How to Calculate Risk & Return
We have all heard the expression “the higher the risk, the higher the reward”, but do we really understand the depth of this statement when it comes to large sum investments? It is common for first time real estate investors to seek out the ‘perfect deal’. While great deals do exist, this is not a favored approach. Becoming a good investor means confronting, analyzing and determining the level of risk associated with an investment. Once this is done, executing a plan to compensate for the identified levels of risk will position an investor to receive the highest potential return. Keep in mind that every project, and every investor is unique. Nevertheless, there are a few key risk factors that apply to any kind of real estate investment.
A common practice in real estate investing is having debt in each project. Placing too much debt into an investment however, can jeopardize it. It is wise to consider the ratio of debt to price paid for the property. For instance, if a property is purchased $100,000 with a $75,000 loan, this equates to a 75% loan to cost ratio. In general, the higher the loan to cost ratio, the higher likelihood that the property company will default. When property companies do not leave enough cushion to compensate for potential tenant defaults and tenants not renewing leases, this can lead to foreclosure, an uneven balance of risk vs reward, and the potential loss of investment.
Location is Everything
Big cities and coasts tend to have high property values. The demand for real estate in these geographic locations are high, which drives prices up with low price volatility. For these reasons, big city and coastal real estate investments have limited growth opportunity. On the flip side, targeting suburban and rural areas where high price volatility is present, more growth opportunity may be available, but demand is significantly lower. It all depends on the investor’s situation and goal.
Occupancy rates and the quality of the tenant population have a tremendous impact on your investment risk. Prior to leasing a unit to a tenant in a commercial or residential venture, the goal is to make sure the lessee can afford to pay the monthly dues. This is called Rent Roll Quality. Some of the ways investors try to minimize risk with Rent Roll Quality is by examining a lessee’s credit worthiness, the lessee’s staying power, or for commercial, the likelihood that the company will not belly up. Occupancy rates are important too, i.e. a 100% occupied building is less risky compared to a 50% occupied building. From a commercial real estate perspective, leasing to a major chain is far less risky than leasing to a startup or local business where proof of concept is simply not where it needs to be.