Real Estate Investment Risks — And How to Protect Against Them

The Big Picture On The Risks of Real Estate Investment:

• • Real estate investments carry risks such as rising interest rates, increased expenses, market stagnation, and capital loss. Sponsors often face challenges from tightening credit markets and delays in distributions, which can impact cash flow and profitability.
  • Passive real estate investments mitigate some risks but require due diligence. Investors must vet the sponsor’s track record, loan terms, and expense forecasts while diversifying across multiple deals to reduce potential losses.
  • Managing risks includes careful analysis of rent trends and property valuations and maintaining a balanced portfolio. Spreading investments minimizes exposure to any single property’s downturn.

Spoiler alert: all investments come with risks and real estate investments are no different.

So, what are the risks of real estate syndications (passive group real estate investments)?

Remember the following as you consider your next passive investment in real estate.

Which Is Riskier: Active or Passive Real Estate Investments?

I would argue that real estate syndications come with lower risks than buying rental properties directly. Here’s my logic.

To begin with, active real estate investors need to develop all the skills required for real estate investing themselves. They need to learn how to find good deals on properties, such as driving for dollars or buying foreclosure homes. They need to learn how to negotiate with contractors, oversee their work, and keep them on schedule and within budget, which is to say nothing of pulling permits and hassling with inspectors.

Then, they need to learn how to secure investment property loans and financing, become landlords, assess market rents, market vacant units, screen tenants, sign lease agreements, and legally store security deposits. They must also collect rent, enforce their lease contracts, and go through the eviction process. The list goes on.

Passive investors don’t need to hassle with any of that. They outsource all those skills to a full-time professional real estate investor.

That doesn’t mean they absolve themselves of all responsibility, of course. They still need to review the deal and the sponsor’s track record to mitigate the risks outlined below.

But as a passive investor, you don’t need to become an expert yourself. You just need to hire the right expert.

Active vs. Passive Real Estate Investing

Here are the differences between active and passive real estate investing. Or should I say, additional factors should be considered when evaluating the risks and benefits of each approach.

Risks of Real Estate Syndications

Passive real estate investments still carry plenty of risk. At the “risk” of scaring you off of them completely, keep the following in mind as you vet syndication deals.

1. Rising Interest Rates

We’ve certainly seen plenty of this going around over the last few years. And it’s knocked out plenty of real estate syndications along the way.

Higher interest rates add real estate risk in several ways. First, many syndicators (AKA sponsors, operators, or general partners) borrow a floating rate loan when they buy the property. When interest rates rise, so too do their monthly payments. Sponsors can (and should!) buy interest rate caps to put a ceiling on their monthly payments, but not every sponsor had the foresight to do so before rates started rising.

Second, many commercial real estate loans have short terms, often three to five years. If interest rates are high when the loan expires, sponsors are left in a pickle: refinance at a high rate or sell in an unfavorable market.

Why an unfavorable market? Because higher interest rates typically cause higher cap rates.

2. Rising Cap Rates

Capitalization rates, or cap rates in real estate, represent how much a buyer is willing to pay for a certain amount of net income. You can think of it as the income yield that buyers will accept.

The cap rate formula looks like this:

The higher the cap rate, the less the buyer is willing to pay for the same income. Lower cap rates mean the buyer is willing to accept a lower yield and pays more for the same property.

Thus, higher cap rates are great for buyers but bad for sellers.

If cap rates rise, property owners can choose between selling now for a lower profit (or a loss) or waiting for better market conditions to sell. But if interest rates remain high and their loan term expires, owners may feel forced to sell in a bad market — potentially for a loss.

3. Stagnating Rents

Cap rates aren’t the only part of the equation that determines a property’s value. Rents also matter as buyers value commercial properties based on their net operating income.

But what happens if rental rates fail to rise? Or worse, fall?

Granted, rents rarely fall, even in recessions and real estate bubbles. But they can stagnate, as many real estate experts fear happening in 2024.

Stagnating rents don’t just mean steady but unimproved cash flow. They mean shrinking or even negative cash flow because expenses don’t dip. Costs like landlord insurance, property taxes, and labor all keep rising.

That not only makes the property unappealing to hold long-term but also makes it harder to sell. Lower net rental income reduces the value of the property, potentially making it unprofitable to either keep or sell.

(article continues below)

Real estate investments? Awesome.

Being a landlord? Less fun.

Learn how to earn 15%+ on passive real estate investments in our free video course.

4. High Vacancy Rates

The same logic applies to high vacancy rates: they reduce the net operating income. That lower cash flow again makes it ugly to hold and sell.

Fortunately, syndicators and property managers have more control over occupancy rates than market rents. They can offer lease incentives or improve the property to make it more attractive to renters.

But those come with costs, of course. No such thing as a free lunch and all that.

5. Sharply Higher Expenses

All sponsors forecast rising expenses with every year that goes by. But that doesn’t mean they always forecast the extent of those cost increases.

For example, in 2023, many sponsors reported enormous insurance premium hikes. Think 40–125% rate hikes in a single year. Woof.

Property management expenses, labor and maintenance costs, and property taxes can also rise faster than expected. These lower the net operating income, again pinching cash flow and reducing the property value. You know how that ends by now: sponsors have to choose between holding property with low or negative cash flow or selling at a loss.

6. Tightening Credit Markets

If banks and lenders tighten their lending standards, it can be difficult to refinance or sell even properties that cash flow well.

Imagine a deal with an approaching loan expiration date. The sponsor contacts dozens of lenders, but none of them agree to refinance because they simply don’t want to touch commercial real estate at that moment.

So, the sponsor lists the property for sale. But who can buy it without a loan? Perhaps a few well-heeled private equity groups or Wall Street firms—but they make lowball offers because they can.

Again, the syndicator cannot hold and sell the property for a profit.

7. Delayed Distributions

So what happens if the above real estate risks impact a property?

In the best-case scenario, distributions are delayed. Instead of starting in Year 1 (or whenever), they are pushed back to Year 2 or 3 or never.

You don’t collect the passive income that you thought would start arriving in your bank account. But it could be worse.

It could be a capital call.

8. Capital Call

If the general partner runs out of money to operate the property, they issue a capital call.

It falls to limited partners like you and me to bail out the sponsor, giving them more money. And hoping that we aren’t chasing good money after bad.

In the best-case scenario, the sponsor uses that money to right the ship, and the property starts cash flowing again. They ultimately sell the property for a profit, and everyone gets their money back plus some returns.

In the worst-case scenario, you lose both your initial investment and the money from the capital call. This is not pretty.

If you refuse to put up extra money in a capital call, the sponsor could take one of several actions. Most likely, they dilute your equity share. Other investors added money but didn’t, so your fractional property ownership diminishes. Alternatively, they could cover your portion of the capital call with an involuntary loan at unfavorable terms.

Want to compare investment property loans?

What do lenders charge for a rental property mortgage? What credit scores and down payments do they require?

How about fix-and-flip loans?

We compare the best purchase-rehab lenders and long-term landlord loans on LTV, interest rates, closing costs, income requirements and more.

9. Loss of Capital

As mentioned above, if a real estate syndication deal goes wrong, you could lose some or all of your investment capital.

While I don’t see it as a common occurrence, it does happen. I’ve said it before and’ll say it again: investments come with risk.

Other Real Estate Investment Risks to Consider

Wait, are there more? Although we’ve covered several key risks in real estate investments, there are a few more areas that every investor should be aware of. 

Core Real Estate Risks

Remember the 2008 financial crisis? Yeah, that wasn’t fun for anyone, especially real estate investors. It’s a stark reminder of how economic risks can blindside seasoned investors.

Market and economic risks are some of the biggest factors in real estate investing. Think about economic downturns, interest rate hikes, sudden drops in market demand, and so on. These factors can send property values plummeting faster than you can say “subprime mortgage.”

But here’s a risk that keeps many new investors up at night: negative cash flow. Let’s say you’ve bought a property, expecting it to rain money, only to find yourself writing checks instead of cashing them.

High vacancy rates, underestimating expenses, or mismanaging rent prices can all lead to this cash flow nightmare. Trust me, I’ve been there, and it’s not a fun place to be.

Property-Specific Risks

Ever heard the phrase “Don’t judge a book by its cover”? In real estate, you sometimes need to judge a property by what’s hiding behind its walls.

Structural defects can turn your real estate dream into a money pit nightmare. That charming fixer-upper might hide a crumbling foundation that could make you say goodbye to your profits. This is why thorough property inspections are worth it. Seriously, don’t skimp on these.

And let’s not forget about tenant issues. Problem tenants can sink a property’s performance even if you’re investing passively. I’m talking about people who treat rent due dates as optional or use your property as a testing ground for their demolition skills.

For that matter, a solid tenant screening process is essential, even if you’re not the one implementing it directly.

Investment Liquidity Issues

Here’s a fun fact: real estate isn’t like your favorite pair of shoes. You can’t just decide to sell it on a whim and expect to get top dollar. God, I wish it were that easy. 

Lack of liquidity is a major consideration in real estate investing. Unlike stocks that you can unload with a click, selling a property takes time, effort, and often, compromises on price – especially in a down market.

So, how do you deal with this? Experienced investors have their ways, but me, I’ve prepared for illiquid periods by maintaining healthy cash reserves. You can think of it like having an umbrella for a rainy day, except in this case, the rain might last for months or even years.

Another strategy is to leverage equity effectively. This doesn’t mean going all-in on debt but rather using it to maintain flexibility in your investments.

Managing these risks doesn’t mean you should run screaming from real estate investing. It’s about going in with your eyes wide open and a roadmap. Remember this: knowledge isn’t just power in real estate investing – it’s profit!

How to Mitigate Real Estate Investment Risks

Now that you’re thoroughly terrified, how do you avoid these nightmare scenarios from happening to you?

In a word, due diligence. Okay, that’s two words, but you get the idea.

First and foremost, look at the sponsor’s track record. How long have they been investing in real estate? What average return have they delivered for passive investors across all the deals they’ve completed? How long have they been raising capital as a sponsor? How many real estate market cycles have they lived through?

Then, review their underwriting assumptions. How conservative are they? What kind of rent growth and exit cap rate are they assuming? What kind of growth in expenses, such as property insurance, taxes, and property management costs? How much are they setting aside as a cash reserve?

Pay close attention to the loan terms. How long is the loan term? At what interest rate? Is it fixed or floating? Did the sponsor buy an interest rate cap? Ideally, you want a longer-term loan at a relatively low fixed interest rate. The shorter the loan term, the greater the risk of the sponsor being forced to refinance or sell in a bad market.

Most of all, you reduce your risk by spreading your money among many deals rather than concentrating it on a few. In our Co-Investing Club, members can invest $5,000 in each deal, instead of $50,000–$100,000. The results will look like a bell curve: some will underperform, some will overperform, and most will perform roughly as forecast.

Diversify by spreading smaller amounts of money across more deals, and sleep easier at night.

We actually teach a class on how to spot low-risk real estate investments. Check it out to learn how to gauge the risk of passive investments quickly.

Final Thoughts on Reducing the Risks of Investing in Real Estate

You may have opinions on passive versus active real estate investing and the risks associated with each type of investment. I’m not here to argue.

If you’re an expert real estate investor, then by all means, invest actively. You probably feel more comfortable controlling all the risks yourself rather than outsourcing control to someone else.

But for busy professionals working full-time jobs who don’t have much real estate experience, you’re better off outsourcing asset management to a professional investor.

You still need to vet the general partner about the deal. But once you wire your money, you don’t need to worry about the day-to-day execution. That removes the labor and the stress of wondering how to handle challenges as they arise. Let someone else manage the emergencies. You have enough on your plate already.♦

How do you manage risk in your real estate investment portfolio? What role do passive real estate syndications play in your investment strategy?

More Real Estate Investing Reads: