Ep 91: How to manage real estate risk

Real estate, even more than other businesses, is about risk management. There are a lot of things that can impact your risk profile, but everything falls into two categories: levers outside of your control and levers inside your control.

Levers outside of your control include interest rates when you refinance, interest rates for buyers down the road, and what somebody else will pay for your property. When you underwrite a deal, it’s best to minimize the things outside of your control that you need to go right. If the deal only makes sense if you can refinance in two years at a lower rate, there’s a lot of risk involved in making that assumption. When I think about what makes a great deal, I focus on placing bets on the things that I can control like operations, deal selection, and deal structure.

A ton of my focus right now is on minimizing risk in my deals, but it’s easier said than done. We’ve gotten lucky and found an industry with tons of tailwinds at the right time, but we also run a good business. It’s not achievable for everybody in every asset class, but it can be a huge advantage if you do it well.

The first component of our risk management is buying cash-flowing properties, rather than making speculative bets on asset appreciation. I want our debt year (Net Operating Income divided by Debt) to be at least 9% in the first year for every deal we buy. This means interest rates can raise to 7% and we’d still be breaking even on the property, and I don’t have to bet on projected cash flows. Portfolio-wide we could even break even at 13% interest rates, which I’m really proud of.

We also charge fair fees in our private equity arm, we’re not tied up in a low-fee approach. We charge asset management fees and operation fees which keep our business healthy even when acquisitions are hard to come by. With market-rate fees, we can keep the lights on even if deal movement is slow.

Our deals aren’t dependent on a sale. We underwrite for sale because we have to, but our base case assumes that we hold the property for 10 years without selling. Again, this is limiting our reliance on factors that are outside of our control.

We’ve reduced our total leverage too. In fact, we’ve lowered our leverage from 75% to 60% on most new deals. The higher your leverage, the more amplified your gains or losses will be, so reducing leverage protects the downside. If you conservatively value our portfolio at a 5.75 cap, we’re <40% levered overall, which is something I really like.

Finally, we abide by the one golden rule of real estate: do not run out of cash. If you run out of cash, it’s game over, and the bank will take everything from you. Real estate investors are often referred to as asset-rich but cash-poor, but you still want to have some cash on hand. We keep over $2M in liquidity that we can access whenever we need it, and that keeps us in line with that golden rule.

Not every real estate investor can follow all of these rules. It’s hard work, but it helps us keep our business in line through both high and low periods.

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I started the Sweaty Startup in December of 2018 because I believe the Shark Tank and Tech Crunch culture is ruining the real spirit of low-risk entrepreneurship.