You Can Dial Back Real Estate Risk

[Editor's Note: Make sure to sign up for Tuesday's free real estate investing webinar with Dr. Jim Dahle. He'll answer all of your questions and talk through the pros and cons of investing in this asset class. Now could be a great time to get started with real estate investing, so make sure to register for the webinar today!]

 

By Dr. Jim Dahle, WCI Founder

I have run into people frustrated with their real estate investment—whether they invested directly, privately, or via public investments. Upon further questioning, I often discover they are relatively new to real estate investing. They might have chosen a rather aggressive style of investing, and then the inevitable risk showed up, as it often does. Their investment underperformed their expectations, often terribly. For some reason, they seemed to think real estate was exempt from the rules that govern all investing.

Although they know it's important to diversify when investing in stocks, they thought that this key principle didn't apply in real estate investing. Putting all of your eggs into one basket has the same negative consequences, whether that basket is a single stock or a single property.

Another important lesson to learn is about the risk continuum. Investors learn early that higher-risk investments often come with higher rewards. But they don't seem to learn that the more risk you take on, the wider the range of possible outcomes you can expect. It's almost comical sometimes to see how little risk an investor might take with a stock and bond portfolio and then see them go hog wild on risk in the real estate portion of the portfolio. They're comfortable with a relatively conservative 60/40 portfolio of stock and bond index funds. Then, they dump a huge chunk of money for them into a single highly leveraged real estate syndication with a questionable value-add strategy managed by a relatively new operator.

 

Dial Back the Risk

The longer I invest in real estate, the more I like less risky real estate investments. The main reason I invest in real estate is for high returns and low correlation with the stocks and bonds in my portfolio. But when I say “high returns,” I think about what I expect out of stocks. It's something like 8%-10% a year long term—maybe a little more if significant leverage is involved. While some of the equity real estate investments I invest in project returns above 15%, I'm very happy when I end up with low double-digit returns (10%-15%) from my real estate investments. Yes, I know lots of funds, syndications, or properties end up with multi-year returns in the high teens or even 20s. However, I don't need those sorts of returns to reach my financial goals, and I hope you don't either.

Newsflash! Most fund managers, syndication operators, and realtors (all being human) overestimate their projected future returns. Most pro-formas are a little too optimistic. Most of the time you won't get what's projected. Sometimes you will. Sometimes you'll do even better. But you should be happy if you achieve the projection minus a few percentage points. If that's not going to make you happy, you probably shouldn't invest.

 

5 Ways to Take Less Risk with Real Estate

There are actually a lot of ways to lower your risk when it comes to real estate. Let's talk about some of the main ones.

 

#1 Less Leverage

Most real estate investments that get into trouble have the same problem. Guess what that problem is. It's the same financial problem most American families have: too much debt and lousy terms on that debt to boot. If you want less risk, take on less leverage risk. If you own properties directly, work on paying them off. It's pretty darn easy to weather a long vacancy when there is no mortgage to pay. That's no different in a single-family home than it is in a 500-apartment complex.

If you're investing on the private side, look at how much leverage the operator or fund manager is planning to use. If they're planning to borrow 75%, 80%, or more of the cost of the property plus improvements, that's a lot of risk. If they're only going to borrow 60% or 65%, they're taking on a lot less leverage risk. Take a look at the terms on the debt, too. The longer the period and the more fixed the interest rate, the less leverage risk there is.

More information here:

Diversification Always Matters (My Syndicated Investment Goes to Zero)

The Minimum Investment vs. Diversification Dilemma in Real Estate

 

#2 Diversify

One of our favorite real estate investments is the Vanguard Real Estate Index Fund, available as a traditional mutual fund (VGSLX) or an ETF (VNQ). It offers all of the usual benefits of mutual fund investing including:

Professional management Diversification Daily liquidity Pooling of costs

But I really want to hone in on No. 2: diversification. This fund owns 155 REITs. That seems like a lot, right? Remember, though, that each REIT owns many properties, too. The largest REIT in the fund, Prologis, owns > 5,500 buildings across 19 countries. The 30th largest REIT in the fund still owns 1,300 different properties. It's fair to say that when you own this REIT, you own a piece of something like 100,000 properties. That's a lot of diversification.

Owning public real estate has its own downsides—like volatility and higher correlation with stocks—but the rules of investing remain the same whether you invest in stocks or real estate, publicly or privately. You must diversify to protect against known and unknown risks. Diversification protects you from what you don't know.

If your real estate portfolio contains fewer than 10 properties, you had darn well better be one of the main people managing those suckers. You should know as much about those properties as anyone else on the planet.

 

#3 Invest Lower in the Capital Stack

One of my favorite types of real estate investing is real estate debt funds. I invest in these on the private side, but if you want something public, you might look at an ETF like the iShares Mortgage Real Estate ETF (REM). A private fund might own something like 75-200 loans or more, so it has a fair amount of diversification among different borrowers.

That's not the main reason the risk is lower here, though. The main reason is that you're lower in the capital stack. In fact, most of these funds sit at the lowest position in the capital stack. The loans they make generally sit in first lien position. That means if the borrower stops paying, the fund can foreclose on the property and sell it to get the principal back for the investors. Since most of these fund managers also have an equity fund or the experience of running one, I'm confident in their ability to do that. The likelihood of loss in this type of diversified real estate investment is just really low. That means returns are lower, too (my long-term returns in real estate debt investments are just over 9% annualized over the last eight years). What has been more impressive to me, though, is just how low the volatility of those returns has been. Here's an example from one of the funds in which I invest:

2011: 14.44% 2012: 17.33% 2013: 15.04% 2014: 14.23% 2015: 13.04% 2016: 11.01% 2017: 13.14% 2018: 12.45% 2019: 11.80% 2020: 7.33% 2021: 8.85% 2022: 10.01% 2023: 9.20% 2024: 9.58%

Even ignoring the outliers in the early years, it's been basically 7%-13% every year. It's 0.75% or so a month in most months. It's not tax-efficient, but it's high AND it's steady. What's not to like? The last time I looked, this particular fund had 74 loans in it, and two of them were “non-performing” (in the process of foreclosure).

Blog sponsor DLP also has a Lending Fund in which Katie and I invest. It's even more “steady-eddy” in its performance than the above fund. Recent returns looked like this:

 

 

You might have to zoom in, but basically you're looking at 10%-13% returns, even after fees. These are stock-like returns with a whole lot less volatility, no? Yet they just don't seem all that popular among investors, and I can't figure out why. This is a sub-asset class I think about owning more of, not less. No, it's not tax-efficient, but these funds can be placed in many self-directed IRAs and 401(k)s.

There are other options in the capital stack besides just debt and equity. When things go bad, the debt holders get paid first. Then, those in the “middle tiers” like mezzanine debt or preferred equity get paid, and finally, the equity holders who are supposed to make out like bandits when everything goes better than expected get paid. I've seen real estate deals go bad where the debt holder got back all their principal and interest, the preferred equity got back all their principal, and the equity holders lost everything. Where you invest in the stack matters.

More information here:

A Tale of 2 Sponsors: How My Real Estate Investments Have Had Vastly Different Results

The 60+ Worst Mistakes You Can Make in Real Estate Investing

 

#4 Look for Funds Focused on Income

I'm more of a “total return” investor than an “income investor,” but when it comes to real estate, one of the big benefits of a fund focused on income is that they are generally taking on less risk. That's less leverage. It's fewer ground-up and value-add projects and more core and core plus properties. It has less of a speculative nature to the investments. There are lower potential returns to be sure, but there's also significantly less risk. They might even have a mix of equity, preferred equity, and debt investments in the fund. An example might be blog sponsor Origin's IncomePlus Fund. As I write this post, its mix of investments looks like this:

 

 

Only about 35% of the fund was invested in equity investments, and most of those were lower-risk core plus properties. The managers thought preferred equity (lower in the capital stack) was a much better place to be in the last couple of years to meet the fund goals (steady income), so that's where they've been. While that might be overly conservative, they seem to have avoided the carnage seen elsewhere in real estate over the last few years, as evidenced by quarterly returns.

 

 

As you can see, the fund is not immune from losses and total returns can be pretty variable, but when a fund focuses on income, it tends to take on less risk. When risk shows up, that strategy pays off. So, if you want less risky real estate investments, quit buying the ones trying to get you 18% and settle for the ones shooting for 10%. It's usually on one of the first pages of their marketing material, as demonstrated below:

 

 

#5 Find (or Wait for) a Long Track Record

Experience matters and the more of it that is possessed by the person managing your real estate investment (whether that's you or someone else) the better. I've been burned twice in private real estate investments—once by dishonesty and once by incompetence. However, I went into both investments with a “tryout” amount of capital, basically investing at their minimum amount. Both had problems that showed up within a year or two of my investment. In my experience, most dishonesty and incompetence don't take decades to manifest.

This is one reason why Bernie Madoff was such a remarkable case. Madoff had been in business for 48 years before the discovery of his crimes, although the Ponzi scheme had really only been going for about 15. Even 15 years is a remarkably long time to successfully run a scam, though. Most people just don't last that long without blowing up or being discovered.

How long of a track record is long enough? That's a matter of opinion, but the longer the track record—especially a track record of doing exactly what I'm investing in—the better. Less than five years seems like nothing to me, and even 5-10 years is not all that much. If the track record isn't longer than that, I'm probably going to invest the minimal amount and wait to see what happens over the next couple of years before investing any more. Don't be in a rush. Diversify among managers and figure out who you trust. Yes, you'll have to deal with more K-1s and maybe a few more state tax returns, but I think it's worth it.

Real estate investing, like stock investing, is not a risk-free activity. Unless you're content with a simple index fund approach with its unique mix of pros and cons, it's going to require a lot more work and some unique risks. Be careful how much risk you take, especially with your first few investments.

 

If you are interested in private real estate investing opportunities, start your due diligence with those who support The White Coat Investor site:

 

What do you think? What have you done to control risk in real estate investing? Comment below!

The post You Can Dial Back Real Estate Risk appeared first on The White Coat Investor - Investing & Personal Finance for Doctors.