Passive Investing: The Number One Risk You Need to Know About

Passive Investing: The Number One Risk You Need to Know About
Are you aware of the biggest threat you face as a passive investor? It's fraud.
You might be curious to uncover the answer to this question, just like I was.
We have a comprehensive 28-point checklist to screen operators and deals. Every item on the list aims to uncover risks and give us grounds to reject an opportunity.
So, what is the top risk for passive real estate investors?
  • Could it be risky debt levels?
  • Lack of sponsor commitment?
  • Inexperience in the specific asset type?
  • Incompetent team members?
Yes, these are significant risks that warrant careful analysis. And many arguments have been made in favor of each one being the number one risk in real estate investing.
However, there's a worse risk out there. Could it be location? Lack of cash reserves? Poor property management?
While these are huge risks, I believe there is an even greater one.
Allow me to explain why.
Many of your investments will involve excellent assets, and the operators may possess decent experience, a solid track record, and a talented team. Much of the debt will be secure, and the operators may have a personal stake in the project.
You'll likely come across properties in prime locations. Operators will maintain cash reserves, and property managers will do their job efficiently.
If all of these factors align—and they usually do to some extent—your investment should yield both a return of principal (the highest priority) and a return on principal.
So why do so many deals fail to deliver on those promises? Fraud.
And sometimes, the fraud remains undetected. Some perpetrators won't make headlines or face legal consequences. Other times, it may result in you receiving a lower return than what was actually earned from the asset.
Even when everything seems perfect, a single fraudulent player can ruin a deal.
So, what can you do to protect yourself against fraud?
Here are some suggestions. Some of these apply to all investors, while others are more relevant to larger investors, such as family offices and funds.
  • Conduct third-party net operating income audits
  • Conduct thorough background checks on principals and key staff
  • Perform background checks on other parties involved in the deal
  • Trust your gut instincts
  • Verify references
  • Conduct comprehensive online research
  • Review and audit the operators' personal commitment to the project
  • Visit the property site in person
After all, you have worked hard to accumulate your capital. Recovering from losses caused by fraud can be an enormous challenge. I don't want to see your portfolio devastated by fraud, so take these precautions.
Final Thoughts
Almost every investor who has been active for decades has fallen victim to fraud at some point during their journey. Despite our best efforts in due diligence, it is impossible to predict when a trustworthy individual may turn deceptive. So, what can you do to safeguard your portfolio against permanent damage caused by fraud?
Diversify to avoid concentration.
The savviest investors I know prioritize diversification, even though it requires discipline.
Why? Because we have all been tempted by those "once in a lifetime" deals. The ones that seem foolproof and could potentially secure your retirement—if you invest a significant amount.
It can be tempting to go all-in on these opportunities, leveraging your home equity and liquid assets. But be cautious.
While many of these deals do work out successfully, they are just as susceptible to fraud as any other investment. And this isn't even taking into account the importance of adjusting projected returns for risk.
My advice is simple: avoid over concentrating your investments on one operator or one specific deal. Broad diversification is your best defense against fraud. And as we've discussed, many experts believe this to be the most overlooked risk in passive real estate investing.

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