“Be fearful when others are greedy and greedy when others are fearful.” — Warren Buffett
We’re starting out 2023 with a lot of risk.
A recent example of this is Veritas, a developer in San Francisco.
They are defaulting on a $450 million loan.
In this blog, I want to define the three greatest risks in real estate.
I also want to go over things you can do to help prevent loss.
We’re gonna talk about how to evaluate deals and put yourself in the best position to succeed in 2023.
Let’s do it!
1. 2023 Real Estate Risks
Rates have gone up.
Everybody’s talking about it.
A lot of people are concerned.
You might be thinking how you can get into a deal with the market going through a rough patch.
How would you even buy a house?
Rates have gone from 3% to 7% and are hovering around that area.
With higher rates, they’re shaking out deals that shouldn’t have gone through in the first place.
Specifically, I mean speculative deals in shaky markets.
People also assumed rents would go up by 20% per year, like they have before.
That didn’t happen.
High risks are everywhere these days.
Here are my top three most risky deals:
1. Class A Deals
Class A deals, are among the highest risk deals.
These deals involve brand new properties built within the last 10 years.
The reason for the high risk is the inability to add any value to the property.
This is also true of development deals because it could be 2 years or more before they are complete and there is no fixed rate financing for construction deals.
2. Undercapitalized Deals
Undercapitalized deals are another high risk.
These are deals where operators did not raise enough money. Sure, they closed the deal but they don’t have the money to complete the work or pay for rising expenses.
If they run into trouble and there’s not enough cash, those deals are at risk.
3. The Team
The greatest risk you find in general is always the team running the deal.
It’s all about how conservative the team is with their finances and if they underwrote the deal.
Someone on the team should have 10 years or more of experience managing similar properties.
At least one person should have seen both the positives and negatives of deals and know how to handle them. Asset management experience. There is no substitute.
They can be the voice of reason.
2023 is going to be the year of operations, according to my friend Ken McElroy.
I recently had him on one of our BE monthly panels.
He said groups that can “work their plan” will succeed.
One way we mitigate all of these risks is by doing a lot of value-add deals.
We typically buy apartment buildings built in the 70’s and 80’s.
We invest around $6,000 to $10,000 per unit for renovations.
After renovations, we then see an upside in the rents.
As long as we can do the value-add, we’ll see around a 50% upside.
That $6,000 investment sees rents rise to around $1,500 per unit (from $1,000).
If we can renovate 80% of those units over a two-to-three-year period, we’ll be just fine.
Even if we need to refinance, we’ve increased the value.
The key to good operations is making sure we work efficiently and foresee challenges the best we can.
Everybody wishes they can predict the future, but that’s impossible.
You can do the best with what you have and learn from your mistakes.
Experience is really the only thing that can help predict possible risks.
For example, with insurance, someone with experience may have seen certain events happen at a past property.
They would know what types of insurance are necessary.
Insurance is very sneaky on what they include.
Having someone who has navigated that before would be a huge help and also maximize your relationship with investors.
2. Your Current Passive Real Estate Investments
The number one thing you can do as a passive investor is communicate with your sponsor.
Your sponsor is the person operating the deal.
Reach out to them.
Ask them questions.
Keep in touch.
If they’re not getting back to you, you should be concerned about the property.
In my opinion, sponsors should respond quickly within a day or two.
There are, of course, some reasons why they may not respond right away.
In these cases, try to reach out to someone else on their team.
You should be able to get answers about the way your deal is being operated.
One question I like to ask as a passive investor is:
How are you mitigating risks?
If interest rates continue rising, how will we tackle that?
One way we’ve seen sponsors deal with these situations is by withholding distributions.
Sometimes with a property, we need to make sure we have enough cash.
It’s not a fun part of the job, but we’d much rather have a little bit of pain now rather than having a lot of pain later.
There are three things you should be doing while investing, particularly in multifamily.
First, you’re going for capital preservation.
This ensures the money you invest is preserved.
Second is capital appreciation.
You’re hoping that the money will go find more dollars and bring it back.
Number two really is secondary.
Preserving capital is key.
Any good operator should be doing that.
The third thing is: Don’t count on cash flow.
If a deal has been cash flowing consistently for the last year or more, don’t assume that will continue.
Things can change, one current example being what the Fed does with interest rates.
In general, you should be cautious of any multifamily deal right now.
Or, at the very least, have a much more conservative number in terms of cash flow.
Your decisions will affect the long term.
Right now, our deals are doing just fine because of a housing shortage.
Rent will continue to rise with an increase in demand.
But we have to keep in mind that interest costs will also rise so there will be some adjustments.
Remember: Operations are super important.
Part of that is cash management and making sure we’re operating on an efficient level.
Sometimes that does mean withholding distributions, but these things happen.
Warren Buffett talks about margin of safety.
You should have a safety net if a deal doesn’t go as planned.
We don’t know what the market will look like in a year.
There’s no fixed-rate construction debt.
You have to pay whatever the market allows.
If rates increase even more, you have to factor that into your plans.
3. The Good News
All this talk about risks might sound intimidating, but don’t worry!
There is good news.
Things may seem tough right now, but they won’t be forever.
Warren Buffett has a famous saying:
“Be fearful when others are greedy and greedy when others are fearful.”
When conditions are less favorable, you get better terms as a buyer.
That means you can buy better deals.
That’s pretty exciting!
Good news and bad news often go hand-in-hand.
The good news is there’s more opportunities for the future.
The bad news is the deals may be a little tighter.
Now I want to hear from you!
How do you feel about the risks we talked about?
Will you take advantage of the unique market right now?
Let us know in the comments!
Before you leave, make sure to check out our special report about inflation investing. It shares the best choices to invest during an inflationary environment.
If you are interested in investing with us, we are happy to answer any questions that you may have. Join our investment club today and we will be in touch.
Disclaimer: I am not your investment advisor. This is for educational purposes only. I am not giving specific advice on what you can do. I am simply giving my opinions.