Risk is one of the most misunderstood terms when discussing investing in any asset class. If you can understand what risk means, you will see as I have seen, that seasoned real estate investors are one of the least risky investors.
If you were to ask someone what they needed to do in order to see bigger profits in their investments. They might say that taking bigger risks is what leads to more profits.
Compare that to a seasoned real estate investors perception of what is riskier – investing in rental property or keeping money in the bank, you might be surprised by their response of rental property.
Usually, when people think about risk when it comes to their investments, they are really thinking about whether or not there is a chance to lose their money. This is really a misappropriation of the term “risk”. It probably has comes from some financial planner providing a risk tolerance questionnaire that asked them, whether they considered themselves risk-averse, average, or above average. And it relates directly to the legal liability incurred by the financial planner losing their money.
But that isn’t what risk is when you are coming from an investment perspective.
Let’s look at an example outside of real estate – skydiving.
You might consider this sport as one of the most risky activities out there. From your perspective they are jumping out of a perfectly good plane, from thousands of feet up in the air, with just a parachute. Risky you say.
From the perspective of the skydiver, they might not see their sport as risky at all. They have the proper equipment, go through a number of pre-jump steps, and do their safety procedures throughout the process. This helps to prepare them and ensure that the skydive is going to be safe. They know what they need to do in order to jump safely and they do it. When you compare driving a car to skydiving, you are actually thousands of times more likely to die in a car crash than skydiving.
So risk is contextual and is based on the knowledge and experience of the person who is doing the activity.
The ability to know what to measure is the key here. A seasoned real estate investor understands that risk is the ability to measure uncertainty and measure the probability of profits.
He or she may use spreadsheets and calculators to help them get a better understanding of the uncertainties of a specific investment, and apply criteria to it. (I.E. cash flow, ROI, cash on cash, or other criteria)
Seasoned real estate investors speak to other investors, listen to economists, read books and articles, and keep track of different trends to be able to understand what different possibilities may affect them.
They make decisions based on their understanding of these measurements.
Because they focus on the probability of profits they are more confident about the results that the investments will provide. The seasoned real estate investor understands and can measure uncertainty.
But how does a seasoned real estate investor approach risk? Really there are three approaches, not just one.
This is quite simply not making the investment at all. It’s much easier to avoid a bad situation . Not every deal is a great deal. There are many variables that go into making a successful deal. And sometimes one of those variables is skewed unfavorably against the investor. Knowing when to say no, is just as important as saying yes.
Reducing the risk means that the seasoned real estate investor will use their knowledge and skills to create a margin of safety within the investment. This will add intrinsic value and look for solutions to ensure that the investment has a probability of profit.
You hear this in common metaphors like, you make money when you buy the property.
It is having that knowledge and understanding of what to do with the property which helps to create an additional margin of safety from the buy.
For example if you were to take an illegal accessory apartment in a detached house, and through few little fixes create a legal accessory apartment. You would have reduced the risk oa a neighbor complaining to the city and shutting down the accessory apartment, and be able to create value that exceeded the cost of the renovations. You would then be able to extract some of this new equity through refinancing the property and lowering the amount of funds that are left in the property. This would increase your return on investment, if by lowering your initial investment. In this one example, you can see that risk is reduced from neighbours, safety, liability, and money.
The last approach to risk is very different from reducing the risk of a particular investment. Once you have reduced the risk for an investment you have simply added it to your portfolio and it simply follows the process and procedures that were setup for it.
When you focus on risks you are actively managing it. For a seasoned real estate investor, the property is getting all of your attention.
This could mean that a seasoned investor would sell an asset, having realized that the property was a mistake and needs to be sold off, or that investment has done what it was intended to do and it is time to reap the profits.
A seasoned investor distances themselves from the real estate market and all the emotions that come with it. They measure current uncertainties and the probability of profits as it relates to the property. And then evaluate what needs to be done with the investment.
Quentin D’Souza is the Chief Education Officer of the Durham Real Estate Investor Club. Author of The Property Management Toolbox: A How-To Guide for Ontario Real Estate Investors and Landlords and The Ultimate Wealth Strategy: Your Complete Guide to Buying, Fixing, Refinancing, and Renting Real Estate.