Passive Real Estate Investments Can Be Risky—These are the Red and Green Flags to Look For

Green Flags

Now that you know what not to invest in, what are some indications of a lower- or moderate-risk passive investment?

A deep track record in the market

I love to invest with sponsors who know their local market and their asset class inside and out, backward and forward. 

Several times now, our co-investing club has invested with a sponsor who specializes in Class B value-add multifamily properties in Cleveland. They specifically target buildings servicing cops, teachers, firefighters, and the like. They’ve done dozens of similar deals, all in the same city, where the principal has lived his entire life. 

Deep experience with the same management teams

That sponsor I was just talking about? All their deals are managed by the same in-house property management and construction teams. 

Long-term protected debt

I couldn’t tell you whether it will be a good market for selling in three years from now. But at some point in the next 10 years, there will almost certainly be a good market for selling. 

Look for longer-term debt, which offers the operator plenty of runway to sell when the market is right—not when their short-term debt expires. And, of course, look for some kind of rate protection if they’re using a floating rate loan.

Truly conservative projections

The market shouldn’t have to improve for a deal to deliver on its projected returns. Look for deals where the projected exit cap rate is equal or preferably higher than today’s local cap rates for that type of property. Likewise, look for slow projected rent hike rates (after the initial bump from renovated units, if applicable). 

Experience through several market cycles

You can read about the 2008 housing crisis and Great Recession in as many online articles as you want, but unless you lived through it as a real estate investor, you won’t truly appreciate what a catastrophic market downturn looks and feels like. 

Operators who have invested through several market cycles will protect themselves from future downturns in a way that newer investors just don’t think to do. Knowing the risks firsthand gives you a greater respect and appreciation for how things can and will go wrong in unexpected ways. 

No online courses or textbooks can convey that feeling of losing hundreds of thousands of dollars. As someone who’s been there myself, I want to invest with operators who have also learned those hard lessons firsthand. 

Diversifying Creates a Bell Curve of Returns

Even when you check for these and other red flags, all investments come with some risk. You can optimize your odds of success by screening out higher-risk investments, like we do. But if you want a sure thing, buy Treasury bonds for a 4% return. 

When you invest in enough passive real estate investments, the returns form a bell curve. For example, I invest $5,000 at a time in 12 to 16 passive investments each year. I have about 40 passive investments outstanding currently. A few will inevitably underperform, while a few others will overperform. Most will deliver somewhere in the middle of the bell curve, typically in the mid-to-high teens. 

Over the long term, these investments average out to deliver strong returns. I put the law of averages to work in my favor. 

You don’t want to get stuck investing $50,000 to $100,000 in one or two deals a year, and having that one deal go sideways on you. That’s a recipe for lying awake at 3 a.m., chewing your fingernails. 

With one or two real estate investments a year, your returns don’t form a bell curve. You get individual data points that could end up anywhere along the curve. 

I learned long ago that I can’t predict the next hot market or asset class. So I no longer try to get clever—I just keep investing month after month, in strong economies and weak, bull markets and bears, and sleep easy knowing that the numbers on the page will average out in my favor over the long run.