Part 1 in the Realized Series "Risk Management and Real Estate"
A fundamental principle of investing is the risk/return tradeoff, which simply states that the greater the risk, the greater the expected return. Conversely, the lower the risk of an investment, the lower the expected returns. Investments in real estate are no exception.
To understand how this applies to real estate, it’s necessary to define Investment Risk. A widely accepted definition of Investment Risk is “the probability or likelihood of occurrence of losses relative to the expected return on any particular investment.” Think of Investment Risk as the likelihood or chance that a specific investment will NOT provide the returns you expect.
Here’s the problem, quantifying risk in real estate is really hard. For this reason, there’s a strong tendency for real estate investors to focus the vast majority of their attention on the expected returns they may receive, rather than the chances that these returns will be less than expected.
When investing in real estate, Investors use metrics like cap rates, “cash-on-cash” returns, and internal rates of returns (IRR) to compare and contrast different properties they are considering. In my experience, it’s rare to have an investor voluntarily say something like “this property carries a much higher risk than that property.” Not because they aren’t capable of making such a determination, but because there is no framework for assessing risk of a particular investment property.
To illustrate this, think about the tools investors have to assess Investment Risk associated with a stock or bonds. These asset classes have widely accepted, standardized metrics for measuring Investment Risk. For stocks, the most common measurement of Investment Risk is a stock’s Beta. In a single number, the Beta of a stock neatly measures that security’s expected volatility (Risk) compared to all other stocks. A beta of less than 1 indicates that the stock is hypothetically less volatile than the stock market. A beta of greater than 1 means that a stock is theoretically more volatile than the market. If a stock has a Beta of 1.35 this, in theory, means that it is 35% more volatile than the entire stock market.
Similarly, Bonds carry “Ratings” set by companies like Standard & Poor's, Moody's Investors Service and Fitch Ratings Inc. These Ratings help investors’ measure the bond issuer's financial strength and the likelihood that they will be able to pay the principal and interest as promised. The higher a bond’s Rating, the lower its theoretical Investment Risk.
Unfortunately for real estate investors, there is not a widely accepted method for assessing the Investment Risk associated with a particular property. If you think about it, this makes sense because each individual property has a unique set of variables that affect its Investment Risk. These include location, the financial strength of the tenants that are paying rent, the loan-to-value of the mortgage, the length of each lease, etc.
Investment Risk in Real Estate-- What’s An Investor To Do?
Perhaps the best place to start is the acknowledgment that Investment Risk is present in all investments, including real estate. Next, think about the different variables that may cause volatility in the returns (cash flow and appreciation) you expect to receive on investment properties being considered.
To help with this, here are 10 Rules of Thumb When Measuring Investment Risk in Real Estate:
- Higher Expected Returns Generally Carry Higher Risk.
- Debt Increases Risk. The higher the loan-to value of the mortgage, the more risk. The closer the maturity date on the mortgage, the greater the risk. Variable rate debt often carries more risk than fixed rate debt.
- Diversifying Into Multiple Properties. In real estate, it’s easy to forget about spreading your risk across multiple properties. This way, when the cash flow from one property unexpectedly decreases, you (hopefully) continue to receive the cash flow from the others.
- Diversifying By Geography. Sometimes it’s easy to ignore the Investment Risks associated with a particular city or region. Say that you diversified into multiple properties, but they are all in the same neighborhood or city. When the city sees an economic downturn, it affects all of your properties.
- Don’t Forget About Supply. It’s easy to get caught in the trap of of looking at demand for a property (i.e. vacancy and rents), assuming no change in supply. When considering a property ask yourself what the likelihood that new, competing properties will be built? What happens to my rents and vacancy assumptions when a new, nicer property is built down the street?
- Volatility in Rents. When considering volatility in rents, think about the probability that existing tenants will renew their leases? How much time will it take to find replacement tenants? -- unexpected vacancy is a primary Investment Risk. What level of rent with new tenants will be willing to pay in a good economy? What level of rent with new tenants will be willing to pay in a bad economy? What are the cost of upgrades required to attract replacement tenants?
- Volatility in Expenses. When considering volatility in expenses, consider the likelihood that property expenses will be greater than expected. This is where putting pencil to paper, or even better using a spreadsheet can really help. Attempt to quantify what happens to the projected cash flow of a property if expenses (taxes, property management, utilities, on-site employees, regulations etc.) increase by more than you are projecting. How likely is this to happen?
- Real Estate Is Local. The one question I always ask myself when considering new property investments is “will this location and general area be better in five years or worse?”
- Interest Rates and Cap Rates Are Related. As a general rule, when the costs of borrowing increases, the price than an investor is willing to pay for your property decreases.
- Capital Expenditure Matter. Nothing can cause volatility in your expected returns like having to unexpectedly replace a roof, fix a foundation, rewire, or replumb a building.
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