When it comes to investments, no discussion would be complete without talking about risk. When discussing risk, I like to start with the investor. What type of investor or should I say risk taker are you? Are you risk averse, a risk minimizer, or do you throw caution to the wind, ignore risk altogether and gamble with your money?
Investors are kind of like the kids at a high school dance. When I was in high school, my friends and I would go to the dances Friday night after the football games. Asking a girl to dance could be a daunting task for a teenager, as there was risk involved. Each of us had a different approach.
Some took the volume approach – indiscriminately asking as many girls as possible, knowing one was bound to say yes. Others were more calculating asking only the girls that they had good rapport with or the ones who had subtly left clues of their affection. The last group never took any risk at all. For them, the fear of rejection was paralyzing. Consequently, this group of people sat in the bleachers watching everyone else dance. To this day, they’ll never know how many missed opportunities passed them by.
I think back on those times and I see similarities with investors. There are those with little to no education on an investment who buy like there is no tomorrow and hope for quality returns. In my mind, this approach is less about investing and more about speculation. Hope is not a plan.
On the other end of the spectrum is the individual who lets one quality opportunity after another pass him by simply out of fear. These risk-averse people don’t experience the big losses that the speculators experience, but their nest egg gets whittled away by the destructive nature of inflation.
The last type of investor takes calculated well informed risks. They educate themselves on their investment and they do everything in their power to mitigate risk. In the end, they make sound purchases in the investment vehicle of their choosing.
The truth of the matter is that all investments have risk. In fact, not investing in anything at all has risk (from inflation). As an investor, you should not ignore risk or become paralyzed by it. Instead, you should mitigate risk. The best way to do this is through education. The fact that you are here on this educational real estate website tells me what kind of investor you are. So please, continue to follow us here at NestEggRx.
Let’s now take a deeper dive into the subject of risk as it applies to multifamily commercial real estate. I divide the risks of real estate into two broad categories: Market Risk and Financial Risk.
There is no efficient system for trading or selling real estate. Unlike the stock market, you cannot get on the phone or computer and sell instantaneously. Instead, the usual process is to find a broker, list the property, entertain offers, negotiate terms, and close the deal. This process takes time which is why real estate is considered illiquid. What you lose in liquidity, you generally gain in stability as real estate tends to be much less volatile than the stock market.
Some of the things that affect liquidity are the quality of the market, submarket, and asset. Supply and demand as well as rising interest rates can also affect your ability to liquidate your property.
With that said, how do we mitigate these market risks? I buy for the long-term hold in thriving markets and submarkets. I avoid stagnant and dying markets where population and job numbers are contracting. Markets with population growth and a plentiful supply of jobs, insures continued demand for apartments. I also look for areas with barriers to entry. Simply put, these are factors specific to an area that restrict new supply.
When you get these things right, few need or want liquidity. As long as I have a superior asset in a superior market and submarket, then I am going to hold for the long-term anyway. I will collect annual tax-advantaged cash flow while watching my equity grow through appreciation and principle pay down. Everybody is different. Real estate may not be right for you or you may need to restrict your asset allocation in real estate to a certain percentage of your portfolio.
Simply put, the financial risk of real estate is the risk of losing the property to foreclosure. What are some of the things that can lead you to foreclosure?
-Overpaying For The Asset
-Underestimating the Capital Needs of a Property
-Owning the Property in Your Own Name and Not Inside a Business Structure
-Obtaining Recourse Lending Instead of Non-Recourse Lending
-Not Having Adequate Insurance
-Over-Leveraging a Property
-Not Employing a Quality, Reputable, Property Management Firm
To mitigate these risks, I start by investing in an entity for asset protection. Purchasing a property in your name instead of a business entity like a limited partnership (LP) or a limited liability company (LLC) is unwise – doing so, can make you personally liable for problems that can arise.
Additionally, I only purchase properties using non-recourse lending. This type of lending limits your downside. With non-recourse lending a lender cannot come after the investor should he or she default. Unlike recourse lending, the investor’s loss is limited to their initial investment and nothing more.
While non-recourse loans limit the downside of leverage, over-leveraging a property is a sure recipe for negative cash-flow and can ultimately lead to foreclosure. To maximize the benefits of leverage and minimize the risks, I follow Fannie Mae underwriting guidelines. Nationally, Fannie underwritten properties have a paltry 1% – 2% foreclosure rate on multifamily properties. In the markets I invest in, the foreclosure rate is even lower. I put 30% down and only go after properties with debt-service coverage ratios and other parameters that Fannie Mae deems safe.
Insurance is a key element for limiting financial risk. It’s important to insure against loss including rental income loss should a block of units go down for a period of time. An additional layer of insurance is critical in the form of business umbrella liability insurance.
Adequate capital reserves and a capital improvement plan are very important when purchasing a property. Capital reserves allow the investor to cover unexpected large ticket items like roofs, blacktop, HVAC, etc. Also, a capital improvement plan can insure that the property is continuing to be upgraded and becoming an even more desirable place to live. This is important when you are looking to drive rents.
Last but not least, is quality property management. This piece is so important, that I have written an entire blog post about it. Remember that even the best property in the best market can be run into the ground by bad management. On the other hand, quality management utilizing economies of scale can make a good property great.
In conclusion, all investments have risk. I would argue that real estate is far less risky than investments in the stock market. To bolster this argument, I point to bank financing. Most banks will lend me up to 70% of the value of a property only requiring me to put down 30%. Can you do that with the stock market? What would Bank of America say if you told them you wanted to buy a million dollars of their stock and you wanted them to lend you $700,000 to do so? You would be laughed out of the building. The reason they would never do this, lies in the subject of risk. The latter scenario is way too risky for the bank to ever consider.
To Your Wealth!
Dennis Bethel M.D.
P.S. The best real estate investments are those in which you minimize risk, maximize return, and create permanent wealth for you in multifamily.