How many of you have heard knowledgeable real estate investors discuss risk? In sober tones they describe “risks” like loss of tenants, market risk, title claims, competition. And their “risk management” approaches are to always buy title insurance, don’t build if there are other projects in the pipeline, only buy where there are diversified economies, and don’t buy if the leases are all due at the same time.
The advice is not necessarily bad (though it could be in some situations) but it is not based on a risk assessment and the items identified as risks are better characterized as “threats.” As a real estate investor who performs quantitative risk assessment in other areas of my professional life, I have been dismayed at the lack of formal risk assessment in real estate investing. The half measures usually used may mislead real estate investors or result in losing deals unnecessarily or paying extra funds for no benefit.
What is a real risk assessment? Kaplan and Garrick in their seminal paper from 1981 identify risk by asking three questions:
- What can go wrong?
- How likely is it?
- What would be the consequences if it happens?
These questions describe a specific risk scenario. A comprehensive set of these scenarios (with all three questions answered) allows us to assess the overall risk of a real estate investment. But in most real estate discussions of risk, they talk about what could go wrong and never ask how likely it is or what would be the consequences. If it is a scenario that is highly unlikely or that would result in only minor consequences, it may not be a risk worth worrying about. In the “risks” discussed in the first paragraph, all are “what could go wrong” with no assessment of likelihood or consequences. And that’s the problem. Until we assess likelihood and consequences, we can’t really know what, if anything, we should do about the risks.
In formal risk assessment we often structure these questions for estimation as “threat,” “vulnerability,” and “consequence.”
- Threat is what could happen. For example, the property could catch fire, or someone could make a claim against title.
- Vulnerability is how susceptible the investment is to the threat. For example, a concrete block and metal building with no contents would be far less susceptible to fire than an older wooden house inhabited by a hoarder.
- Consequences can be estimated as the negative impacts that would occur if the investment succumbed to the threat. In the case of a fire, the impacts might be anything from a scorched area to complete destruction of the property. If the property is a tear down, a fire might result in positive consequences (not that we are advocating that). One could argue, however, that having fire insurance on a tear down is a waste of money from a risk management perspective.
Calculating the risk of a particular scenario is usually done by comparing the likelihood and consequences. This can be done qualitatively (high, medium, low), semi-quantitatively (usually in orders of magnitude), or quantitatively by multiplying the estimated likelihood with the estimated consequences. In the latter case, the risks from multiple scenarios can be added together to estimate the expected loss due to risk for the investment. Alternatively, the scenarios may be addressed individually. For example, if we find that the likelihood of a title claim is about 1 in 2,000 (0.05%) and the cost of the claim to the investor is the equity in the property (say 25 percent of the purchase price), then the expected cost to the investment would be 0.0125% of the purchase price. Since title insurance costs about .5% of the purchase price, title insurance costs about 40 times the cost of the risk it addresses. There are other considerations here, too, but strictly from a risk and cost perspective, title insurance may less cost effective than just accepting the risk.
This brings us to the real point of any risk assessment: risk management. Once we have identified, estimated, and assessed the risks, what do we do about them? In general, there are four approaches to managing risk:
- accept the risk
- avoid/prevent the risk
- transfer the risk; or
- mitigate the risk.
All of these approaches are often used when addressing the risk of fire. In the case of the tear down we might just do nothing and accept that the property could burn down while we are figuring out how to tear it down. We can avoid the risk by not doing the investment because of the fire hazard or prevent the risk by removing all sources of fire and combustible materials. We can transfer the risk by buying fire insurance (the risk is transferred to the insurance company). Or we could mitigate the risk by installing a sprinkler system, providing fire extinguishers, or training a tenant in fire response.
Why don’t real estate investors usually think this way? Why do they default to all or nothing views of threats? I think it is a combination of laziness in doing the analysis and ignorance of how to assess risks. But you no longer have that excuse.
What do I recommend as a risk analyst? Go beyond the usual real estate doctrine of “always” or “never” when addressing risks. Do a risk assessment on those risk scenarios when you evaluate an investment. You may find cost savings that allow you to more intelligently bid than your competitors. You may find deals that others shun that can be your most profitable properties. And as you become adept at risk assessment and evaluation, you may find ways to creatively structure projects that reduce your risk in ways other than just insurance or avoidance (or ways that reduce your insurance costs since your risks are less than those of the usual investor).
Flexibility and creativity will set you above the investors who won’t do the real analysis and assessment work and give that edge that may be more valuable in a challenging economy.