4 Ways to Protect Your Passive Investments

With multifamily markets changing significantly over the past 24 months -- and not for the better -- and that trend potentially continuing for the foreseeable future, it's more important than ever for passive investors (often called "Limited Partners") to take extra precautions when investing in real estate syndications and funds.

Over the past week, I've had a number of conversations with passive investors who are a bit concerned about where the markets (both real estate and the broader economy) are headed, and as a passive investor myself in other people's deals, I've been asked repeatedly what I'm doing to protect my new investments these days.

Here are the top 4 things I'm personally doing to protect my limited partner investments right now:

1. Vet The Operator

There are a number of areas in a passive investment where you things can go wrong.? A bad property, a bad location, a bad business plan.? But, nearly all of those things can be avoided -- or at least mitigated -- by having a great operator.

A great operator will first and foremost do the due diligence necessary to ensure that the deal is as low-risk as possible.? Additionally, a great operator will know how to course correct and pivot should something derail the business plan during the investment.

For these reasons, when I look at a passive investment, the vast, vast amount of time I spend is vetting the operator.? Here are some of the things I like to do to vet the operators I consider:

*? First, I will always ensure that that I have a phone or Zoom call with the operator.? I may not be able to get the top person in the company (though it's nice), but I want to know that I can talk to someone who is more than just an "investor relations" person who is essentially reading me a script and trying to make a sale.

*? My favorite question when speaking with an operator is, "What is the worst thing you've had happen on one of your deals?"? Followed up with, "And how did you handle it?"? If an operator tells me they've never struggled on a deal (thinking that's a good thing), I actually consider it a bad thing.? They are either lying to me (most of us have had a challenging situation), or if they are telling the truth, they likely don't have enough experience that I would trust them if a major issue were to arise on this deal.

*? I'm big on communication, so I always want to clarify the communication strategy of the operator before I invest.? Maybe you don't care much about communication (we have a lot of investors like that), but many investor do.? I want to see that there is some regular communication between the operator and me (monthly or quarterly reports), along with regular financial statements for the deal (generally quarterly or semi-annually).? Likewise, I want to know that I can get in touch with the operator should I have a question or concern -- will I have an email address for them, a telephone number, etc?

*? Most importantly, I like to get referrals for operators from other investors I know and trust.? Instead of taking the operator's word for how they communicate, how they run their deals, how they handle adversity, etc., I prefer to get that information from actual investors in their deals.? If I don't know an investor who has invested with a particular operators I'm considering, I have no issue asking the operator for a couple investors who I can call and chat with.

2.? Diversify

Probably the easiest and most effective way to reduce your risk in the current market and moving forward is through diversification.? While diversification can reduce your returns as well -- you're splitting your investment across deals, where the bad deals will somewhat cancel out the good deals -- for many of us, the ability to lower our risk is a worthwhile tradeoff.

When thinking about diversification in commercial real estate, here are the ways I like to diversify:

* Across operators:? While I like it when my investors put a lot of money into my deals, the reality is that good diversification includes not putting too many of your eggs into a single operator basket.? While an operator may be great (we think we are!), we tend to focus most of our investments in areas where we are experts, and we don't generally provide wide diversification for our passive investors.

* Across Asset Classes:? While there's nothing wrong with focusing many of your investments in one asset class that you know and like (multifamily is my asset class of choice, both as operator and passive investor), now is a great time to diversify across asset classes as well.? We don't always know which asset classes are going to perform well (or poorly), so owning a mix of multifamily, self storage, retail, office, industrial, etc. is a great way to hedge your big bets if your preferred asset class under-performs.? Or if another asset class over-performs.

* Across Locations:? As operators, we do a lot of research on trends that define good investment locations.? Population trends, employment trends, industry trends, etc.? But, sometimes things happen that we can't predict.? We saw this with Covid -- some big cities that were otherwise well positioned to continue to grow saw massive population departure in a short period of time.? Diversifying across locations can provide safety from a national or local event that has an impact on specific areas.

* Across Exit Strategies:? Even within an asset class, not all deals are created equally.? Investing in a stabilized property has a different set of risks and a different set of returns associated with it than buying a value-add property.? Or a new construction property.? Or a conversion property.? Investing across exit strategies can provide a wider range of return benefits, plus spread out risk across different types of investments.

* Across The Capital Stack:? Perhaps the best way to diversify and reduce risk is to invest in across different parts of the capital stack.? What that means is that, instead of just investing as a regular equity investor across all deals, consider investing in debt or preferred equity , safer investments (albeit with lower returns).

3.? Ensure Conservative AssumptionsIt's important to remember that much of the risk in a typical syndication or fund arises from the assumptions made by the operator when analyzing the deal.? If an operator uses conservative underwriting assumptions, they can eliminate many of the risks that they'd otherwise see if they instead used aggressive underwriting assumptions.

When I invest in a deal (or when we put together a deal ourselves), here are some of the biggest places where I want to ensure that the underwriting is conservative in assumptions:

* Exit Cap Rate:? Perhaps the single most important assumption that an operator needs to make is what the exit cap rate will be upon property sale.? This is a tough number to figure out, as a lot can change in the next 3-7 years during the hold period of the investment.? But, being off on the exit cap rate by even a quarter point can mean the difference of millions of dollars at sale, so you want to ensure that the operator is being conservative with this assumption, not aggressive.

* Income Growth:? Operators and investors have grown accustomed to income/rents growing 3-5% per year over the past several years.? But, the reality is that it's unlikely that we're going to see that kind of growth continued into the near future.? More likely, for most properties in most markets, we're likely to see historically average rent growth for the foreseeable future. This means 1-3% growth in many cases.? If an operator is assuming higher growth than that, they should have a very good reason for it.

* Expense Growth:? Historically, operators have assumed 2-3% expense growth, year over year.? Which is reasonable considering that inflation has historically been between 2-3%.? But, with inflation now well over 3% (and perhaps much higher, depending on the data you believe), it's unrealistic for an operator to assume expense growth under 3% for the near future.

* Hold Period:? While we may want or hope to sell a property in under 3 years -- like we've seen a good bit recently -- the reality is that most multifamily syndications require at least 3-5 years to achieve the income growth that will allow the project to meet return projections.? When I invest in a deal -- whether as an LP or GP -- I want to see an analysis of the deal both in the short-term (3-5 years) and also longer-term (5-10 years), just in case the deal must be held longer than expected.

4.? Avoid Catastrophic Risk

Finally, as an investor, the worst possible outcome for any deal is that I lose my entire investment (or as an operator, if my investors lose their entire investment).? To minimize this risk, I like to avoid investments that have any catastrophic risk associated with it.?

For example, I have chosen not to invest in any multifamily properties on the coasts of Florida, as I believe there is a catastrophic insurance risk -- should there be a couple major storms, it's possible that insurers could pull out of the state, leaving some properties essentially uninsuranable.? And uninsurable property is worth nothing.

As an investor, I always recommend asking a prospective operator what the biggest risks are on the project, and then following up that question with, "And how will you mitigate that risk should it arise?"

While it's impossible to eliminate all risk when investing as a limited partner, taking these steps and asking these questions will help you reduce and mitigate that risk to a large extent.