What’s more important in investing – growing your money as much as possible, or making sure you don’t lose it?
As much as we’d all love both, reality rarely presents that option (and if it does, the opportunity might actually be too good to be true).
This is why risk and return are two of the most common topics in the investing world. While you can get as nuanced or complicated as you’d like, the general principle holds the same: there is a correlation between potential return and risk. If you’re seeking higher returns, you face a higher chance of losing your money. If you try not to lose your money, don’t expect as high of returns.
This relationship is not an exact tradeoff (though some treat it as such). There are imaginable scenarios where you have virtually no risk with a high potential of return – like if you bet on a game and pay off the star players to lose. Alternatively, I can think of plenty of high-risk scenarios with no potential reward – ever tried throwing cash in a bonfire?
So the caveat is that the risk-return relationship is a principle to be aware of in any investment, not a set of rules to follow or a formula to check.
This post is focused on the risk-return relationship in Real Estate. We’ll cover the important risk and return categories to pay attention to, examples of where different types of deals lay on the spectrum, and how to manage risk to be a successful investor in the long run.
Before listing the most common types of risk you face in Real Estate, it’s worth noting that the biggest risk in any investment is the one you aren’t prepared for. This is not referring to black swan events (which by definition are unpredictable). Rather, it’s the risk of failing to understand where you might face difficulty, then doing what you can to prepare for those difficulties.
For instance, if you’re buying a vacant office building and the investment success depends on signing a lease that brings in $300,000 in revenue each year, you better know all of the details of that market to judge how likely it will be that you don’t get leases signed at that rate. Or if you buy an apartment complex with promising rent growth and vacancy metrics, you need to know the likelihood that the roof will need to be replaced in the next five years. If you do your research and find out that you might get lower rents than you expect, or have a major capital expense, that’s ok – you can make a plan for dealing with those. You can’t prepare to deal with an issue you weren’t aware of.
In sum, the biggest risk is not doing your research. Don’t be lazy.
After you check that box, what are some other common risks to be aware of?
Real estate, like much of our modern economy, goes through market cycles where the value of an asset is subject to volatility. Most recently, everyone remembers the crash in 2008 – many investors went bankrupt when they faced sudden vacancies and couldn’t make loan payments. These types of booms and busts are unpredictable, and should especially be taken into consideration when leveraging an investment.
Whether you’re investing in Oklahoma City’s tornado alley, Houston’s hurricane zone, or earthquake-prone California, natural disasters can (literally) destroy an investment. Thankfully, we have a sophisticated economy where you can insure your properties against these types of risks, but you’ll still have to deal with the headaches and red-tape of filing a claim in the event of a loss.
On a side note, after the events of the last eleven months, pandemics should also be added to the category of Natural Disaster risk. If governments around the world respond similarly to future pandemics (shutting down evictions, quarantine orders, etc.), real estate will continue to bear the impact.
One of the most difficult things about investing in Real Estate is the process of exiting an investment. Depending on the asset type and market, it might take years to find an interested buyer and get through the due diligence process before getting paid. And the more expensive the asset, the longer this process could last.
This is an all-encompassing category for the things that can (and will) go wrong in operating a business. One of the great things about real estate is that there’s generally less business risk than other industries (due to simpler business models and operations), but you still have to sign leases, pay expenses, manage tenant problems, maintain structures, clean common areas, and hundreds of other tasks. And the costs for these tasks can skyrocket at any time – or all at once. If you’re already operating on a slim margin, this could put you in the red, leaving you unable to make vendor and loan payments and at risk of lawsuits and bankruptcy.
The real estate industry in the United States is supported by a sophisticated legal system that is designed to protect the right to own property. The downside is that the legal system can also be used as a weapon against property owners. There are thousands of different avenues for property owners to be sued and if you’re in real estate long enough, it’s an inevitable reality.
As “risk” is such a general concept, there are many other ways to lose money in real estate that aren’t listed here. If you want to get a more thorough understanding, I’d recommend reading the “Risk Factor” sections of a few REIT prospectuses (like this one from KBS).
On a more optimistic note, there are also a lot of ways to make money in Real Estate. These are the main areas where investors generate revenue (a.k.a. returns):
Depending on the investment strategy, selling an asset can be the largest source of return on a Real Estate asset. Many strategies even depend on the sale as the sole source of return (like house flipping). While selling a property can take time and incur significant costs (see liquidity risk above), it can allow you to realize a large amount of revenue at once and fund future investments.
Rent – or the income you earn from leasing a property – is arguably the most important form of revenue in Real Estate. For most properties (single-family homes are the exception), the rent determines the property value. And in most of the commercial world, where leases are long-term, complex, and require significant negotiation, the type of lease you’re able to sign can break a deal or make it a home run.
This category of revenue is not common in all types of real estate, but when applicable, income from related services can be a great boost to your return. These services would include parking and pet fees in an apartment complex, janitorial services in an office complex, moving assistance in a self-storage facility, and all kinds of other creative ideas that owners come up with. The power of these extra income streams are not just in the cash flow – for most properties, the income counts toward your property valuation as additional rent. So an extra $5,000/year of parking income in your apartment could translate to $100,000 of additional value (depending on the market capitalization rates).
Ok, this one is kind of cheating because depreciation is not technically revenue. It does lower the amount you pay in taxes, though, which means more cash in the bank.
Depreciation is based on the idea that assets lose value over time. The IRS lets you write off an assumed amount of losses from capital, which you can then deduct from the amount of taxes that you owe. Check out this page for a more detailed definition, but in short, it’s one of the biggest perks of Real Estate and a great way to increase your take-home income.
The real estate industry attracts capital from every corner of the market because it provides investment options for a wide range of risk tolerance.
At a high level, all Real Estate capital can be considered debt or equity. Just like stocks and bonds, the lowest risk investments are generally on the debt side. We won’t focus on this category today because the market is almost exclusive to institutional capital like banks, insurance companies, and pension funds.
Within equity investments, there is still a wide range on the risk-return spectrum. Here are some examples (in order of lowest-to-highest risk):
This illustration – over-simplified as it is – shows the wide range of risk & return aspects in real estate. In reality, there are thousands of potential strategies that all fall somewhere between these extremes. The risk and potential return cannot be calculated objectively in any of them, which is why learning to manage risk well is such an important part of real estate investing.
How you manage risk is a deeply personal matter. Yes, there are best practices around operations, leverage, contractors, and so on. But at the end of the day, you have to decide how much you can afford to lose in search of potential returns, and what you have the stomach to endure.
This personal aspect is usually termed risk tolerance. While there are “calculators” out there that try to assign a score to your risk tolerance, it’s truly a subjective matter. The amount of risk you take should be influenced by factors like:
In other words, there’s no true formula. But that doesn’t make it a useless concept – it’s the opposite. An understanding of risk tolerance is important because, by the time you think through the potential impact of an investment to each of the above factors, you will make a decision with conviction (whether you invest or decide not to invest). Conviction leads to peace of mind, which keeps you from losing sleep at night when things don’t go as expected.
There are a lot of great resources out there about tools to manage risk (diversification, investment timing, hedging). In the context of real estate, however, not everyone has the ability or funds to implement these strategies. This means you need to be even more aware of your risk tolerance when buying a property.
A final note: if you’re investing in a deal or fund managed by someone else, make sure the General Partner asks about your risk tolerance and expectations for an investment. It’s not a good sign if they don’t care about whether a certain investment is a good fit with your financial strategy