Most investors will evaluate potential investments and account for scenarios that would negatively impact their investment returns. They describe this as risk assessment or risk management, though technically it is a threat analysis (see my article in Think Realty in June 2020 for a more thorough explanation).
Real estate investors tend to focus on operational risks. What is the tenant base like? Will they be able to continue paying rent? Are there physical issues with the property that could result in large expenses – new roofs anyone? Some real estate investors go deeper into market issues. Is the locality landlord-friendly? Is there a broad base of jobs so that one industry or one company failing can’t destroy your profitability. These are important risks to understand and assessing them is a good practice that all investors should follow.
But there are other layers of risk that investors need to understand. The first that every investor in these times should be concerned with is inflation risk. The government (mis)reports inflation as a consumer price index (CPI). The CPI calculates the price increases on a common basket of goods and services. But those who calculate that metric carefully remove the most inflationary expenses. The CPI is then managed by the Federal Reserve to be in the 2-3 percent range. But more accurate measures of inflation put current inflation between 8-11 percent. (See, for example, the Chapwood index). That means your investments must provide returns around 10 percent just to maintain purchasing power.
Fortunately, owning cash-flowing real estate is one of the few investments that rides the inflation wave up. Just as other costs increase, rents and property values increase. And since real estate investors can use leverage, it is common for real returns to be in the double digits – more than keeping up with real inflation.
Holding cash for any length of time, however, is guaranteed to reduce your purchasing power. Dollars deflate in proportion to inflation. And returns from bank accounts and bonds don’t come close to keeping up with inflation. A good risk management discipline, then, is to own assets that tend to rise with inflation keeping your purchasing power at least constant, if not improving.
A second risk that few assess is the risk of not investing in a project. Remember that risk is 1) what can happen – scenarios, 2) how likely it is, and 3) what the impact would be if it happens. Most investors identify all the things that can go wrong. Really good investors assess the likelihood and impact of those scenarios (though most don’t).
But if you really want to assess a decision to invest in a project or purchase a property, you need to include scenarios where you didn’t invest. What happens to your returns if you don’t invest? Will you be on the sidelines for a few months? How long until you can source a deal as good or better than the one you are evaluating? Are there other types of capital: relationships, teams, partners, investors that may also be lost?
You shouldn’t go into a bad deal to preserve relationships or just to get your money into assets. But the potential loss of purchasing power and loss of other resources should be a consideration that might make you take a good solid deal rather than wait and hope for a home run. And the way to perform the risk management is to include scenarios where you don’t invest as part of your risk assessment.
Just as with assessing the risks of owning a property, you should assess likelihood and impact of the non-investment scenarios.
And ultimately, you should compare the risks of investing with the risks of not investing as you make your decision. It is even possible to compare estimated returns from investing/not investing, though it can be challenging to assess the risks over time. And assessing the risks of not investing requires you to make assumptions about the type and quality of projects that may be available to you. That’s not easy, but it certainly makes you perform a whole new level of market analysis.
Inflation risk and opportunity risk are related, of course. Inflation is one of the impacts that should be assessed if you don’t invest in an asset that rises with inflation. And assessing the risks of not investing might just be the ticket for those of you plagued with paralysis by analysis. Understanding that inaction has its own risks tends to force you to make a decision one way or the other.
Up your game. When you evaluate properties, and you do your risk assessment, make sure you assess what happens if you don’t invest and allow for the impact of inflation. Perhaps this analysis will provide a different perspective on how you view your investments.