Part 1 in the Realized Series "Risk Management and Real Estate"
Part 2: How to Reduce Risk in Real Estate Investing
Part 3: 8 Ways to Mitigate Risk in Real Estate Investing
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:
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