Uncertainty vs Risk in Real Estate

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In today’s uncertain economic climate, people tend to throw out any form of risk management and opt for “safe” investments, not realizing that all investments are exposed to some sort of risk. Elements of uncertainty and risk are associated with all asset classes, including Real Estate, and can be managed and optimized by looking at how all your investments interact in a portfolio context.

UNCERTAINTY IMPLIES AN UNKNOWN # OF OUTCOMES

Events such as the 911 terrorist attack and its economic effects could not be forecasted and reflect uncertainty. By definition, uncertainty is unmeasurable. Uncertain events can not be quantified and estimated with any degree of certainty.

RISK IMPLIES A RANGE OF PROBABLE OUTCOMES

Elements of risk can be analyzed through research and various techniques. Ranges of possible outcomes can be predicted. Formal risk analysis incorporating sampling techniques, statistical inference, and probability measures can be used to great effect. Nobody can accurately predict the future, but we can estimate possible outcomes with differing degrees of confidence. Investors who purchase property are simply purchasing an anticipated stream of benefits.

The three primary forms of risk for Real Estate investments are Financial, Insurable, and Business risks. Other forms of risk to consider include Market, Capital Market, Inflation, Liquidity, Environmental, Legislative, and Management risks. Certain market areas such as Boston, NY, and some West coast cities are highly sensitive to changes in local ordinances which affect the amount of new construction, the supply/demand curve, and trends in migration patterns.

UTILIZE ALL FORMS OF RISK MANAGEMENT

Risk can be controlled through diversification, extensive market research, extremely competent property managers, and hedging. Landlords can often shift risk to tenants using tax stops, rent escalator clauses, net leases, and rental rates pegged to certain price indices.

Purchase properties that differ by type, are affected by different market forces, and cater towards tenants of differing socio-economic classes. Certain investments and property may be more sensitive to some elements of risk than others. This is why it is important to make sure that you hold investments that are uncorrelated with Real Estate as a whole, in order to further diversify your portfolio. Thinking through all your financial decisions from a broad, portfolio context, instead of each individual investment, will minimize your exposure towards risk.

Photo Credit: KYZ

About Author

Anwell Tsai, a Realtor for Real Estate One, grew up in the Real Estate business. Anwell is extremely interested in analyzing property from a variety of viewpoints, utilizing different financial models. He explores various issues in Real Estate on his blog at ValuationHome.com. When he is not out looking at homes, Anwell, a conservatory trained violinist, loves expressing his creative side through the joys of music.

2 Comments

  1. >Elements of risk can be analyzed through research and various techniques.

    Not just analyzed but controlled.

    Real Estate is perhaps the riskiest investment available. However the great thing about real estate is you can limit your risk by being more knowledgeable – the analysis you mention.

    Additionally you have control. You can upgrade the property, reduce expenses, raise rents, upgrade tenants or management. Try any of those with your stocks.

  2. Great point Ned. When you purchase stocks, you have little control as an investor while in Real Estate, your actions can directly affect your investment. There have been studies that have supported the notion that effective property management is vital in minimizing risk and affecting investment value.

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