You’re undoubtedly wondering what the answer to this question is. I was, too.
As a due diligence partner for over 800 investors, we think about risks all the time. Since our default is to say no, we probably think about risks more than most people do.
In The Road Less Stupid, author Keith Cunningham says (I’m paraphrasing):
- Rookie investors: “How much can I make?”
- Seasoned investors: “How much can I lose?”
- Professional investors: “Can I afford to lose that much?
We believe the best investors think about risk more than return.
Anyway, our due diligence team is constantly assessing risks. We have a 28-point checklist we use to screen operators and deals. And all the actions on that list are attempting to uncover risks—and trying to find reasons to say no.
So, what is your No. 1 risk as a passive real estate investor? Is it:
- Risky levels and structure of debt?
- Lack of sponsor skin in the game?
- Lack of track record in this asset type?
- Lack of a capable team?
These are huge risks—and you should analyze every one of them. I’ve heard each of these convincingly argued as the No. 1 risk in real estate investing.
But there’s a worse one. Is it:
Yes, these are massive risks. But I don’t believe these are the worst risks.
I think your most significant risk is likely this one:
FRAUD!
Why?
Because many of your investments will be into great assets, and many of the operators have decent experience, a respectable track record, and a talented team.
And much of the debt will be safe, while many of the operators will put skin in the game.
Many assets will be in stellar locations. Operators will keep cash in reserve. And property managers will manage well.
If this is all true—and it is usually at least partially true—your deal is destined to pay you both the return of principal (top priority) plus a return on principal.
So why do so many deals fail to do that? Fraud.
And sometimes,…