Risk vs. Reward

Many investors get into real estate because they like to know that there is something physical and tangible that they are buying. It is perceived as lower risk than some other investments. In the case of providing housing, we are providing a much-needed service, so the presumption is that there is an inherent value.  In a perfect world with property rights, this is true.

One of the measures that many people use to determine if an investment is worth making is the risk vs reward. For instance, a small investment with a huge possible reward is frequently perceived to be worthwhile – putting 5¢ into the slot machine that may return $1000, or $1 into the lottery that may return $2,000,000.  Even though the long odds of winning may make both of these have a negative expected value, they are still perceived by many as a chance worth taking. When played over the long run, “bets” with a negative expected value will lose.

Real estate investments also come with risks and rewards. Both are less well defined and have less certain outcomes than the slot machine or lottery example above. They also frequently require more of an investment, both of time and money. Financial modeling is one of the things many investors do to try to determine the potential outcomes for a deal.  If I invest $X today, I will receive an income of $Y-Y⁺ per month, net of costs, for the next 5 years, and then when I sell the property, I will receive $Z in net proceeds. We make assumptions in the modeling process about what rents and expenses will be, what sales prices will look like, what the transactions costs will be, and more. The devil is in the details in this analysis. Two investors can look at the same property and see vastly different scenarios. There are no right answers, except when looking at a deal in hindsight.

Many investors look at economic forecasts to try to incorporate inflationary effects in their modeling. This is not an exact science either. Today we see investors trying to predict the next downturn. Some advisors are suggesting strategies that reflect their beliefs about timing and severity. Everyone has a different opinion. Some of these opinions are even based in experience or economic modeling. None of these opinions are guaranteed.

One thing that many investors seem to be overlooking, or even ignoring, is political risk. In my perspective, this is one of the biggest risks we are facing. It has always been there, but today property rights are taking a beating in the halls of government. Rent control, restrictions on screening for evictions or criminal behavior, prohibitions on evictions during winter, fines for leaving property vacant, restrictions on using property at its highest and best use through zoning, impact fees, and on, and on. We need to make better decisions about what we buy and where we buy it to mitigate these risks.

I recommend that you start looking around and making plans. Other geographic areas may offer less political risk. Other investment types may be less of a target. Do some exploring, before you need to get out. Real estate is not liquid. It will take some time to shift, so be prepared.

One of the things we hold dear as investors is that we should be able to see a return on our investment. We recognize there is no guarantee. We are at risk to the economic conditions, the weather, changing taste in housing, and many other variables of a free market. In today’s society there is an ever-increasing drum beat of “housing is a right” for those who we rent to. They do not have ownership, so they should only have the rights given to them in the contracts they sign to lease the property. Unfortunately, as investors, we need to realize that we do not have the votes to carry the day at the polls. We can also only go so far in using logic to change peoples’ minds. I feel strongly that we need to include the risk of legislative change in the list of risks we are facing. The returns need to go up to account for them, and if they don’t, our investment money needs to go elsewhere.

In the Chicago Creative Investors Association’s Code of Ethics, we state:

“…The acquisition, ownership, management, and disposition of real estate or its contracts (hereinafter the RE Business or RE Industry) is a highly regulated segment of our free enterprise system that entails substantial risks, and we who freely assume those risks are entitled to a suitable profit.…”

Unfortunately, that view is not shared by all.

Jane Garvey is President of the Chicago Creative Investors Association.