The Extra Downside Protection I Look For in Investments

The last two years have felt like a slow-motion car crash in commercial real estate.

That goes for office space, of course, but it also goes for multifamily and other commercial property classes. Look no further than this piece by BiggerPockets if you need a refresher. Two regional banks went under because of the industry’s woes in 2023.

But even in one of the worst stretches for commercial real estate on record, many operators and passive investors have continued earning solid returns. Since 2022, I’ve invested in nearly 30 passive real estate deals as one more member of SparkRental’s Co-Investing Club. Of those, only one has imploded and resulted in a loss—and it was one of the first deals we invested in as a club.

One advantage to getting together with a group of other passive investors every month to vet deals is that you get better at doing it and quickly. This year, I’ve shifted how I think about risk.

As you continue (or start) investing passively in real estate, consider this framework for looking at risk.

Why Standard Vetting Isn’t Enough

I used to approach vetting from a classic sponsor- and deal analysis perspective: Get references, look at track records, look at competitive advantages and expertise, run the numbers on the specific deal, etc.

We still do all that, of course. Check out this article on the nine passive investing risks that we check first when we look at sponsors and their deals.

Those will help you immediately eliminate most bad operators and deals. That one deal I mentioned that completely fell apart? We would have dodged it with a closer look at the risks outlined in that article. Of course, that was 20-some deals ago, and we’ve all learned a lot since then.

Even so, two of the sponsors behind that deal were big-name sponsors—one enormously so. Both enjoyed sterling reputations at the time. Everyone we talked to about them gushed about how great they were. They had sparkling track records to show off to potential investors.

I have certainly learned that reputations and track records only take you so far when you’re vetting operators. On top of more thorough vetting, I now also want to see something extra.

“Something Extra” Downside Risk Protection

I’ve increasingly come to share Warren Buffett’s view that the only rule that matters in investing is never to lose your principal.

Every time I look at private partnerships, private notes, syndications, or some other type of passive real estate investment, my first question is, “Does it offer any special downside protection?” Is there some extra barrier in place between me and losing money?

Put another way, what would have to happen for my investment to lose money—and how confident am I that such a scenario is vanishingly unlikely?

There’s no such thing as a completely risk-free investment (and anyone who says otherwise is selling something). Aliens could invade Earth tomorrow and disrupt every investment on the planet. But you can look for extra protections that create extremely low odds of lost principal.

Examples of Downside Risk Protection We Like

So, what do these extra protections look like for different types of passive investments? Here are a few case studies.

Private note case study

I’ve mentioned them before, but there’s a boutique house-flipping company that our Co-Investing Club has invested with several times now and really likes.

First and foremost, they check all the typical boxes. They’ve done over 300 flips and currently do 70 to 90 a year. They also currently own over $15 million in rental properties, with over $6 million in equity. You can’t do that kind of volume without getting all the common mistakes out of your system.

That doesn’t mean every deal turns a profit. Again, at that volume, you’ll have the occasional dud, but their win rate is in the 93% to 95% range each year.

Because they must move fast on buying deals and need so much flexible capital, they offer private notes paying 10% fixed interest. Investors can terminate the note at any time with six months’ notice.

These notes normally come with two strong downside risk protections. First, the company—which again has over $6 million in equity in its rental portfolio—signs a corporate guarantee. Second, the owner himself signs a personal guarantee as a multimillionaire pledging his personal assets.

That’s pretty unusual in itself and great downside risk protection. But to get even better protection, our investment club negotiated with him to secure our note with a sub-50% LTV lien against one of his free-and-clear properties. If something catastrophic happens, we can foreclose to recover our money.

See why I feel so secure in that investment?

Private partnership case study

We’re preparing to invest shortly with another boutique investment company based in Texas.

This company builds spec homes, a perfectly profitable business model on its own. They take it a step further, specializing in buying dilapidated homes on large lots, tearing them down, subdividing the lot into two or three normal-sized lots, and then building new single-family homes on each of them.

As you can see, they create value not just by building new homes but also by subdividing valuable lots. They only work in a small geographic area where they’ve established relationships with local municipalities. Their lot subdivisions get rubber-stamped at this point because the municipalities know them, trust them, and like that, they’re creating more housing supply (and property tax revenue).

