Recent conversations have reminded me of the angst experienced by many of us as we do our best to balance what has often been called the Risk-Reward Paradigm.
Put in plain, regular folk English, is the reward worth the risk — and — is the risk at about the right level for the reward?
Most will quickly agree that a double digit yield on their investment capital is a relatively high yield. Just as readily, they’ll nod their heads when we say 1.5% is a very low yield. However, when both are put into context via their relative risk levels, then compared side to side, so to speak, each risk and return begins to make obvious sense. If we put up $10,000 into a 10 year treasury bond and make $150 on it over the next year, we’re not surprised. We knew goin’ in that the relatively low, low risk of our capital would only merit about a 1.5% yield. Conversely if the perceived risk escalates several times, we expect the ultimate yield to reflect that reality.
Perception of risk — is it accurately evaluated?
The U.S. government treasury bond has generally set the bar for many. It’s backed by the good credit of the federal government. These days though, there are those who demur, saying that the relatively low risk historically attached to those bonds are arguably less safe than in the 1950s. I only point that out to showcase the perception of risk, and how it’s different for different people. Take my grandpa for instance.
He’s long gone, but not long after Dad and I had formed our firm, we’d talk about investing, returns, and risk — especially the perception of risk. In Grandpa’s experience, anything to do with real estate other than his home was far to risky an investment in which to put his excess capital. Most would conclude this was a direct result of arriving at voting age mere months for the infamous crash of 1929, which presaged the Great Depression. Most would be wrong. Since his father lost everything due to dealing with the wrong folks, Grandpa stayed away from real estate his entire life. To what degree was his perception of risk/yield skewed? Even Grandpa got a kick out of my reactions, bellowing his signature laughter, which I’m sure could be heard a block away.
One of these laughs came after his answer, as in no way, no how, to this question:
“If I brought you a $100,000 note, secured by a trust deed on Disneyland — in first position — at 12% — and you could buy it for $65,000 — with an appraisal done by the expert of your choice, showing a conservative value of $10,000,000 — would you buy it?”
“Nope, wouldn’t do it.” Cue the camera towards me, lookin’ like the RCA Dog, with him bursting into earsplitting gales of laughter.
Though his relative risk was virtually non-existent, what with the LTV (loan to value) being 1% of a conservative appraisal, AND buying it at a deep discount, he passed without giving it a second thought. Perceived risk doesn’t have to be accurate, it just has to exist and be believed.
This is why so many don’t invest in much of anything. The risk they perceive overpowers them. What happened in the stock market in ’08 didn’t help much, right? ‘Course, before that, I heard there was some sorta bubble thing goin’ on in real estate.
Back to risk and yield
Let’s always remember why it’s called ‘risk capital’, alright? The bigger the risk the greater the yield. Thing is, people often disagree on the degree of risk for a given investment. For example, I’ve had several clients over the decades, maybe half a dozen or so, who think real estate offers a yield commensurate with the risk, yet wouldn’t, under any circumstances borrow money for the purchase. The mere use of even demonstrably mild leverage, say, 50-60% down, increased the risk, in their eyes beyond the point at which they remained comfortable. They bought for cash.
Don’t get me wrong, using borrowed money to acquire real estate does increase risk. Anyone saying otherwise is only foolin’ themselves. But history shows that when interest rates are low, and the rent/price ratios attractive, prudent leverage imposes less increased risk than when those factors are much less favorable. And the congregation answered, Duh. But you get the point.
Risk and yield go hand in hand.
Investing, whether it’s in real estate or hula hoops is most successfully carried out when the investor has appraised the Risk-Reward Paradigm as accurately and realistically as possible. This is why I’m always pounding the Sominex Account (cash reserves), and the individual’s comfort zone. It’s why I refuse to help investors put their capital into what my boots on the ground due diligence has shown me to be inferior areas/regions.
The same goes for investing in notes secured by the very same real estate. When the faithful and realistic risk assessment is done, the investor realizes the yield is relatively higher due to the increased risk discerned by the market in general. As do virtually all serious investors, a diligent effort should always be made to assume the acceptable risk while concurrently, if possible, reducing that very same risk.
The potential reduction of risk is another post altogether, but you get the gist.
BawldGuy Axiom: The Risk-Reward Paradigm is undefeated in the history of investing. Get it right or wrong, but when the smoke clears, the results will speak for themselves. Attempting to gain extraordinary yield through equally extraordinarily low risk is folly. Some would say wishful thinking. Someone who genuinely cares for that investor might say delusional.
Investing in real estate, or anything else for that matter, brings the lines of ‘risk tolerance’ (read: comfort zone), required retirement income, the time window at your disposal, and available investment capital into play. It’s where those lines ‘cross’ that the ability to ascertain what’s possible can be estimated. Even then we can never lose sight of the ever present truth that any crystal ball we might deign to employ would be as cracked as any other.
The Risk-Reward Paradigm insists we must accept the reality of risk increasing with the hunt for the higher yields our analysis tells us is necessary to generate the retirement income we covet. Also, keep in mind that when you read or hear ‘high yield’ it’s always a relative term. High compared to what? The risk, or some other investment? Real estate investors have shown for decades, generations, that since the yield is historically higher than other investments, the risk has also been shown to be manageable. That is, as long as the investor insists on knowing the real level of risk vs the real level of reward.
Yeah, I know, it ain’t rocket science, is it?
I doesn’t take rocket science to gimme a call. You’ll find me at 619 889-7100. Prefer writing me?Just use the Contact BawldGuy button up top. We’ll figure out where your lines might cross, and get a Plan goin’. Have a good one.