I feel so secure in that investment?<\/span><\/p>\n\n\n\n

Private partnership case study<\/span><\/h3>\n\n\n\n

We\u2019re preparing to invest shortly with another boutique investment company based in Texas. <\/span><\/p>\n\n\n\n

This company builds spec homes,<\/span> a <\/span>perfectly profitable business model <\/span>on its own<\/span>. They take it a step further, specializing in buying dilapidated homes on large lots, tearing them down, subdividing the lot into two or three normal-sized lots, and then building new single-family homes on each <\/span>of them<\/span>. <\/span><\/p>\n\n\n\n

As you can see, they create value <\/span>not just<\/span> by building new homes <\/span>but also by<\/span> subdividing valuable lots.<\/span> They only work in a small <\/span>geographic<\/span> area where they\u2019ve established relationships with local municipalities. Their lot subdivisions get rubber-stamped at this point because the municipalities know them, <\/span>trust<\/span> them, and like that, they\u2019re creating more housing supply (and <\/span>property tax<\/span><\/a> revenue). <\/span><\/p>\n\n\n\n

To fund their investments,<\/span> they form private partnerships with passive investors like you and me.<\/span> At a project level, they typically earn 40% to 70% returns, <\/span>and<\/span> their passive partners <\/span>typically<\/span> earn 15% to 25% <\/span>returns<\/span>.<\/span> <\/span><\/p>\n\n\n\n

Even so, they have the occasional miss\u2014every investor does. So, they protect their investors against lost principal by guaranteeing a floor return of 5% on each project. If one <\/span>of them<\/span> fails to earn at least 5% annualized returns, they come out of pocket to preserve the relationship. <\/span><\/p>\n\n\n\n

The guarantee is backed by their <\/span>own<\/span> portfolio of long-term rentals, again providing a backstop against losses. <\/span><\/p>\n\n\n\n

Syndication case study<\/span><\/h3>\n\n\n\n

When I go on the <\/span>BiggerPockets forums<\/span><\/a>, <\/span>all too often I<\/span> see comments like, \u201cReal estate syndications are too risky.\u201d<\/span><\/p>\n\n\n\n

That\u2019s like saying \u201call stocks are too risky\u201d or \u201call bonds are too risky.\u201d <\/span>Some <\/span><\/em>stocks are risky. <\/span>Some <\/span><\/em>bonds are risky. <\/span>But there\u2019s a <\/span>huge<\/span> difference between investing in<\/span>, say,<\/span> a U.S. Treasury bond <\/span>versus<\/span> a junk bond.<\/span> <\/span><\/p>\n\n\n\n

When we look at syndications, we look for asymmetric returns: high probable returns with low-to-medium risk probability. <\/span><\/p>\n\n\n\n

A few months ago, our Co-Investing Club invested with a sponsor who has done 135 deals over the last 17 years. That\u2019s incredible longevity and shows they\u2019ve invested through many market cycles. <\/span><\/p>\n\n\n\n

This <\/span>particular<\/span> deal came with that \u201csomething extra\u201d we look for in downside risk protection. Sure, the sponsor scored a bargain price on a multifamily property with deferred maintenance, and they plan on forcing equity through renovations. Value-add syndications are all <\/span>well and<\/span> good, but the <\/span>real<\/span> protection <\/span>here<\/span> goes beyond the discount price and \u201cconservative underwriting\u201d that every sponsor claims.<\/span><\/p>\n\n\n\n

This sponsor created instant equity in the property within the first 24 hours of ownership. How? Before buying, they partnered with the local municipality to designate half the units for affordable housing in exchange for a 50% property tax exemption. The tax savings pay for the lost rental income many times over, making the net operating income jump before the sponsor swings a <\/span>single<\/span> hammer. <\/span><\/p>\n\n\n\n

The affordable housing units also enjoy not just 100% occupancy but a waiting list because they charge under-market rents. In <\/span>the event of<\/span> a recession, these units <\/span>are protected<\/span> against vacancy and high turnover rates. <\/span><\/p>\n\n\n\n