To fund their investments, they form private partnerships with passive investors like you and me. At a project level, they typically earn 40% to 70% returns, and their passive partners typically earn 15% to 25% returns.

Even so, they have the occasional miss—every investor does. So, they protect their investors against lost principal by guaranteeing a floor return of 5% on each project. If one of them fails to earn at least 5% annualized returns, they come out of pocket to preserve the relationship.

The guarantee is backed by their own portfolio of long-term rentals, again providing a backstop against losses.

Syndication case study

When I go on the BiggerPockets forums, all too often I see comments like, “Real estate syndications are too risky.”

That’s like saying “all stocks are too risky” or “all bonds are too risky.” Some stocks are risky. Some bonds are risky. But there’s a huge difference between investing in, say, a U.S. Treasury bond versus a junk bond.

When we look at syndications, we look for asymmetric returns: high probable returns with low-to-medium risk probability.

A few months ago, our Co-Investing Club invested with a sponsor who has done 135 deals over the last 17 years. That’s incredible longevity and shows they’ve invested through many market cycles.

This particular deal came with that “something extra” we look for in downside risk protection. Sure, the sponsor scored a bargain price on a multifamily property with deferred maintenance, and they plan on forcing equity through renovations. Value-add syndications are all well and good, but the real protection here goes beyond the discount price and “conservative underwriting” that every sponsor claims.

This sponsor created instant equity in the property within the first 24 hours of ownership. How? Before buying, they partnered with the local municipality to designate half the units for affordable housing in exchange for a 50% property tax exemption. The tax savings pay for the lost rental income many times over, making the net operating income jump before the sponsor swings a single hammer.

The affordable housing units also enjoy not just 100% occupancy but a waiting list because they charge under-market rents. In the event of a recession, these units are protected against vacancy and high turnover rates.

See? Something extra.

Equity fund case study

This month, our Co-Investing Club is investing in a small land-flipping fund. The investor buys mid-price parcels of land for 35 to 60 cents on the dollar. That alone provides plenty of instant equity for downside protection. But then he adds even more equity by doing a “minor subdivision”—splitting the parcel into five or fewer lots. He may make a minor improvement, such as creating a dirt-access road so each lot has road access.

This investor buys an average of 50 parcels a year and resells them within 4.2 months on average. He earns shockingly high net returns in the mid-double digits since he started.

Best of all, there’s no construction risk, property management risk, risk of tenant property damage or defaults, or risk of tenant lawsuits. There’s no debt risk because the investor funds these deals with cash raised from the fund. There’s no regulatory risk of eviction moratoriums or tenant-friendly laws.

It’s just raw land.

Oh, and there’s no zoning or permit risk, either. The investor only works in jurisdictions where zoning approval is not required for minor subdivisions of five lots or fewer.

Sure, he could theoretically miscalculate on a parcel and end up reselling for a lower sales price than he planned. Good thing he’ll do 49 other deals this year.

The fund has paid 16% annualized distributions each quarter like clockwork since inception. It’s a lean, moneymaking machine that has few moving parts to break.

Debt fund case study

As a final example, I’ll give a shout-out to Chris Seveney of 7e Investments.

Chris operates a debt fund that buys non-performing mortgage loans at a steep discount. He and his team then work closely with the borrowers to get them caught up on payments, whether that means a payment plan, loan modification, or some other custom approach based on the borrower’s needs. They then resell the now-performing loans to a more traditional mortgage servicer—for much closer to the full loan amount.

So, what’s the extra downside risk protection?

The average loan that 7e acquires is around $195,000. The average property value is around $500,000. In the worst-case scenario, 7e forecloses to recover its capital.

To his credit, Chris prides himself on an extremely low foreclosure rate (under 10%). That’s incredible, given that every single loan is distressed when 7e first buys it.

Final Thoughts

Asymmetric returns exist in passive real estate investing. Once you accept and embrace that, your entire investing strategy shifts to finding them. Or rather, I consider it my job, as I look to constantly network to find hidden gem operators to invite to speak at our Co-Investing Club. And at this point, we always look for that “something extra” in downside risk protection.

I’ve lost money on real estate before. I have no intention of losing another cent on my real estate investments moving forward.

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