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

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.

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.

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.

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.

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!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.