Six Types of Risks To Evaluate When Investing In Someone’s Real Estate Deal

Real Estate Investing 101
Yannik Cudjoe-Virgil

Modern advancement by way of the internet has made the ability to invest in many different asset classes in real estate relatively easy through structures like crowdfunding. If you’re new to real estate, it can be easy to get enticed by attractively angled pictures of buildings, catchy videos and attractive projected returns for you to invest in; However, to ensure your likelihood of achieving investment success, it’s imperative that you clearly understand the fundamental elements of real estate.

In this era of technology, anyone with a phone or a computer can make the worst deal look extremely compelling. Oftentimes, there are risks to investing, but understanding the risks vs. returns lies in your ability to holistically analyze a real estate opportunity and protect your hard-earned capital from the risk of loss. With this in mind, here are six types of risks you should look out for when evaluating someone else’s real estate opportunity:

1) Sponsor Risk – Do you really know who you’re investing with? This is the most crucial risk you can take when investing in someone else’s deal. Do you know their experience? Do they have any experience in this asset class and a track record? If they don’t, then I would take caution with making an investment of your dollars into their deal. Are they a peacetime general, or a war time general? A person’s character tends to reveal themselves when problems arise and the ship starts to sink. A good sponsor has good morals, expertise and experience in their particular asset class. They also have a fantastic team to ensure their probability for success. The jockey is more important than the horse.

2) Business plan risk – What is the investment strategy? Does the market demand this particular product? Does the sponsor have empirical evidence in the market to support their going-in proforma or are they just speculating? Are their assumptions too aggressive and unrealistic? This is an opportunity to understand the vision of the operator and question their business acumen. The right real estate investment has conservative numbers in the proforma and enough data to support the investment thesis. 

3) Financial risk – How is the investment structured? Does the operator have enough skin in the game (do not overlook this)? How long will your investment be at risk? Does the return reflect the amount of risk taken? Is the project highly leveraged with debt to boost returns? Is there interest rate risk? Debt is the biggest killer of real estate deals and often overlooked. Evaluating the financial risk of a deal is crucial to hedging your risk and making sure your risk tolerance is aligned with both the investment strategy and return expectations. 

4) Asset risk – What property type are you investing in? Is there user and investor demand for the asset in the marketplace? Investing in a Class C apartment building may have a high demand for affordability by workforce renters, but may be an older building in need of repairs. Does the operator have value-add experience to handle this asset? Will the property be attractive for sale? This goes hand-in-hand with business plan risk – as it reflects on the overall investment thesis. Be Careful of investing in Class D assets.

5) Market Risk – The market risk can be categorized as the fundamentals that contribute to the health of a local economy. A market can be one city like Baltimore, MD or it can be an MSA (Metropolitan Statistical Area) like Baltimore-Columbia-Towson which comprises a larger geography. Generally, exceptional real estate markets tend to have high job growth, population growth and wage growth – leading to positive economic market growth holistically. This helps us understand which markets are ripe for investment with a higher probability of achieving high returns. If you are investing in a stagnant market, chances are it will reflect in your real estate values and returns. 

6) Location Risk – This is different from Market risk in that this refers to the actual location of the property. Is the area developing or has there been no investment made in the area? What about crime rates in the area? What makes the area so compelling to make this investment worthwhile? Is the property well-located to generate the projected income? Real estate is all about location, location, location and this has a direct impact on your investment. These areas are defined as Class A, B, C & D, from best to worst areas respectively. The closer you are to the best, the likelihood that the area is more desirable. 

These risk factors are basic fundamentals that one should consider when evaluating real estate investment opportunities from sponsors. There are other factors that should also be taken into consideration such as investment time spans and potential tax implications - just to name a few. Investing in real estate can appear exciting and “sexy” at a glance, but building a strong foundation is essential to protecting your investment capital and focusing on your investment goals and what makes sense financially. 

Photo by: Makyzz