How to calculate risk to determine probability of an outcome
When talking to prospective clients for my property management business, I always say, “rental property management is really about Risk Management.” I often tell the story of a client, who had previously decided to self-manage. Although he always tried to do the right thing, a small, innocent error led to a spiraling sequence of unfortunate events. The story was an example of how small errors may go undetected, unknown, and remain unrealized, until something goes wrong. Consequences in total were severe, not only financial misfortune, but it also left a lasting and profound psychological impact. But, if nothing goes wrong, is there any risk?
Risk is measured using statistics and derived from both quantitative components and qualitative factors. Qualitative factors are a challenge, particularly for individual or small unit-count property investments. Included are interpersonal relationship dynamics, such as behavior, which is possible to recognize but a challenge to quantify.
Qualitative risk management planning effectively reduces or eliminates consequences — and is the focus of this column — with most benefits achievable without statistics. An annual assessment exercise allows most real estate investors to improve business practices, whether doing rehabs, long-term holds, lending, or some combination. It is not difficult with the right tools and understanding and will elevate your business to the next level resulting in larger gains and smaller losses. Critical thinking and arithmetic are the only things necessary for implementation.
The path to eliminate problems before they occur
Calculating risk is an attempt to determine probability of an outcome. A conceptual understanding of how those numbers are derived is critical for effective implementation of risk management practices. A grasp of risk theory only requires a bell curve illustration and a sprinkling of a few statistical terms when combined with practical real estate examples.
The bell curve figure has a symmetrical area under the curve that (eventually) totals 1.00 (one). Where:
μ = [mu, (pronounced “mew”)] is the data mean, the average, (expected outcome or return)
𝝈 = [sigma] the standard deviation, shows six equidistant intervals, known as the range (99.7% of 1.00)
Any given point in the graph is a probability of an event or an accumulated series of events. Events are plotted in relation to the frequency they occur (height) and distance from average (left or right of centerline). Closely plotted points indicate the deviation from average is low; loosely plotted points mean less predictability (the deviation from average is high).
Grasping the concept of risk theory is important for Risk Management planning
Roughly speaking, events that occur with high frequency are prone to have more variation than events that occur less frequently while less frequent events may mean less variation. Symmetrically speaking, consider that high frequency events having low consequence may have an aggregate severity equal to low frequency events having high consequence. Reducing variation of outcome through tighter controls reduces total severity of consequence, which is how you will apply risk management to your business.
Example of Risk Management indicators in real estate
Imagine two Renters, A & B. Renter A paid rent consistently late, on the fourth day of the month with rarely any variation. Plotted on the curve, the average would show a high frequency of late rent as averaging –four. Renter B is different. The average is one, which would indicate rent is paid on average a day early. Except many of the plots are largely spread out into the negative teens and twenties, with a few plots at 30, 40, and 60. Which has higher variation? Which has more risk? Which can you be more confident of getting paid rent on a given day?
As a separate event, the number of opportunities that a basement will flood may be far less than opportunities for rent to be paid on time, yet, the financial consequence may be quite severe. A sump pump with battery backup is installed, so all should be okay, right? Now evaluate the same two renter households. Consider Renter A vs. Renter B. Would you consider the likelihood of tampering with the sump pump between Renter A and Renter B as the same? Why or why not?
Statistics attempt to bring together all events of different types, each having probabilities and frequencies of their own, and normalize them into a single measure (expected outcome) that you determine is important. Managing the causal factors that impact the outcome is up to you.
Application of Risk Management Principles without Statistics
The key is to identify possible causes that prevent achieving the expected outcome.
It has been established now, with the iterative cycle of real estate operations, even though an event never gets tested or realized (a failure does not occur), that risk remains inherit in the system. A step most overlooked is a critical thinking exercise that accounts for possibilities of what can go wrong. Possibilities considered are possibilities managed. Proactive vs. Reactive.
Identification of 95 percent of causes are either obvious or routine enough to identify with a smidge of critical thinking. Reducing variation and consequences of those causes is a qualitative and subjective exercise. Tighter controls and mitigation plans are how risk management can be applied to your business to reduce losses and improve gains. The sum of all the individual multi-factorial events and iterative processes (e.g., getting paid rent on time, having contractors show up on time, detecting water leaks or pests before they become a problem, etc.), over time add up to the expected outcome.
Risk Management Methodology
There is a simple methodology that does not require the use of any statistics to assist with managing mistake-prone qualitative risk factors:
- Consider what can go wrong (this is often the hardest part)
- Determine how bad the outcome would be (consequences)
- Determine how likely it is to happen (likelihood of occurrence)
- Determine the risk level of the event with application of a risk score
- Manage the event; eliminate or reduce the likelihood; mitigate the consequence.
How it works:
Below are some examples to subjectively score criteria. Consequence criteria may be how severely could it cause financial or legal harm and likelihood indicates likeliness or propensity for realization.
With each event, determine the consequence and likelihood of occurrence to apply a risk score and determine if it requires some form of mitigation management. With Renter B, for example, perhaps a remote monitoring alarm should be installed that would warn you of a high-water level. Consider how to mitigate, and then re-assess:
- Eliminate the possibility for the event from happening (risk of ceiling fan breaking, replace with a dome light instead if the market isn’t sensitive to having ceiling fans).
- Substitute with an alternative option (unreliable and poor-quality maintenance contractor, utilize a more competent and professional contractor that gets it done right the first time).
- Utilize automation and controls (put in place as a proxy assistant to make operations easier and results in less hassle for both you and the tenant — could be software and hardware).
- Administrative controls with clear policies and procedures (move-in and move-out procedures, and security deposit management are a big source of dispute, or have your own Terms and Conditions, or quality standards that you expect contractors to follow).
- Develop policies, procedures, practices and guidelines, for renters and contractors to mitigate against possible symptoms of dispute. Provide training, instruction, and supervision.
The matrix shown above is an interactive spreadsheet that contains a series of multiple worksheets with internal linking as a roadmap to assist with Risk Management planning. It is available for download through the links provided at RealtyMatters.Online/Column/June-2020. It contains an exhaustive list of 60+ categorized risk components that is applicable to most investment strategies. Go to the links identified to get your free copy.
Please Tell Me What You Think
For those statisticians reading, please tell me how I did.
A simplified Risk Management Approach in Real Estate online course or module for the individual small unit-count investor category is lacking. Would you find value with something like that? Write to me and let me know. Go to RealtyMatters.Online
For Column Notes, Resources and Language Translation for this Column, go to: