If you have been paying attention to the economy lately, you know there is a lot going on.

We just had another major bank failure in the US. Interest rates are high, and the Fed just raised their rate again. Inflation is high, although down from its peak. Countries are moving away from the dollar for international trade [1]. And, you may have noticed, that a high profile foreclosure wiped out millions of dollars of investor money [2].

Given everything that is going on, it can be tempting to conclude that it isn’t the time to invest in real estate and that you are better off holding your money in T-Bills or other safe assets while things sort themselves out.

I disagree. We are heading in to a great time to invest. If you know how to manage risk.

“Be fearful when others are greedy, and greedy when others are fearful.” – Warren Buffet [3]

In the great financial crisis, people who were being aggressive with their investments and not paying attention to the risk involved lost everything. But the ones who were prepared and took steps to mitigate their risk make fortunes (Ken McElroy [4] often credits this period of time for most of his current wealth).

I think we are heading in to a time of great opportunity. But it is important to understand the risks involved with the project and have plans to adapt as circumstances change. If you aren’t paying attention or don’t have experience, you might not be able to move fast enough and get caught by an event your weren’t expecting.

One of the unfortunate realities is that people don’t always recognize the risks that they are taking.

When looking at real estate investments, how do you know if the opportunity you are looking at is high or low risk? I judge the risk of a project by looking at a number of things including:

• How much debt is being used. Debt is an excellent way to increase investor returns. However, it is important to ensure that you can always pay back the debt, since if you can’t, you lose the property. There are two ratios typically used to define how much debt you have. The loan-to-value ratio is familiar to most homeowners as it is the amount of the mortgage relative to the purchase price on the property. In residential real estate, the mortgage is typically between 80% and 95% of the value of the property, for commercial real estate, it is typically between 60% and 75%. However, this number doesn’t really give you any way to know if your debt is “too much” for the property. That is where the debt service coverage ratio (DSCR) comes in. The DSCR is the ratio of the net operating income (NOI) of the property over the debt payment. If the mortgage is $5,000 and the NOI is $5,000, the DSCR is 1.00. If the NOI is $10,000, the DSCR increases to 2.00. If the NOI is only $4,000, the DSCR drops to 0.80. Any DSCR less than 1 means that the property doesn’t generate enough money to pay the debt. Obviously, a property that has a DSCR of <1 is going to be much riskier than one that has a DSCR >1.25 since cash needs to be put into the property every month just to cover the debt.
• The type of debt on the property. Fixed rate loans are lower risk that variable rate loans. The initial rate is typically a little higher, but there is safety in knowing that the rate won’t change at all for the life of the. The loan period also matters. In commercial loans, the maximum period is typically 10 years. Unfortunately, 30 year loans are only on residential property. The longer the term, the more stability, but there are usually prepayment penalties on commercial loans so you will typically be stuck with the loan until it expires. Some people try to guess when rates will change and time their loans to expire based on that guess. If they are right, they can refinance and look like geniuses. If they are wrong, they can end up paying a lot more over the long term. Given the uncertainty involved in refinancing, keeping things as stable as possible for as long as possible reduces the risk to the project.
• Whether or not the property cash flows from the start. A project where the ability of the investors to get their investment back depends entirely on the successful completion of some amount of work is much higher risk than one where there is already sufficient cash flow to hold the property and provide a modest return to investors. Adding value to the property is an excellent way to increase investor returns, but if the property doesn’t cash flow from the start, any delays or cost increases can put the entire investment in jeopardy.
• What the projected IRR is and when the sponsor starts making money. If a sponsor is presenting a deal with an IRR over 20%, the deal is almost always higher risk that a deal with lower projected numbers. This is typically reflected in the assumptions about how the deal will exit. Perhaps it is how fast they will be able to complete their work, what the cost of renovations will be, what will happen to rents or sales prices in the next few years, what their exit cap rate will be, or the terms of the loan they will be able to get on a refinance. While these can all be great strategies to increase the investor return, if the deal requires these assumptions to make any money it is riskier than a deal that will provide lower returns with less aggressive assumptions. A risk to pay particular attention to is whether the sponsor is incentivized to reach those higher returns instead of returning the original investment, for example because they don’t start making money until the deal returns a high pref to the investors. These deals become extremely high risk since the sponsor and investor interests may diverge if the project doesn’t go to plan.
• Where the property is located and target demographic of the investment. The risk associated with a luxury short term rental on the coast in Miami is very different than the risk associated with a D-class [5] apartment building in a high crime area in downtown Detroit. The highest risk is when the location of the property and the target demographic don’t align – for example, trying to establish a luxury short term rental in the middle of a high crime area is not likely to be successful. While it is possible to use real estate to improve a neighborhood, these types of investments are much higher risk than investments where the location and demographic are already aligned.

“Rule #1: Never lose money. Rule #2: never forget Rule #1” – Warren Buffet

High risk deals can be worthwhile, as long as everyone understands the risks involved and plans to mitigate the risks are established. The down side of mitigating risk is that the return is lower than on deals that don’t attempt to reduce the investor risk. For example, the cost of buying a rate cap on a variable rate bridge loan is unnecessary if the rates don’t go up and is money that could have been returned to investors in that scenario.

Unfortunately, many investors aren’t aware of the risk profile of the deal that they are investing with. They just look at the IRR and assume the risk across all real estate investments is the same. It isn’t. It is really important to ensure that you understand the risks involved in your investments and that they align with your risk tolerance and expectations. Otherwise, you can be putting your money at more risk than you realize.

I have always been a very conservative investor. I focus on long-term, fixed rate debt at high DSCRs (in some cases paying all cash to ensure that I don’t have to worry about the loans at all). I only buy properties that cash flow from day 1. Even when I intend to pursue a value add strategy, the property needs to be self sustaining while I go through those updates. And since I am focused on very long term, buy and hold, I don’t plan for a high IRR (which almost always requires an exit within 5 years), instead I focus on CoC returns from cash flow and structure my deals in a way that my interests align with my investors throughout the lifespan of the deal.

By being transparent about my investment thesis and clearly communicating my goals to investors, I can ensure that there is alignment about the risk of the investment and that my investors are making an educated assessment of the risk-adjusted return.

If you have any questions or comment about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.

1. https://www.cnbc.com/2023/04/24/economic-and-political-factors-behind-acceleration-of-de-dollarization.html
2. https://www.rentalhousingbusiness.ca/houston-apartment-owner-loses-3200-units-to-foreclosure-as-multifamily-feels-the-heat/ – this also made the WSJ news, but since that is behind a paywall, I went with an open link
3. Berkshire Hathaway, Inc. “Chairman’s Letter, 1986.” https://www.berkshirehathaway.com/letters/1986.html
4. https://kenmcelroy.com/
5. https://www.apartmentguide.com/blog/apartment-building-classes/

This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.