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Understanding Risk
The key to successful investing is understanding risk. All investments by their nature have risk associated with them. Understanding risk can be especially daunting if the investor is trying to transition into an asset class they are not familiar with.
For example; an investor owns apartment properties and now would like to enjoy the fruits of their labor. To accomplish this, the investor wants to maximize cash flow, eliminate the headache of management and minimize risk. The most common way to eliminate management responsibility is by acquiring Net Lease and Tenant In Common properties. Net Lease and Tenant In Common properties come in all asset classes.
The investor understands owning and managing apartment buildings but now needs to grasp the nuances of other asset classes such as office, retail and industrial properties and the way these assets are owned and managed in order to clearly understand the risk involved.
Each asset class has a different set of characteristics that can produce different results and risk for the investor. Asset classes also vary in their response to changing economic conditions.
We will cover the differences in these asset classes and forms of ownership in other articles. Today’s article focuses on a “broad brush” approach to help sort out viable investments based on their risk and return.
The following criteria can be helpful when screening and sorting out properties to consider.
1.Location and Demographics. Where is the investment located, what type of population growth is there, what does the current and future employment picture look like?
2.What is the term of the lease or leases? Are they for five years, ten years or more? Will the lease rate be increased, how often, are the increases fixed, adjusted for inflation, or based on the performance of the tenant (percentage lease)?
3. How credit worthy is/are the tenant or tenants? Are they a national credit tenant like Walgreens, or a local merchant? The risk profile (how likely they are to pay) is very different for each.
While there are a number of additional risk factors to consider, the above can be a good place to start when comparing investments. If an investment fails any one of the above tests, the investor should seriously consider eliminating it as a possibility.
For example the investor might be comparing a class A office building and a regional shopping center, both with major credit tenants in a strong metropolitan market and similar projected returns.
On reviewing the rent rolls the investor notices that two of the major tenants occupying over 60% of the rental space in the office building’s leases are up for renewal in two years, while the regional shopping center has staggered leases. All other factors being equal, the risk of having to re-tenant 60% of the office building in two years makes the shopping center far more attractive. The return on the office building would have to be significantly higher to make it a competitive alternative.
Even with a higher rate of return the office building could be the wrong investment for an investor looking for steady, uninterrupted cash flow.
A common mistake inexperienced investors make is to think that a low return investment is by its nature low risk. To avoid this mistake it is important that the investor first understand the risk of an investment.
By understanding the risk for a given investment the investor can then compare investment returns and select the best property for their individual needs.
Every investor’s need and risk tolerance is different. The secret to successful investing is to truly understand both the investor’s needs and the risk and potential reward of a given investment. In the final analysis only the investor knows the amount of risk they are comfortable with and the type of return that will satisfy their individual needs.
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