The Risks Of Passive Investing & How To Mitigate Them

[Justin Moy]

There are 3 major risks investors need to be aware of before investing in a deal, in this post I’ll outline these risks and some strong strategies to mitigate them.

1. Investing in a poor sponsor team

The sponsor you invest with arguably has the strongest impact on the performance of the property and your investment. You’ll want to look for signs of a strong sponsor team. A few things to look for are: accuracy of previous deals underwriting to their actual performance, experience in the market the property is in, and deal size. I like to look at deal size because repeat investors is a great indicator of a strong sponsor team, and it’s very hard to raise several millions of dollars without repeat investors and strong word of mouth marketing

2. Investing in faulty proformas

All deals can look great on a proforma, but there are a few key items I look at to determine if a proforma is too aggressive. The 2 biggest that can throw off your proforma returns are organic rent growth assumptions and exit cap rates. Being too aggressive in organic rent growth (not growth by renovations or forced appreciation) can throw off your entire annual income since these numbers compound on each other. Cap rates are also one of the biggest factors in final valuation of a property, so missing this crucial metric can result in a very far off return.

Some ways to mitigate these risks are looking for stable rent growth projections, I typically like to see 3-4% depending on the market. And, analyzing multiple deals in a market to look for cap rate trends. That way you can see if a deal is projecting wildly different cap rate exits than others you’ve looked at in the same market, you can ask about it. Cap rates can vary block by block, so ask why this property might have a different cap rate projection than others you’ve seen in the same area.

3. Debt terms that expose you during downturns

The debt terms on a deal are crucial to risk mitigation. Many investors are feeling that pain now that payments are due in a very high interest rate environment. Look for the term of the loan and extension options. A common structure might read 3 + 1 + 1, meaning the initial term is 3 years, then there are two options for a 1 year extension. Taking advantage of these extensions can help shield a property from being forced to sell at unfavorable times