3 Additional Mistakes Passive investors Make When Investing In Real Estate

Recently, we released an article covering three common mistakes we see passive investors/LPs committing as they invest in real estate. Building on that foundation, we want to dive deep into 3 more mistakes we see investors committing when judging investment opportunities.

Not Scrutinizing Debt and Leverage

More leverage (debt) in real estate investment equates to more risk because it increases the potential for financial losses if the investment does not perform as expected. Leverage refers to using borrowed funds to finance an investment.

While leverage can amplify returns in a strong market, it also increases the potential for losses in a weak market. For example, if an investor uses a significant amount of leverage to purchase a property and the property value declines, the investor may not be able to sell the property for enough to cover the outstanding loan balance, resulting in a financial loss.

Additionally, leverage also increases the investor's interest expenses, which can impact the property's cash flow and overall profitability. This can be especially risky in a market where interest rates are high or rising, as it can significantly increase the investor's financing costs.

On an unstabilized (value-add) asset, it is difficult to get a permanent loan (fixed rate – 10 years, etc.). Most lenders will want to do a transitional or construction loan that might mature in 18 months to 36 months. These shorter-term loans carry more risk because the sponsor does not have as much time to execute the business plan, or flexibility when it comes time to pay back the loan.

Additionally, it is important to pay attention to the amount of leverage used in an investment opportunity. An investment where the sponsor is borrowing at 50% LTV with a fixed rate will generally have a lower return than an investment borrowing at 80% LTV with a floating rate – all else being equal. However, the two investments carry far different risk profiles. And an LP will need to factor this into their assessment of an investment opportunity. An LP may be looking at a renovation opportunity with very high leverage and floating rate debt with great returns, but in this case, the sponsor that misses on their assumptions would see a drastic negative effect on the overall returns and LPs could be asked to contribute additional capital if the sponsor is not able to refinance the entire outstanding loan balance when the acquisition loan hits its maturity date.

Ignoring Fees and Sponsorship Alignment of Interests:

It is important for LPs to evaluate all the fees associated with a private equity real estate investment before committing capital. Fees are essential for a sponsor to run their platform, cover their overhead, pay their team, and maintain key employees. It is important that some fees be incorporated into the deal. That being said, management fees, incentive fees, and other fees can have a significant impact on returns, so it's essential to understand how the fees are structured and how they will impact returns. We have another blog dedicated entirely to the topic of fees here if you would like to learn more.

LPs need to consider the sponsorship’s alignment of interests. This is typically done with a sponsor co-investment of their own capital. Co-investment is important, but we would argue it is equally or even more important to scrutinize the dollar amount in fees the sponsor will collect regardless of the investment’s success. If the acquisition fees, asset management fees, debt placement fees, etc are large enough that the sponsor will make significant money regardless of the success of an investment, then this is an issue with incentives. Sponsors with high guaranteed fees will be incentivized to push deals that should not have been pursued. All things being equal, you want your sponsors to be making most of their money on the incentive fee (aka promote) and their investment into the project, so their compensation is reliant on the success of the investment. We have a blog available on incentive fees (aka promote) and we dive deep into incentive fees in our Real Estate Investor Guidebook for Passive Investors.

Failing To Align Passive Investments With Their Individual Investment Goals

In a similar breath to the above section, another common mistake that real estate investors make is failing to align their passive real estate investments with their individual investment goals. This can come into play when considering properties that cashflow more throughout the life of the hold period vs properties that generate more return on the exit through capital gains, and different strategies will call for different hold period length in order to maximize the opportunity given the business plan.

For example, an investor who is nearing retirement may prioritize steady, passive cash flow over potential capital gains on exit. On the other hand, a younger investor with a longer investment horizon may prioritize finding investments with high potential for appreciation, with a shorter hold period and a majority of the return contrived from the exit. In either case, it is important for the investor to align their investment goals with their individual financial situation and overall investment strategy.

Another factor to consider is risk tolerance. Some investors may be more comfortable with lower-risk, lower-reward investments that generate steady cash flow, while others may be willing to take on more risk in exchange for higher potential returns. Again, it is important for the investor to understand their individual risk tolerance and align their investment decisions accordingly.

Ultimately, the key to success in real estate investing is to have a clear understanding of your individual investment goals and to make investment decisions based on those goals. By taking a strategic approach and carefully evaluating the potential risks and rewards of each investment opportunity, investors can build a real estate portfolio that is aligned with their individual investment goals and delivers long-term success.

Dive Deeper

To learn more about investing passively in real estate, please download our Real Estate Investor Guidebook for Passive Investors by clicking here: Guidebook Download.

About Breneman Capital

Breneman Capital is a private real estate investment management firm specializing in the multifamily property sector.  Breneman Capital employs a deliberate investment approach, leveraging data analytics and proprietary technology to generate superior risk-adjusted returns for investors.

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