Simplified Method to Analyze Risk

A good poker player knows how to balance risk and return. Players are given only moments to evaluate the current pot balance, the strength of their hand and their odds of winning as they make the decision to raise, call or fold.

If only our intuitive sense of risk vs reward was so well attuned as Investors...

As real estate investors, most of us are already pretty good at evaluating potential returns when we analyze our deals. For new investors here on BiggerPockets, there are plenty of great tools and articles like this one on how to analyze cash-on-cash return, cap rates, etc.

But return is just one side of the equation. In all our focus on calculating potential returns, too often we neglect the other side altogether.

Analyzing Deals - WITHOUT considering Risk

Consider the following hypothetical:

An investor has $50,000 in cash and is evaluating two potential deals.

Deal 1: Put 50% down on a $100,000 SFR in a class B neighborhood.

Expected rent = $1150/mo

Expected expenses & capex reserves = $250/mo

Cash on Cash Return (assumes 5%, 30yr loan) = 15.5%

Deal 2: Fix & Flip a class-C-minus property selling for $25,000 and needing $25,000 in rehab

ARV = $65,000

Assuming a quick flip with no holding costs, Cash on Cash Return = 30%

Clearly, if we judge these two deals strictly by their returns, Deal 2 is the winner. But digging into the details, we can also see that it is also almost certainly the riskier investment.

And this of course makes sense. We all understand that greater returns usually also carry greater risk.

How do we know when the greater risk begins to outweigh the higher return?

Do we just 'go with our guts' when evaluating risk? As much as investors love to analyze the return numbers, we too often shy away from trying to quantify risk at all.

Now, we do have a good excuse for doing this: formal risk analysis is a complex subject. Hedge funds, for instance, use complicated computer models to analyze the risk of their investments. Frankly, most of us investors have neither the resources nor sophistication to follow suit in our investments.

But that doesn't mean we have to just throw up our hands and 'wing it'.

Simplified Risk Analysis Method

There are simple methods accessible to a typical real estate investor that can help us to evaluate the effect of risk in our deals.

One such method - and my favorite way of thinking about risk - is by estimating theExpected Value.

Expected value is calculated as the sum of all possible values each multiplied by the probability of its occurrence.

This calculation is straightforward as we are essentially just taking a weighted average of possible returns. The hardest part is simply estimating the odds of each possibility occurring. But this can be determined by looking and past and typical performance.

Let's go back to Deal 2, discussed above. We all know flipping houses carries risk; sometimes even the most experienced investors underestimate repair value, overestimate ARV, or some combination thereof. A good investor can do well over the long-term, but the reality is that if you do enough flips, eventually you'll hit a snag and lose money on one of them. Maybe break even on a couple. Overall you're fine because you're making money on the rest - but not every deal is profitable for a typical investor.

Given this knowledge, the first step to determining the expected value of a flip is to use historical performance to estimate the odds of a range of outcomes. For simplicity sake, let's take X as the expected profit you anticipate for a given flip. (In our case above it was $65K-$50K = $15K).

Lets assume, after looking at your past flips, you determine that:

On 50% of them, you make your expected profit.

On 25%, you only make half what you'd expected.

On 15%, you break even.

On 10%, you lose money - you lose an average of half your expected profit. (Ouch!)

So now - your Expected Value for any given flip can be calculated as:

(50% * X) + (25% * .5X) + (15% * 0) + (10% * -.5X) = .575X

where: X = expected profit

We can now plug in our expected profit from Deal 2 above ($15K) and see that the Expected Value of Deal 2, after risk is included is really only $8,625. This means that instead of the 30% cash-on-cash return we analyzed earlier, we should really only count on a 17.3% cash-on-cash return when we're comparing between the deals.

(It should be noted that in order to compare apples to apples, we would need to go through a similar process for Deal 1, using historical data for our buy-and-hold deals. But because there is less risk in Deal 1, we would expect the return to not drop as dramatically as did Deal 2.)

The Bottom Line

All real estate investors need to remember to consider risk when they analyze deals. The highest return is not always the best investment.

True risk analysis is complex, but a simplified method like estimating Expected Value can be a good tool for investors to know as they try to balance risk against reward.

About the Author:

Bryan Reid is an Investor, Realtor, and Structural Engineer who has owned investment property since 2008. He is located in Lexington, Kentucky.

Disclaimers:

This article to be used for information only, and should not be construed as accounting, legal, or other professional advice. Stock photo is free image available at dreamstime.com.