You’re undoubtedly wondering what the answer to this question is. I was, too.
As a due diligence partner for over 800 investors, we think about risks all the time. Since our default is to say no, we probably think about risks more than most people do.
In The Road Less Stupid, author Keith Cunningham says (I’m paraphrasing):
- Rookie investors: “How much can I make?”
- Seasoned investors: “How much can I lose?”
- Professional investors: “Can I afford to lose that much?
We believe the best investors think about risk more than return.
Anyway, our due diligence team is constantly assessing risks. We have a 28-point checklist we use to screen operators and deals. And all the actions on that list are attempting to uncover risks—and trying to find reasons to say no.
So, what is your No. 1 risk as a passive real estate investor? Is it:
- Risky levels and structure of debt?
- Lack of sponsor skin in the game?
- Lack of track record in this asset type?
- Lack of a capable team?
These are huge risks—and you should analyze every one of them. I’ve heard each of these convincingly argued as the No. 1 risk in real estate investing.
But there’s a worse one. Is it:
Yes, these are massive risks. But I don’t believe these are the worst risks.
I think your most significant risk is likely this one:
Because many of your investments will be into great assets, and many of the operators have decent experience, a respectable track record, and a talented team.
And much of the debt will be safe, while many of the operators will put skin in the game.
Many assets will be in stellar locations. Operators will keep cash in reserve. And property managers will manage well.
If this is all true—and it is usually at least partially true—your deal is destined to pay you both the return of principal (top priority) plus a return on principal.
So why do so many deals fail to do that? Fraud.
And sometimes, the fraud will never be identified. Some of the bad guys won’t make headlines or go to prison. Sometimes it will result in you receiving 11% rather than the 15% actual returns from the asset.
Because even when everything I just listed goes perfectly well, one fraudulent player can ruin a deal. I know—I was a victim of fraud myself back in 1999.
So, What Can You Do to Protect Against Fraud?
Here are some things to consider. Some of these items will be appropriate for all investors. Others will be for larger investors (such as family offices and funds).
- Third-party net operating income audits
- Deep background checks on principals and key staff
- Background checks on other parties in the deal (like small lenders)
- Gut checks
- Reference checks
- Death by Google
- Review and audit of skin in the game
- Site visits
After all, you have a lot to protect: your hard-earned capital. It is a massive lift to regain what is lost when the principal evaporates. Fraud can devastate your portfolio, and I don’t want to see this happen to you.
Most investors who invest over decades are victims of fraud at some point in their journey. For all our due diligence efforts, it is impossible to know when a good apple will turn bad along the way. So, what can you do to ensure fraud doesn’t permanently wreck your portfolio?
Avoid concentration through diversification.
The most sophisticated investors I know well are obsessed with diversification—which takes a lot of discipline.
Why? Because we have all seen those “deals of a lifetime.” You know, the deal that couldn’t fail. The game changer that will allow you to retire—if you invest enough.
It can be tempting to bet the farm on these deals—max out your home equity line and cash in liquid assets. Be very careful.
Many of these deals work well, but they are just as prone to fraud as others. I’m not even talking about adjusting your projected returns for risk, which is another issue.
I’m just recommending that you don’t concentrate your investments too heavily on one operator or on one deal. Broad diversification protects your portfolio against fraud. And as we’ve discussed, many believe this is the No. 1 overlooked risk in passive real estate investing.
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Mr. Moore is a partner of Wellings Capital Management, LLC, the investment advisor of the Wellings Real Estate Income Fund (WREIF), which is available to accredited investors. Investors should consider the investment objectives, risks, charges, and expenses before investing. For a Private Placement Memorandum (“PPM”) with this and other information about the Wellings Real Estate Income Fund, please call 800-844-2188, visit wellingscapital.com, or email [email protected]. Read the PPM carefully before investing. Past performance is no guarantee of future results. The information contained in this communication is for information purposes, does not constitute a recommendation, and should not be regarded as an offer to sell or a solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be in violation of any local laws. All investing involves the risk of loss, including a loss of principal. We do not provide tax, accounting, or legal advice, and all investors are advised to consult with their tax, accounting, or legal advisors before investing.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.