main owner, Equity Equity Partners, LLC. Real estate investment sponsor, developer, syndicator, operator, advisor and coach.
If you are just starting out in real estate investing, don’t be tempted by a sexy looking building or great expected returns. To ensure a higher conversion rate, you need to understand the basic elements of the offering and then decide if it is right for your investment tolerance.
Real estate investing continues to gain popularity among the masses through crowdfunding sites and private offerings offered directly by sponsors executing individual projects they wish to fund. If you’re just starting out, or have a little experience, I hope to help you on your way to success.
Any form of investing requires that you, as an investor, understand the risks versus the rewards, and real estate is no different. When evaluating a real estate offering, here are some of the key risks to consider before committing your hard-earned dollars.
1. Operator Risk: Who do you invest in? What is the track record of this person or team? A lack of experience in an operator is a primary factor to consider. If that operator has not worked within the asset class it is proposing, the market it is entering or the size of the asset, proceed with caution. A smart operator will surround himself with a team of people who will support their resume where they are weak.
2. Market Risk: Market risk is different from location risk. Market risk is the area of the investment, which may be referred to as a metropolitan statistical area (MSA). This division divides the area and can be more easily classified into not just a major city, but the entire area around it. For example, where I currently live is the Boston, Cambridge, Newton MSA, which spans southern New Hampshire all the way to Cape Cod. The statistics of each MSA help us evaluate and determine what is going on in a general part of the country. The items of interest for real estate investments are centered around job growth, population growth and family formation. If your real estate investment market isn’t growing, expect your returns to do the same. So, where is the investment you are 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 a suburb? Is it a new development area or is the area gentrifying? How are the crime rates? Most people know that real estate is about location, location, location. So where is the asset located and what is happening in the environment to make it a good investment? Areas can be labeled 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 is defined as grade A, B, C, or D. Like your school grades, the rating makes it easy to understand a building’s age and condition. If you are investing in Class B real estate in a Class C location, you may want to proceed with caution. If the building is older and in need of a lot of repair work, does the operator have the experience to properly estimate, budget and execute the value-added renovations needed to execute their business plan? This touches on the strategy risk, which we will examine in a moment.
5. Financial Risk: What are the terms of the investment? How much are you going to invest, for how long and at what return? The return should always be proportionate to the 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 isn’t much risk there. Based on those factors, with reduced risks, comes a lower return as well. If you want more risk, you can find the opportunity to buy the C-class building in a fringe area of the C-class and be the catalyst of change that will start the move to upgrade the area. There is much more risk in that, so the return should be higher. This is where you start to feel your sense and evaluate the level of risk you personally want for your dollars.
6. Strategy Risk: What is the operator’s strategy? Are they tackling attraction and amenity packages? Are they going to improve the interiors of units and then increase the rents? What evidence is there in the market to support those increases? Are you comparing apples to apples in the market? You can get very detailed in understanding the operator’s strategy. This is where the rubber usually meets the road. The right real estate with the wrong strategy can yield a flat return on investment, which is not the goal.
These risk categories are not the only ones to consider, as there are certainly other risk factors to consider, such as tax implications, investment terms and diversification priorities. Getting involved in real estate investing can be exciting and rewarding, but make sure you understand who and what you’re starting with before you get started to achieve your individual goals. In real estate investing, just like in life, sometimes a sexy opportunity just sits deep in the skin.
Pyjama People Real Estate Council is an invite-only community for real estate executives. Am I eligible?