New real estate investors are correctly advised to seek out a mentor to help them learn the business. Someone with experience can help the newcomer think through issues and bring up important considerations that might not be obvious. This is because experience is often the best teacher, and one of the best lessons it teaches is that no one has a crystal ball. No one can anticipate everything that can go wrong with a real estate investment.
The list of things that could hurt the return on a real estate investment is probably longer than the list of things that can help it. The negatives can be broken down into two broad categories: risks that can be foreseen and evaluated and risks that are unknown and so can’t be evaluated. No amount of due diligence can completely eliminate the second category.
Risk Management For Your Next Deal
Risks that can be foreseen and evaluated can be managed with the traditional tools of risk management, shown on the grid to the right. Risks are evaluated based on their severity (top) and frequency (side).
Losses that do not happen very often and have minor consequences when they do occur can be accepted. An example of this might be a car getting dirty. No one buys insurance against this risk.
However, people buy life insurance because that loss is infrequent (once, actually) and is very severe when it happens. The other types of insurance – fire, theft, flood – also fall into this category. However, if these severe losses happen frequently, an insurance company cannot charge enough to take the risk. This is why people with a record of driving while drunk can’t buy car insurance. The insurance company knows they frequently have large losses.
Risk reduction applies to situations where the loss happens often but has small consequences. People who park outside in northern climates are familiar with this risk. Every morning they need to scrape frost off the windshield of their car. The only option is to reduce the frequency of the loss by finding an indoor parking spot.
Fitting Unknown Risks to the Grid
If neither the frequency nor severity of the loss is known, it is impossible to correctly determine the best risk management strategy. Since every available strategy is listed in the table, the only reasonable course of action is to employ all of them. Sometimes an experienced real estate investor will walk away from a transaction because of gut instinct. It may not always be right, but risk avoidance is a risk management strategy.
Of the remaining three, risk acceptance is the least attractive option, which has given birth to the expression “don’t bet the farm”. If a risk is going to be accepted, it has to be managed by risk transfer and risk reduction. This is why real estate partnerships are a common method of investing in real estate. They are a way for the general partner to transfer some of the risk of loss to other investors. The “premium” paid for this risk is a portion of the investment return.
Diversification among real estate projects is also a common investment technique because it is a form of risk reduction. Losses from any particular project are reduced to the amount that is invested in the project. Most importantly, diversification is a way of reducing the impact of unknown risks on a real estate investment portfolio. The losses caused by unknown risks are also limited to the amount invested in a project.
While every project has unknown risks, the probability of unknown risks causing losses on several projects at the same time is lower than the probability for a single project. This is what “don’t put all your eggs in one basket” looks like for the real estate investor. For investors who want to experience the historically higher returns produced by real estate but who need to reduce the risk, diversification is the only way to go.