The Side of the Equation Investors Shouldn’t Ignore

Most investors, unless very experienced, concentrate almost exclusively on some method of measuring return on investment, i.e., cap rate, Internal rate of return, discounted cash flow. However, just as important is the other side of the equation – risk. Because risk doesn’t easily lend itself to quantitative measures, it’s easy to ignore.

The fact that an investment has historically returned an amount equal to 12% of the asking price by itself tells me little. First, I need to know the likelihood of this cash stream continuing. Are key tenant leases up? Is the layoit only suitable for the current tenants? What is the chance tenants don’t renew their leases? How much will it cost to attract new tenants?

Even in the residential field we need to account for risk. What is the risk that very expensive repairs will be mandated by government? What is the risk that some form of rent control will be enacted eliminating rent increases as costs continue to rise. What is the risk the major employer leaves town resulting in a 50% vacancy.

So as evident, I want a higher return as risk increases. To properly evaluate a real estate investment, Have to know not only the expected rate of return, but also the associated risks.