How to Understand Risk and Return
It is an axiom of investment that, should you wish to achieve a rate of return over and above the Risk Free Rate, then you have to take on more risk.
The same principle applies to property investment, which is inherently risky.
What is a risk? Put simply, a risk is an issue that hasn’t happened yet!
This is an element that so many property investors seem to ignore or misunderstand. The higher the return, the higher the risk. Your job, as CEO of your property investment business, is to:
- Understand what risks you face. You will face some, that is the axiom of investment.
- Understand what impact they might have, should they become reality (moving from a risk, to an issue).
- Determine what steps you can take to mitigate the risks that would have a high impact on your property investment business.
This short article will give you some examples. I cover this in much more detail when determining your individual Property Investment Blueprint.
Examples of Risk in Property Investing
In property investment terms, a risk is any potential problem that might affect the performance of your investment. For a Buy-to-Let investment, here are some example risks:
- You purchase a property of low tenant demand.
- You underestimate the cost of any forced appreciation.
- You get a tenant that stops paying the rent or ends up trashing the place.
Examples of risks in a Buy-to-Sell scenario are:
- You have your planning permission refused.
- Your chosen builder walks off site half-way through.
- You underestimate the finished market value of the units.
- You fail to sell some, or all, of your units.
Some risks will apply to all property investments, some will apply to particular properties or projects.
Your job is to identify, mitigate and manage any risks that become actual issues.
Note that not all risks are the same. Risks have an impact (financial or reputational) and a probability of occurring. You should be focusing your efforts on those risks that have a high probability of occurring and a high impact.
The takeaway from this section is to realise that the lure of higher returns, by definition, come with higher risks. This means you shouldn’t blindly chase higher returns without fully understand what risks you are taking on.
A good example is the lure of a high-yielding property. This is a generalisation, but this could come with the risks of:
- Lower tenant demand.
- Tenants in receipt of Local Housing Allowance.
- Potential for higher voids.
- Potential for higher maintenance costs.
- Mortgage availability for such products.
- Onward resale potential (e.g. if your only realistic market is other investors).
Look beyond the headline of the higher return to really understand what this means as an investment.
If you do, you will be way ahead of your competitors.