Principal Owner, Capital Equity Partners, LLC. Real estate investment sponsor, developer, syndicator, operator, consultant and coach.
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If you’re new to investing in real estate, don’t get seduced by a sexy-looking building or great projected returns. To ensure a higher rate of success, understand the basic elements of the offering and then decide if it’s right for your investment tolerance.
Real estate investing continues to gain popularity among the masses through crowdfunding sites as well as private offerings provided directly by sponsors who are operating individual projects they are looking to fund. If you’re just starting out, or have a little bit of experience, I hope to help guide you on your way to success.
Any type of investing requires you, as the investor, to understand the risks versus the returns, and real estate is no different. When evaluating a real estate offering, here are a few of the core risks you should consider before committing your hard-earned dollars.
1. Operator risk: Who are you investing in? What is this individual’s or team’s track record? A lack of experience in an operator is a primary factor to consider. If that operator hasn’t worked within the asset class they’re proposing, the market they are entering or the size of the asset before, then proceed with caution. A smart operator will surround themselves with a team of people who support their resume where they are weak.
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2. Market risk: Market risk is different than location risk. Market risk is the area of the investment, which can be referred to as a metropolitan statistical area (MSA). This categorization breaks down the area and can be more easily classified to not just a major city, but to the entire area that surrounds it. For example, where I currently live is the Boston, Cambridge, Newton MSA, which covers southern New Hampshire all the way down to Cape Cod. The statistics of each MSA help us evaluate and determine what’s going on in a general area of the country. The items of interest to real estate investing are centered around job growth, population growth and household formation. In real estate investing, if your market isn’t growing, then expect your returns to do the same. So, where is the investment you’re evaluating located?
3. Location risk: This would refer to the actual location of the property you are considering investing in within the actual MSA. Is it in an urban location or is it suburban? Is it a newly developing area, or is the area gentrifying? What are the crime rates like? Most people know that real estate is about location, location, location. So where is the asset located, and what’s happening around the area to make it a good investment? Areas can be referred to as a grade letter, such as A, B, C or D. The better the grade, the more desirable the area.
4. Asset risk: What kind of building are you investing in? In commercial real estate, this gets defined as Class A, B, C or D. Just like your school grades, the grading makes it easy to understand the age and condition of a building. If you’re investing in a B Class property in a C Class location, you may want to proceed with caution. If the building is older and needs a lot of repair work, does the operator have the experience to properly estimate, budget and execute the value-add renovations required in order to execute their business plan? This touches on strategy risk, which we’ll explore in a bit.
5. Financial risk: What are the terms of the investment? How much will you invest, for how long and at what rate of return? The rate of return should always be commensurate with the amount of risk involved. Investing in the new apartment building across the street from the area’s largest employer is akin to buying a Class A property in a Class A area. There’s not a ton of risk there. Based on those factors, with reduced risks come reduced returns. If you want more risk, you can find the opportunity to buy the C Class building in a fringe C Class area and be the catalyst of change that will start the movement to upgrade the area. There’s much more risk in that, so the returns should be higher. This is where you start to feel your gut and evaluate the level of risk you personally want for your dollars.
6. Strategy risk: What is the strategy of the operator? Are they addressing curb appeal and amenity packages? Are they going to improve the interiors of units and then increase rents? What evidence is there in the marketplace to support those increases? Are you comparing apples to apples in the marketplace? You can get very granular in understanding the strategy of the operator. This is where the rubber usually meets the road. The right property with the wrong strategy can spell flat investment returns, which is not the goal.
These risk categories aren’t the only ones to consider, as there are certainly other risk factors that should be taken into consideration, such as tax implications, investment timelines and diversification priorities. Getting involved in real estate investing can be filled with excitement and become very rewarding, but make sure you understand who and what you’re getting into before jumping in to achieve your individual goals. In real estate investing, just like in life, sometimes a sexy opportunity is only skin deep.
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