For several years now, our passive real estate investment club has met monthly to discuss and vet hands-off investments. Every month, we go in on a new passive investment together so we can each invest small amounts without becoming a landlord.
While we historically focused on syndications, we’ve increasingly focused on private partnerships. We go in on deals together with smaller investment companies that don’t raise capital from the public.
These companies don’t have podcasts or YouTube channels. They aren’t out there trying to build a brand for themselves or sell courses or become “gurus.” They just focus on earning consistently high returns on real estate investments. Plus, private partnerships allow non-accredited investors since they aren’t securities.
Here’s what our Co-Investing Club looks for when we explore private partnerships to invest passively in real estate deals.
Asymmetric Returns
Ultimately, we want high returns with low risk: what fancy finance types call “asymmetric returns.”
On the return side, that typically means we look for 10% to 12% or higher for secured debt investments, and 15% or higher for equity investments. Because otherwise, what would be the point? If I wanted to earn 7% to 10% on equities, I’d just put all my money in the stock market. If I wanted 4% to 7% on debt investments, I’d invest in bonds.
I invest in real estate for high returns, stable income, tax benefits, diversification, and—here’s the kicker—low risk.
Anyone who’s invested in real estate long enough knows that you can earn asymmetric returns. An investor’s first real estate deal comes with enormous risk. But their 100th deal? If they’ve done that many, they’ve already learned all the expensive lessons. They know how to minimize risk while maximizing returns.
Plenty of passive real estate investments target high returns. Some of those come with equally high risk, while others come with relatively low risk.
Increasingly, we obsess over downside risk: protecting against losses.
Why We Focus on Risk
Rock star investor Warren Buffett famously said, “Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No. 1.” The longer I invest passively in real estate, the more I appreciate just how right he is.
When you invest in enough deals (and this is why our Co-Investing Club invests every month), returns on real estate investments follow a bell curve. Some investments will underperform, some will overperform, and most will fall somewhere in the middle of the curve.
Picture the bottom far-left corner of that bell curve—deals that underperform so badly they lose money. That’s what we aim to eliminate with our risk analysis.
If a deal underperforms and I earn 5% instead of 15%, I’d shrug my shoulders and say, “I’ll make it up on the next one.” If I were to invest in a deal and lose 100% of my capital? Let’s just say I wouldn’t be so philosophical about it.
In real estate investing, downside risk is everything. You have endless investment opportunities that target 15% or higher returns. The trick is spotting the ones with extremely low downside risk.
That raises the critical question: How do you identify low-risk real estate investments?
Risks We Scrutinize and Minimize
When we look at deals, we try to look at risk from as many angles as possible. These are the main ones we look at first.
Partner trustworthiness
Every investor who’s done enough deals has lost money occasionally. We love to talk with investors about the deals that have gone sideways on them. What went wrong? How did you handle it? Did your partners or financial investors lose money?
The better answers focus on the lessons the investor learned—and how they then took a loss personally in order to make their investors or partners whole.
Trustworthiness is actually the hardest thing to measure about a partner or sponsor. There’s no formula, no numbers you can run. You simply have to talk to the person again and again and again until you feel 100% confident in them. And if you don’t feel that total confidence, pass on their investments until you do (or just move on).
The bottom line: It doesn’t matter how skilled or experienced an investor is if they take all your money and run off to the Caymans.
Partner experience
If someone says, “I’ve never lost money on a deal,” I immediately want to know how many deals they’ve done. It probably isn’t enough to make me confident in their experience.
Consider a case study of an investor we’ve partnered with on a few investments. He’s not a sponsor or public figure, he’s a private citizen, so I’ll call him Casey.
Casey flips 60 to 90 houses a year—some standard fast flips, some longer-term flips with lease-buyback deals. Additionally, the company keeps some long-term rental properties. Casey runs a team of 10 people, with some in-person and some virtual assistants.
With roughly 300 properties in the rearview mirror, suffice it to say that Casey knows what he’s doing. As his volume has grown, he’s expanded beyond his home city, but only within a few hours of it. He doesn’t hop all over the U.S. looking for the latest hot housing market. He sticks with what he knows and only expands cautiously.
Debt
Leverage adds risk. Hard stop.
Yes, I understand that leverage can increase your return on capital. We don’t avoid leverage—but we do want to keep it modest and manageable.
Casey’s company owns around 110 properties worth around $15.1 million. Those properties are collectively leveraged at 62.2%.
At one point, our Co-Investing Club signed a private note with Casey at 10% interest. He provided us with three protections, starting with a lien in first position against one of his free-and-clear properties. That lien was under 50% of the property value (under 50% LTV).
Personal and corporate guarantees
We don’t always get a personal guarantee from the principal. But it sure does make me feel better about the risk when we do.
The other two protections Casey gave us on that note was a personal guarantee and a corporate guarantee from his company that owns all the properties. If he defaulted, we could not only pursue all of those 110 properties and their millions in equity, but also his personal assets.
As you can probably guess, Casey has paid our monthly interest payments like clockwork.
Property management risk
I particularly love investments with no property management required at all. For example, the latest investment we made with Casey was a partnership for several flips. These are classic short-term flips, where Casey’s team simply renovates and sells the properties within a few months—no tenants, no leases, no rent default risk.
Likewise, we’re investing with a land flipper who buys large lots for 25 to 40 cents on the dollar, then subdivides and sells the smaller lots for a hefty premium. He further protects against downside risk by getting approval to subdivide before he buys.
That said, we do often invest in properties that require management. When we do, we look at how many properties the sponsor or partner has worked with together with the property manager before. We like to see partnerships going back years for many different properties.
Construction risk
I love the partnership with the land flipper because there’s no construction risk at all.
But with Casey, for example, there is rehab risk. So when renovation or construction is involved, we ask the same question: How many properties have you worked on with this contractor team?
“None” is a terrible answer. “Three dozen” is a much better one. And Casey’s been working with his team for years, flipping hundreds of houses.
Regulatory risk
Tenant-friendly states and cities keep passing more aggressive laws regulating residential rentals. And that risk has started spreading to the federal level, with presidential candidates talking about nationwide rent stabilization laws.
These risks apply to residential rental properties—and nothing else. It doesn’t apply to flipping houses, short-term vacation rentals, storage facilities, retail, industrial, or anything else. It certainly doesn’t apply to raw land, which is one reason I’m so stoked to partner with that land investor.
Key principal risk
The greatest risk to partnering with a small real estate investing company is that something happens to the key principal.
If Casey gets hit by a bus tomorrow, it would take a while for his estate and company to sort out the wreckage. I’m confident we’d get our money back, but it would still be a mess.
A 150-employee real estate syndication firm doesn’t come with that same risk. If one of the managing partners kicks the bucket, enough other people stand poised to take over.
How do you protect against key principal risk? You ask about the contingency plan if something happens to them. Who takes over? Are they qualified to do so? Do the assets go straight to probate for your estate, or do they go directly to a partner for disposition or continued management?
The risk of a healthy 40-year-old man like Casey croaking tomorrow is slim. I’m willing to accept that risk. But that doesn’t mean you should ignore it entirely.
Final Thoughts
Some months, our Co-Investing Club vets and invests in real estate syndications. Those have mostly gone well for us, giving us the benefits of ownership (passive income, appreciation, tax advantages) without the headaches of becoming a landlord. But increasingly, I find the risks lower with private partnerships, and the returns just as strong.
Every day, we learn about new passive real estate investments. We look at them through the lens of the risks above, and many more besides. But as I get closer to financial independence, I increasingly fixate on downside risk—without sacrificing returns.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
