Episode 21: How to Manage Risk in Real Estate

In this episode of the Nick Huber Show, we go into depth on how to manage risk when investing in real estate. When you first start investing, it’s important to keep in mind that there are levers both in and outside of your control. As soon as you learn how to manage these levers, that is when you will gain the most out of your real estate investments and have greater control over the risk you take on. 

When we talk about levers outside of your control, I’m referring to situations like when supplies are able to be delivered, interest rates when you refinance, who is going to buy my asset five years from now, etc.  I can’t control interest rates, I can’t control cap rates, and I can’t control what somebody else is willing to pay for my asset. When it comes to the positive side, what are the levers I can control? These are things such as operations, the deals we buy, how a deal is structured, and so on.  All I can do is try to minimize the effect of these levers on my investment opportunities while maximizing the effects of the levers that ARE under my control. 

To better display this, let’s use my portfolio as an example.

When trying to minimize what is outside of my control, I focus on lowering the chance these influences will hurt my investments.  A good example of this is the choice we have made to only invest in properties where we are buying in-place cash flow. This isn’t to say there is something wrong with development and adding value to a property as an investment strategy, but the reason we have chosen to do this is to lower the amount of debt risk we hold in the properties we have. 

Although it is true that reducing debt risk is also a reduction in leverage, this reduction in leverage also provides some sense of protection against unexpected downturns. To better explain this, if anyone were to raise the leverage of one of their investments to 80 % when times are good, this understandably amplifies the return, but when things go south, it also amplifies the potential hurt if it doesn’t go according to plan. In other words, it amplifies the gain but it amplifies the pain. This is something that many investors in real estate often don’t consider; they don’t account for the risk-adjusted rate of return.

In an example of investments in a development, raising leverage to 75% allows you the capability to improve the property but would equally cause you to raise rents to try and cover the cost of that large of a loan. At the end of the day if you have only gained a return of 15%; that’s awful when compared to the debt you incurred.  In contrast, if you were to buy a completely full storage facility at a lower leverage of 60%, but have the capacity of that facility filled and cash flowing, even if you were to have a projected 15% internal rate of return, that is much more manageable. Yes, it means you have come up with more equity to put down on the property, and that isn’t always easy, but you have a lower risk, making the net return better in the long run.

Because we subscribe to a lower risk debt strategy, our preference is to keep our debt yield (The percentage of our loan amount that is covered by our NOI) at above 9% in year one for every property we attain. This makes it possible for us to take a 7% interest rate with principal and interest payments on a 25 year amortization schedule. If you look at the deals that we bought our portfolio-wide, our yield is over 15%, meaning interest rates on all my self-storage should go up to about 13% principal and interest rates, and we’re about to break even on cash flow. I’m proud of that; so proud I created a free crash course to help you do the same.

Another thing we do to lower risk is we charge fees: an annual asset management fee, monthly building management fee, etc. These fees allow us to have our bases covered if we hit a downturn we can still make payroll even if we don’t have any deals in the pipeline and we can keep our team intact. Outside of survival, these fees also help us so we aren’t as dependent on any one particular sale. Like I explained in a previous episode, it allows us the flexibility to go into each investment structuring it in our best interest; we can hold the property for 10 years without having to sell and keep it cash flowing.

The last thing I’ll tell you is what I consider to be the golden rule in real estate investing. If you break this rule, it’s game over: Do not run out of cash! If you run out of cash or cash flow in this business, you can say goodbye to your hard work. The bank will take everything from you and leave you starting back at ground zero. So, while you may have heard the saying: “asset rich, cash poor” from a real estate investor, it’s a wiser principle to keep some cash on hand. In our company, we keep what some would consider an uncomfortable amount of cash in reserve over $2 million in liquidity. This is available to us in case we need it: we can cover debt service, we can jump on new deals, cover surprise expenses, etc. 

I won’t deny that this is a little bit easier said than done. It has taken a lot to get our company where it is today and in many ways, we have been very lucky in the self-storage market. Yes, we’ve had some tremendous tailwinds, but this isn’t to overlook the sweat it has taken to trudge through our Messy Middle and build a good system to help us find prime deals. But despite this, we have done everything in our power to reduce our risk in many areas of our investments to allow us to keep our eye on the long game and allow us the ability to be more in control of our investments. 

You can learn more about the specific strategies we use in our real estate investments that would help you build your portfolio.

Three Key Takeaways:

  1. When investing in real estate, all you can do is try to minimize the effect of these levers on your investment opportunities while maximizing the effects of the levers that ARE under your control.
  2. Many investors in real estate often don’t consider; they don’t account for the risk-adjusted rate of return.
  3. Keep in mind the Golden Rule of Investing in Real Estate: Don’t run out of cash!

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About Me

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.