How a Risk Analysis Will Help You Make Smarter Real Estate Investment Decisions
Anyone actively engaged in real estate investment knows that many factors can affect the analysis of rental property profitability which in turn make it virtually impossible for any investor to resolve with simple math.
Real estate investors, for instance, cannot account for trends in the economy or tenant availability and renting habits. Whether the economy will be favorable enough to real estate investment to bring tenants knocking at the door with deposit money in hand,or so unfavorable that it depletes the pool of available tenants and provides no paying tenants is not something any real estate investor can predict with absolute certainty.
In this article, we will consider a method many real estate investors use to measure investment risk at least to some partial degree. It is called risk analysis. And when used effectively it has been proven to help investors make better real estate investment decisions.
Since all investment includes some level of risk and uncertainty, it stands to reason that the rate of return provided by various opportunities would be relative to the risk and uncertainty associated with the investment.
Government Treasury bills, for instance, are practically risk-free investments so it’s no surprise that they provide low rates of return. On the other hand, other types of investments fraught with more risk and uncertainty like investment real estate usually provide a higher rate of return.
In each case, therefore, investors must consider both the level of risk and rate of return when making investment decisions and then proceed based upon their own comfort level. And this, of course, does vary from investor to investor.
Some investors, for instance, avoid real estate investment altogether and opt for the lower rates of return associated with “less-risk” investments. Others are willing to make the trade-off and accept some amount of the uncertainty and risk associated with real estate investment as long as the return is high enough to substantiate (or perhaps minimize) the ambiguity of the unknown.
Real estate investors attempt to do this by applying what is known as a "probability distribution" to prospective investment real estate opportunities to measure the risk.
How It Works
As an example, we’ll consider how a real estate investor might apply a probability distribution to a rental property’s income.
In this case, rather than ascertaining potential cash flows and returns generated by a rental property based upon one scenario of rents, the real estate investor would make his or her analysis based upon a range of rent probabilities.
- “most likely rent”
- “somewhat likely rent”
- “not very likely rent (but, hey, kudos if it happens)”
This way the real estate investor can determine what rate of return can be expected for each rent probability and then decide whether the returns are high enough to offset the risk and uncertainty associated with the real estate investment.
Okay, now let's consider the Rent Scenarios illustrated above and break it down so you get the idea how a real estate investor might have used it in a real estate analysis to measure the risk associated with a potential real estate investment opportunity.
We see that the rental property being analyzed consists of 100 units comprised of three separate unit configurations each generating a current average monthly rent (dark blue area of the upper portion of the form).
In this case, the real estate investor has elected to determine what affect changes to those rents would make to the property's profitability. Therefore an average monthly rent amount is entered for each unit configuration in the columns labeled Rent Scenario 1, Rent Scenario 2, Rent Scenario 3 (white area of the upper portion of the form)..
Remember, each column intends to reflect an average monthly rent the investor deems as "most likely", "somewhat likely" and "not very likely" for the rental property.
In other words, whereas the investor deems that the one bedroom one bath units "most likely" can be raised to an average monthly rent of $520, they are only "somewhat likely" to rent for $530 monthly, and "not likely" to ever rent for $540 monthly.
What's the point?
The investor has created a probability distribution for the rental property's rents that reveal what amount of profitability might be achieved for each scenario (dark blue area of the lower portion of the form) thereby associating the element of risk required to achieve the return.
Let's consider the Cash on Cash Return. As is, the real estate investment returns 11.56%, but continues to climb for each degree of risk until it reaches 13.73%. What significance these results are, of course, depends upon the one doing the real estate analysis.
The real estate investment may or may not provide a good investment opportunity depending on the real estate investor's desired rate of return and the amount of risk he or she is willing to take on the rental property and make the investment in hopes of achieving that return.
Probability distribution is only one of the mathematical and statistical approaches to risk analysis, But it is appropriate to discuss because it is used routinely by real estate investors to measure the uncertainties of investment real estate during their real estate analysis. Hopefully you see the benefit. Here's to your real estate investing success.
About the Author
James Kobzeff is a real estate professional and the owner/developer of ProAPOD - leading real estate investment software solutions since 2000. Create cash flow, rates of return, and profitability analysis on rental property at your fingertips in minutes! Learn more at www.proapod.com
ProAPOD also provides iCalculator - an online real estate calculator that enables you to learn dozens of real estate definitions and formulas as you calculate. You save 64%. Learn more at real estate calculator
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