See? Something extra. <\/span><\/p>\n\n\n\n

Equity fund case study<\/span><\/h3>\n\n\n\n

This month, our Co-Investing Club is investing in a small land-flipping fund. The investor buys mid-price parcels of land for 35 to 60 cents on the dollar. That alone provides plenty of instant equity for downside protection. But then he adds even more equity by doing a \u201cminor subdivision\u201d\u2014splitting the parcel into five or fewer lots. He may make a minor improvement, such as creating a dirt-access road so each lot has road access. <\/span><\/p>\n\n\n\n

This investor buys an average of 50 parcels <\/span>a year<\/span> and resells them within 4.2 months on average. He <\/span>earns<\/span> shockingly high net returns in the mid-double digits since he started. <\/span><\/p>\n\n\n\n

Best of all, there\u2019s no construction risk, property management risk, risk of tenant property damage or defaults, or risk of tenant lawsuits. There\u2019s no debt risk because the investor funds these deals with cash raised from the fund. There\u2019s no regulatory risk of eviction moratoriums or <\/span>tenant-friendly laws<\/span><\/a>. <\/span><\/p>\n\n\n\n

It\u2019s just raw land. <\/span><\/p>\n\n\n\n

Oh, and there\u2019s no zoning or permit risk, either. The investor only works in jurisdictions where zoning approval <\/span>is not required<\/span> for minor subdivisions of five lots or fewer. <\/span><\/p>\n\n\n\n

Sure, he could <\/span>theoretically<\/span> miscalculate on a parcel and <\/span>end up reselling<\/span> for a lower sales price than he planned.<\/span> Good<\/span> thing he\u2019ll do 49 other deals this year. <\/span><\/p>\n\n\n\n

The fund has paid 16% annualized distributions each quarter like clockwork <\/span>since inception<\/span>.<\/span> It\u2019s a lean, moneymaking machine <\/span>that has<\/span> few moving parts to break. <\/span><\/p>\n\n\n\n

Debt fund case study<\/span><\/h3>\n\n\n\n

As a final example, I\u2019ll <\/span>give a shout-out<\/span> to Chris Seveney of <\/span>7e Investments<\/span><\/a>. <\/span><\/p>\n\n\n\n

Chris operates a debt fund that buys non-performing mortgage loans at a steep discount. He and his team then work closely with the borrowers to <\/span>get them caught<\/span> up on payments, whether that means a payment plan, loan modification, or some other custom approach based on the borrower\u2019s needs. They then resell the now-performing loans to a more traditional mortgage servicer\u2014for much closer to the <\/span>full<\/span> loan amount. <\/span><\/p>\n\n\n\n

So, what\u2019s the extra downside risk protection? <\/span><\/p>\n\n\n\n

The average loan that 7e acquires is around $195,000. The average property value is around $500,000. In the worst-case scenario, 7e forecloses to recover its capital. <\/span><\/p>\n\n\n\n

To his credit, Chris prides himself on <\/span>an extremely low<\/span> foreclosure rate (under 10%). That\u2019s incredible, given that <\/span>every <\/span>single<\/span> loan<\/span><\/em> is distressed when 7e first buys it. <\/span><\/p>\n\n\n\n

Final Thoughts<\/span><\/h2>\n\n\n\n

Asymmetric returns exist in passive real estate investing. Once you accept and embrace that, your <\/span>entire<\/span> investing strategy shifts to finding them. Or rather, I consider it my job, as I <\/span>look to<\/span> constantly network to find hidden gem operators to invite to speak at our Co-Investing Club. And at this point, we always look for that \u201csomething extra\u201d in downside risk protection.<\/span><\/p>\n\n\n\n

I\u2019ve lost money on real estate before. I have no intention of losing another cent on my real estate investments moving forward.<\/span><\/p>\n\n\n\n

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\n \"passivepockets\n <\/div>\n <\/div>\n<\/div>","protected":false},"excerpt":{"rendered":"

Commercial real estate has felt like a slow-motion car crash over the last two years, but as you continue (or start) investing passively, consider this framework for evaluating risk.<\/p>\n","protected":false},"author":158586,"featured_media":177851,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[7389],"tags":[],"class_list":["post-177848","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-market-analysis"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/177848","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/158586"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=177848"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/177848\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/177851"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=177848"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=177848"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=177848"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}