For today’s episode, we will be discussing whether or not you will be losing money
We will play devil’s advocate and identify the 5 to 6 of the biggest risks to real estate investing.
We will talk about these things…and more in another episode of Multifamily Investing Made Simple in under 10 minutes.
Tweetable Quotes:
“we have a very pessimistic lens that we look at every deal through to make sure that if the worst-case scenario plays out, that the deals we are getting into still pencil out.” – Dan Kreuger
“So it’s tempting for operators to try to be as skimpy as possible with the budget” – Dan Kreuger
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The Risks of Real Estate Investing In Under 10 Minutes
Anthony Vicino: [00:00:15] Hello and welcome to multifamily investing made simple in under 10 minutes, I am your host, Anthony Ticino of Invictus Capital, joined as always by Dan. I’m ready to do this thing quick and dirty and let’s get out of here in under 10 minutes. That is me.
Dan Kreuger: [00:00:28] And all of a
Anthony Vicino: [00:00:30] Sudden today we’re going to be talking about the biggest risks in real estate. We are unapologetically pro real estate, almost to a fault. We sing the praises of this mighty investment vehicle from the rafters because we believe in it so strongly. But let’s play devil’s advocate. Let’s look at it from the other side of the coin today and think about the biggest risks to real estate investing. And we’ve identified, I don’t know, what do we get here, five or six of the biggest risks. We’re going to go through them real quickly for you. And let’s start at the top. No. One, as with all investments. You could lose your money,
Dan Kreuger: [00:01:10] Lose your money, lose all of it. It’s a thing. It could go away. Yeah, obviously, if you do your homework, you listen to our content. The likelihood of that happening is quite low. But theoretically, if you put your money into a bad deal, you could be out all of that money. So the main question is, OK, that’s a risk that’s out there with any investment. How do you mitigate that risk? How do we mitigate that risk? So we do a lot of things to mitigate the risk of losing money in our deals. Specifically, we have inspectors that come in and take a look at any property that we’re going into and they inspect everything from every outlet and sync up to the roof, down to the boilers and HVAC systems, windows, grounds around the building. Every little piece of every little building gets inspected so that we know exactly how long all those components on that building are going to last. That really mitigates the risk of having your roof caved if you didn’t see that coming or something like that. So that’s one of the biggest things we do, is we inspect each property we do thoroughly. Every unit, every outlet, every window gets inspected.
Anthony Vicino: [00:02:08] And then as a result of that, we’re coming to the table as capitalized as possible so that as those things fail, we’re not caught with our pants down and without money in the bag, like being able to weather those storms is pretty crucial. Another thing I want to add to the losing money because in real estate, it’s actually very difficult, I would say, to lose all of your money. The most likely scenario where you would lose all your money as a passive investor in apartment syndication is because you gave it to a crooked operator who absconded to Jamaica with all your money. They didn’t even buy the property. They just took your money and ran. That would be the most likely scenario where you would lose all your money.
Dan Kreuger: [00:02:51] And if you listen to our concern, you’ve heard us say it a million times. The most important thing that investors need to do is they need to vet operators before they start getting deals. And if you do that properly, the risk of that happening is quite low. But a few other things to point out as far as mitigating the risk of losing money. We only do cash flow, positive properties. There are some people out there that will go into properties, assuming that once they get to point X or point Y, they’re going to start making cash flow from a deal, whereas we only do deals that produce cash flow from day one and there’s upside potential from there. Another thing that mitigates the risk of losing money, because we start getting paychecks from day one, from positive cash flow in properties and we invest in strong markets, you know, we don’t go into markets that are, you know, appear to be maybe screaming hot, but have some other risks to them. We look at markets that are very diverse and their job market stable. They’ve responded well in previous recessions. And so good job markets are a good market, inspecting the properties and only doing cash flow. Positive properties are some of the major ways that we mitigate the risk of ever losing money on a deal. Mm-hmm.
Anthony Vicino: [00:03:58] Yep. And also coming in well-capitalized on some operators. They do not come in having raised or CAPEX funds and then they take that out of cash flow. That’s number two. I wanted to kind of bucket it because it’s kind of tied in with losing your money. If you come in undercapitalized, your margin of safety is so much thinner, your likelihood of losing your money is very, very high. And this is something that some operators will do where they won’t raise all the CapEx funds at the beginning of the project with the idea that they will just siphon out of cash flow distributions each month and use that to pay out the cash, the CapEx. But the problem with that is, let’s say cash flows light like you have some tenants that don’t pay or there’s something that happens and it takes longer than expected. Well, then the project can’t move forward because you’re not the cash flow isn’t there like you expected it to be as a slippery slope. Exactly. Exactly. So now you can’t do the repairs. You can’t get the new tenants in. They can’t get the higher rents like it’s one thing after another.
Dan Kreuger: [00:04:57] Yeah, it’s very tempting to try to get into a deal for as little money as possible because that will bump up your projected returns because your denominator is lower. The amount of money you need to get into a deal is lower. The same amount of money coming back at you is going to be a higher return on a percentage basis. So it’s tempting for operators to try to be as skimpy as possible with the budget, but kind of leading into number two. The second biggest risk in real estate is under capitalization. And I guess at the same time, we can throw in their over-leverage because they’re kind of the kind of end up with the same kind of risk, same effect.
Anthony Vicino: [00:05:34] All right. What’s our next big risk?
