The Risk Paradox: How (& Why) Investors Fail to Gauge Investment Risk Correctly

by | BiggerPockets.com

After rigorous research, you have narrowed down your options to two potential investments. The first is a new construction duplex priced in the mid $300,000s. It is located in a market with strong fundamentals and good growth prospects. Between down payment and closing costs, you would invest approximately $92,000 to complete its acquisition. The second is a recently built single family home priced at $180k. It is located in an established neighborhood with good schools. The required capital investment for this property is just under $50,000. You currently have $500k in available, investable capital.

Based on the case study I just laid out, which deal feels riskier to you?

If you’re like the overwhelming majority of investors, you would say the duplex feels like the riskier of the two deals. You have just fallen prey to the risk paradox.

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The Risk Paradox

The reason why the single family property feels like a much safer bet is because it requires a smaller capital investment. But the amount of capital invested in the property has no bearing on the risk of that investment. In the case study, the investor has sufficient capital on hand, so you are not going “all in.”

Think about it this way: A $10 million shopping center in a prime location is a lower risk investment than a $30,000 house in a dilapidated neighborhood.

Related: The 4 Main Risks of Owning Rental Properties (& How to Mitigate Them!)

You might argue that not putting all your eggs in one basket and spreading your capital over multiple properties reduces risk. That point is well taken. But that’s not why the investment feels riskier almost instantaneously. When we evaluate risk on autopilot, we tend to imagine the worst case scenario: What would total loss look like? When you frame the issue that way, it makes perfect sense that if you have to lose it all, it’s much better to lose less than more. But a seasoned real estate investor recognizes that framing the issue in that manner is a bias that leads to a misguided assessment of investment risk.

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So What’s the Best Way to Assess Risk in a Real Estate Investment?

If you want to properly evaluate risk in an investment, you must first clearly define what you stand to lose. When you invest your capital in purchasing an investment property, you have two return expectations: return ON investment and return OF investment. In other words, you are hoping that the property will produce a return on your invested capital via cashflow and a return of your invested capital when you sell the property.

Related: Don’t Let the Risk of Investing in Real Estate Paralyze You: Here’s How

Put simply, risk is uncertainty. Risk is the probability that either of those outcomes will not materialize as expected. When you perform due diligence, you’re actually trying to determine the risk that your investment will not produce cash flow or that (even worse) you will not recoup your invested capital back. For example, when you purchase an older property, you might underestimate repairs, and the cash flow you thought you would receive will actually cover those unexpected costs. Or if you purchase a property in a neighborhood where values are declining over time, you risk that when you sell your capital, it will not be returned to you in full.

The factors that determine risk are the same factors that determine returns: quality of location, construction, schools, tenants, market. It’s not the amount invested or the purchase price. So when you are sizing up a deal, pay attention to the quality of that asset, its ability to attract great tenants, and the overall market prospects for growth. If all three are present, you are dealing with a lower risk investment than a property that requires a smaller cash infusion but doesn’t possess those qualities.

How do YOU assess risk? Do you agree with the above?

Let me know with a comment!

About Author

Erion Shehaj

Erion Shehaj is the founder of Investing Architect. I help successful professionals design and execute a custom Blueprint Real Estate Investing™ strategy so they can achieve financial independence, retire early and gain the freedom to live the life they always wanted. Side effects might include: Early retirement, wealth and piece of mind. Follow on Twitter if that's your thing.

6 Comments

    • Erion Shehaj

      Gautam

      Good question and good points. Let’s take them one at a time:

      Argument: SFRs are easier to exit in case you need to sell on short notice

      First of all, the investing method I advocate has a long-term timeframe. That means we would try to avoid abrupt exits in favor of more “sober” and planned exits. That said, sometimes an abrupt exit cannot be avoided. In those scenarios, SFR can be easier to exit if the real estate market is in an up cycle. If you try to exit SFRs during a downturn, they can be more difficult to pull off than a multi that brings in income. If you purchase a good quality property that stays rented to good quality tenants, there is always an investor that will purchase that income stream at a reasonable CAP rate. SFRs have one advantage – they can be sold for top dollar to an end user Buyer based on emotional reasons during a hot market. Small (2-4) multifamily properties can have hybrid buyers as well (live in one unit, rent the others).

      Argument: Tenants tend to be more transient leading to higher turnover

      I agree with this point when it comes to larger multifamily properties. Smaller, Class A duplex – fourplex properties tend to be higher priced and tend to attract longer term tenants with less turnover.

  1. Julie Thompson

    Good article and I agree with you on the second half of the article. However, I selected the SFR instead of the duplex in the top of the article, not because of the initial outlay of funds, but the other wording you used. Here’s a narrowed down version of what you wrote:

    … The first is a new construction duplex priced in the mid $300,000s. It is located in a market with strong fundamentals and good growth prospects. … The second is a recently built single family home priced at $180k. It is located in an established neighborhood with good schools. …

    In my experience, you can’t get the same rents from an SFR as you can for one unit in a duplex, maybe 5-20% more for the SFR, depending on your area, which means your ROI will be higher per door with the SFR vs the duplex. Assuming “mid 300s” could mean 360k, you’re better off right away with two of the 180k SFRs if you can find them.

    The second reason I chose the SFR in your example was because of the surrounding neighborhood – the duplex has “strong fundamentals and good growth prospects” which doesn’t mean too much – taking an “established neighborhood with good schools” is far less risky to jump into than the unknown.

    The final reason the SFR beats out the duplex for me is that the duplex is new construction and the SFR is “recently built”. New construction sounds less risky because you have a brand new roof and foundation, and everything else is brand spanking new which lowers your expected expenses, right? Disagree – I think with a brand new house, you should save more money for the unknown due to the plethora of “crappy construction” that seems to dominate the new home building businesses these days. The big home builders are getting hit with lawsuits constantly about homes that look nice, but are made out of lower quality materials. The “recently built” SFR has had some lived-in experience. When you send in your contractor or inspector, they should be able to identify if there were any low quality materials used, because it may manifest as excessive wear and tear. For instance, if the home construction team used a poor grade roof flashing, you may not notice when inspecting a brand new home. But a home that’s been through a couple of storms, perhaps a strong winter snow storm or two? It’ll show up and give you reasons to look deeper.

    Overall, I’d say the SFR is by far the less risky choice.

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