As a real estate investor, you probably like that housing investments have less volatility than stocks.
Measurements of standard deviation, which is used to measure volatility, show real estate investments don’t swing too far from average values over time. For instance, multi-family investments have had a standard deviation of 7.75% over the last 90 years. The stock market has experienced much wider swings, with a standard deviation of 19.7%.
That means success in the stock market depends much more on timing, as values fluctuate much more wildly. The volatility of the stock market leaves you susceptible to buying at a value that’s too high.
Such data may have investors thinking they don’t have to worry about asset risk with their real estate investments. The market will steadily trend upwards and they’ll enjoy consistent, solid returns.
Don’t get caught sleeping!
While all investment options carry risk and volatility, real estate has less. That’s because it’s backed by a hard asset. However, less risk doesn’t mean you can forge ahead with your eyes closed.
While it’s true that real estate carries less risk than other asset classes, you can run into trouble if you don’t deal with those risks well. If you want to have success in real estate, you must understand asset risks that could affect your investments.
A successful real estate investor will carefully measure those risks associated with every deal. Then, they’ll mitigate that risk as much as possible.
In this article, we’ll detail how to properly handle asset risk in real estate investments. This way, you can take the actions that will deliver you maximum ROI.
Want to learn more about real estate risk management? Check out our other articles in our series on Risk.
Get good deal flow
You need to find deals to get them. That begins with having methods to source meaningful deal flow.
First, pay attention. Prepare your team by setting responsibilities and expectations. How many deals do you want to review per day and per month?
Second, get deals from multiple sources, including sources for off-market deals. Establish strategic relationships that enable you to procure deals your competition can’t.
For example, you could build a network that includes small community banks, title companies, real estate agents, and mortgage brokers. This can provide access to off-market deals, enable you to analyze deals even before they hit the market, and give you inside knowledge on properties facing foreclosure.
Third, identify a way you can create a competitive edge. On top of having the right team and multiple sources for deals, you must analyze the leading real estate investors in your area. See where they’re spending their marketing money and examine how they structure deals. What sets them apart from other buyers? How can you make better offers than them?
To get the best deals, you also have to go the extra mile. In addition to networking with industry professionals, do some grassroots marketing. Get active on social media, build an email list, leverage the power of your network, and stay engaged on real estate websites. You never know where a good deal will come from, so keep your eyes and ears open. Put yourself out there and sellers may come to you directly when they want to sell.
When you have a good deal flow, you reduce asset risk by ensuring you have the best investment opportunities arriving at your desk.
Analyze deals and value investments conservatively
The Seattle real estate market has some lessons to teach about asset risk and why investors shouldn’t get caught up in the market.
During the recovery, bidding wars happened during the vast majority of home sales in Seattle. Bidding wars peaked in 2017-early 2018 (at nearly 92% of sales), before declining dramatically in late 2018-2019.
When the bidding hysteria slowed down, the market slowly cooled. Seattle real estate prices dipped by about 1.2% in 2019.
Many real estate investors that bought during the bidding war frenzy undoubtedly paid higher prices. Unfortunately, they may have taken on too much asset risk by paying more. They now may have an asset that’s worth less than what they paid for it.
The lesson is this: first and foremost, don’t overpay on your investments. When it comes to asset risk management, you make money when you buy value. Furthermore, to minimize asset risk, you not only have to ensure accurate bids, but you must also think through all your costs. This necessitates you do comprehensive due diligence and not get swept up in market sentiment.
When analyzing a property, examine market conditions and the price of the property. Is it above or below market value? Analyze property risk, such as construction issues, as well as cash flow estimates. How much income will the property generate per month? If monthly revenue doesn’t equal 1% or more of your total investment, or if annual returns don’t yield you 10%, the property may not be worth it.
“When you perform due diligence, use conservative estimates, not “pie in the sky” best-case scenario estimates. Think through all of the costs associated with the acquisition, re-position, holding, and disposition of your investment. Also, make sure the title is free of any issues, such as past-due taxes or other liens. You must resolve title issues to obtain a clear title as a buyer,” states Nathan Trunfio, President of Direct Lending Partners, a provider of private loans for real estate investors.
Trunfio makes a great point about title issues. As a report published in the Washington Post notes, roughly one-third of real estate transactions involve lots of work to address title issues. Don’t overlook this asset risk.
Another asset risk to consider is the probability you can get the total returns you want. If you plan to sell, make sure there’s a profit after all expenses. If you plan to rent the property, be cognizant of cash flow compared to the loan and/or cash investment.
“During the underwriting process, dial in contractor renovation costs and other carrying costs. Think through the total investment, and all the money you will spend, and prove that a profitable return is possible. Don’t guess, or skip part of the deal analysis and due diligence.” says Trunfio.
Have a capital plan
To properly manage asset risks, you must understand all the financial metrics of your deal. Know how much money you’ll put into the investment and how much you’ll make.
You also must find a reliable lender. After all, you not only need to get pre-approved, know your leverage options, and how your loans can be structured, but you also need to be able to close deals promptly. Moreover, you need to plan for the exact amount of money needed. A reliable lender can help with that.
For example, at Direct Lending Partners, we know that one of the biggest reasons deals fail is because they’re undercapitalized. That’s why we make sure you have the funds for all phases of investment, from acquisition to re-position to sale.
“When managing asset risk, pay attention to often-forgotten items, such as the amount of cash needed at closing and your holding costs and debt or loan payments, and more. This puts you in a position to plan better and get better returns on your investment,” attests Trunfio.
Real estate investors also shouldn’t put all their eggs in one basket. Doing so concentrates asset risks in one property or area, and external market conditions could damage your investment.
Don’t spend all your money on the acquisition, either. If you sink everything into one deal, you leave yourself vulnerable to asset risks, as you won’t have the funds available to navigate and solve those issues that come your way.
So, in addition to cash for closing, calculate these other costs to reduce your asset risk:
- Money needed for renovations
- Holding costs, such as taxes, insurance, and HOA fees
- Reserve funds for unexpected expenses
Effective asset risk management: the key to successful real estate investing
Your success depends on solid real estate risk management, especially managing asset risk. You need to focus on good deal flow, buying value, analyzing all costs, and having a capital plan. This will enable you to reduce asset risk and enter deals that can deliver the returns you seek.
If you can implement the right process, you stand to gain over time. Success in one venture can lead to success on the next. And you’ll have the momentum to build a diversified, strong portfolio of properties.
To make that happen, don’t forget about having a capital plan (an important component of proper asset risk management). Look for a reliable capital partner that can meet your cash needs and allow you to close deals efficiently. At Direct Lending Partners, we’re ready to do that and help you meet your real estate investment goals.