Dan Kreuger: [00:05:40] Undercapitalization over-leverage, really, the main thing that we want to say about that one is even though it lowers the returns, we don’t do debt to fund our CapEx. We come in with cash on day one. So the money sitting in the bank to fund any improvements we’re going to be doing. We also have money for reserves sitting in the bank from day one just to make sure that in addition to those CapEx repairs that are going to be doing over the life cycle of the deal, we also have a rainy day fund for all that stuff that we didn’t anticipate. So those things, although they might drop our projected returns, a pointer to reduce the risk profile significantly on our deals. And not everybody does that. It’s definitely worth looking at. And the next one is going to be more of a macroeconomic issue, not really something you can vet out when looking at deals or operators per se, but it’s something you need to be aware of. What if the market just takes a bath and gets really bad? That is a risk.
Anthony Vicino: [00:06:36] A bathtub is not a good thing in the scenario, right?
Dan Kreuger: [00:06:38] No bath is
Anthony Vicino: [00:06:40] Ok. OK, we don’t take baths, and honestly, like we could use covid as an example of this, that that was a real thing. And so, again, for us, coming in well-capitalized and buying cash flow, cash-flowing assets from day one, these are ways of mitigating the macro market risk, because even if the market has a correction or just a big dip, it doesn’t matter because we have a wider margin of error to play with. Whereas if you don’t come in from day one with your cap-ex, let’s say raised and you have you don’t have a cash flow generating property, then if anything goes a little bit wobbly in the market, you’re going to feel it. You’re going to feel a lot more than if you had been prepared.
Dan Kreuger: [00:07:21] So now one of the biggest things we do to mitigate that risk and we already mentioned we’re always well-capitalized. Another thing we do is we really stress test our deals aggressively. And we have a very pessimistic lens that we look at every deal through to make sure that if the worst-case scenario plays out, that the deals we are getting into still pencil out. And that means that we don’t do as many deals as some guys out there. But it also means that we don’t put ourselves in sticky situations with deals that might not perform that well if there is some sort of unfortunate economic event.
Anthony Vicino: [00:07:54] Mm-hmm. Another thing I’ll point out here, too, is, you know, for us, we’re vertically integrated. So we handle property management in-house. We have a team that does that and we invest in our backyard. And so if the market does weird things, one, we know our market really well, where were the local experts? And so we know how to navigate those waters. And second, because we’re the closest to our residents in terms of property management, we’re able to work closely with them to get them the help that they need in these tough economic times where there may be a high unemployment rate, but there’s still a lot of money out there in the form of aid. And so those are some non-intuitive ways that really help us risk our personal investment.
Dan Kreuger: [00:08:31] And then one other quick bonus on that. Just reducing the macroeconomic risk of a market change is we always have very forgiving. I shouldn’t say forgiving, but we have long terms on our debt, which means that we have the ability to sit tight and not do anything for a long period of time. If there’s some sort of shift in the market, we need to sit and wait things out. Ideally, we’d like to do Al-Rifai pretty quickly after getting a property to return our investor’s capital in a nontaxable event. But given our debt terms that we put on our deals, we have the option to sit there for many, many years. If there’s some sort of pullback in the market, we can wait until there’s a good time to make a move, whether it be a fire sale. There are other operators out there that get in with bridge loans or shorter-term debt that might have some really attractive terms with respect to the interest rate or maybe an interest-only period. But they put themselves into a situation where they’re going to have to do some kind of capital event, whether it’s a fire sale at a certain point in time. And if that falls in some sort of economic downturn, that’s not too good of a situation to be a
Anthony Vicino: [00:09:31] A little bit troublesome. All right. So another risk. I’m going to jump straight to this one. I think we had it on our list a little bit later. But I’m going to put it here because regulatory changes, whether that’s in the local MSA like our city council is trying to put through rent control, let’s say, or harder screening criteria, make it more difficult for landlords to operate in general. This is a risk because you just can’t predict what the local councils and city is going to do. But what you can do is be the local experts and have your ears close to the ground. You know, who to who’s who to talk to, who to get your information from, and you know how to navigate those waters. And again, this is one of the big pros in our book for operating locally, like we really understand the political climate in our markets, whereas if we were trying to invest in multiple remote markets, we probably wouldn’t be able to keep our finger on the pulse in the same way.
Dan Kreuger: [00:10:22] Mm-hmm. Yeah, so much of that stuff is hyperlocal with various cities and counties making decisions that could impact a deal. Or if you’re all over the place, like you said, Anthony, that’s tough to keep track of. So and then also another thing that we do is we just have, you know, fairly I don’t know what the right word is, but our business model isn’t hyperaggressive. Right. So even if some of these things come to fruition, we can still we were slow at our business plans, which is, again, something that’s fairly conservative. But if any of this stuff actually does end up coming to fruition, we could still keep doing exactly what we’ve been doing because we’re not the types of guys who get a property and within a couple of months have taken over, rejected the rent, up 20 percent on people. It’s really those overly aggressive business models that are going to have hurt the city.
Anthony Vicino: [00:11:10] Mm-hmm. All right. So that I think we’re at our ten-minute mark. So that is all the risks of real estate that we’re going to be able to get through. We might do a follow-up episode. I don’t think there are too many more risks to really dive into. Once you get your head around these ones, then you kind of understand the global landscape, really. So that is going to do it for us here at multifamily investing. Made simple. We appreciate you taking these ten minutes out of your day and we’ll see you next week.
