Every investment involves a certain level of risk. Given the adage that higher risk often leads to higher rewards, risk is inherently advantageous. So the real question every investor must ask is, is the risk really your friend or your foe? The answer hinges on the investor’s unique risk tolerance and financial goals. While risk is commonly viewed in a negative light, instilling fear in the investment journey, it’s worth considering that risk could, in fact, be a beneficial ally. In this article, we explore the intricacies of how investors make decisions regarding risk, the extent to which they embrace it, and the underlying motivations guiding these choices.
Risk Appetite
Each individual possesses unique risk tendencies. Some are naturally drawn to excitement and thrills. We all have that one friend who revels in activities like skydiving, swimming with sharks, bungee jumping, or betting everything on black at the roulette table. This adventurous spirit often extends to their financial life, as they exhibit an aggressive risk tolerance, seeking the highest potential rewards.
On the other hand, there’s the friend who prefers safety and predictability. They’re always home by curfew, wait for the walk sign before crossing the street, and stick to ordering the same familiar dish out of fear of disappointment. This person is risk-averse, avoiding risk at all costs.
Between these extremes lie individuals who fall into the moderate category. Depending on the circumstances, they may fluctuate between embracing risk and adopting a more conservative approach.
Understanding these risk tolerance profiles is crucial as external influences also play a significant role in the decision-making process.
External Risk Tolerance Factors
It’s important to understand external factors such as age, lifestyle, marriage status, salary, and net worth often influence risk tolerance as well. For example, a person in their early thirties embarking on the initial stages of their investment journey is motivated differently than someone entering retirement after years of investing. The underlying assumption is that the individual building their investment portfolio for the first time is inclined to take more substantial risks to generate higher returns.
To delve deeper, the individual in their thirties might be driven by the desire to secure a stable future for themselves and their growing family. Whereas, someone reliant on savings and retirement funds is likely focused on preserving capital, aiming to generate sufficient income to sustain their desired lifestyle without returning to work. In both scenarios age, lifestyle, and salary play a pivotal role in why each person may take more risk or invest more conservatively.
Understanding Risk
To better understand the complexities of risk, let’s examine an investment nearly every individual encounters by the age of 18, purchasing their first car. Let’s delve into this investment.
Conservative Risk Takers
Opting for a brand new car. This vehicle carries minimal risk. It has no miles, is reliable, and is backed by a warranty. For the person who wants to have this long-term and be the most risk-averse, they would pick the new vehicle. Now in terms of a Multifamily investment, this aligns with a Core plus asset. It’s a newer vintage, requires minimal to no deferred maintenance, and does not need renovations. This asset is considered turn-key.
Moderate to Moderately Conservative Risk Takers
The next option is a slightly used vehicle, often a previously leased car with low mileage, well-maintained, and the option to purchase an extended warranty. While it offers many of the comforts of a new car, it lacks the hefty price tag associated with brand-new models. This parallels a Core asset in the realm of multifamily investments: under 10 years old, with minimal room for updates and light deferred maintenance, situated in a B+ location. Moderately conservative investors typically favor such an asset.
Now, let’s imagine the same property experiences wind damage to half of the building’s roofs, while everything else remains unchanged. This scenario introduces a slightly higher level of risk, requiring repairs. Investors comfortable with this level of risk tolerance would be considered moderate risk takers.
Moderate to Moderately Aggressive Risk Takers
Next, we encounter a single-owner certified used vehicle. It exhibits typical wear and tear, with a few scratches on the exterior, a small rip in the passenger seat, and an outdated sound system. While mechanically sound, there is room for aesthetic improvement to match newer models. This vehicle mirrors a value-add Multifamily property in the realm of real estate investments. Value-add properties maintain a solid foundation and have been well-maintained, yet they require some upgrades such as appliance replacements, a fresh paint job, and flooring updates to compete with newer complexes without the hefty price tag. This tier appeals to investors with a moderate to moderately aggressive risk profile. While associated risks are higher compared to previous tiers, the potential upside is greater due to the opportunity to enhance the value of the apartments.
Agressive Risk Takers
Finally, there’s the car you purchase at auction. It requires new tires, a new air conditioning system, new brakes, and a complete interior overhaul. While it possesses strong foundational elements, extensive work is needed. Despite its considerable shortcomings, this car is obtained at the lowest possible price, offering affordability. It appeals to aggressive risk-takers who recognize that by cutting costs and undertaking the necessary work themselves, they can transform it into something remarkable.
This scenario parallels an Opportunistic asset in the realm of real estate investments, akin to a Class C property. Such properties necessitate renovation, repair, and updating. However, purchasing at a low basis and undertaking the necessary renovations presents the opportunity for substantial returns. Nonetheless, this tier carries the highest risk, as failure to complete the renovations could result in significant losses for investors.
Risk Potential
Now that we have explored the various risk profiles, it’s crucial to grasp the potential upside associated with risk. Unlike vehicles, multifamily assets and real estate as an asset class tend to appreciate over time. The value of the multifamily examples discussed earlier is closely tied to the potential risk. As the saying goes, “The bigger the risk, the bigger the reward”. This adage holds true when analyzing the investment risks outlined previously.
Safest Risk Potential
The most risk-averse Core Plus property has the most limited upside for investors. While it is projected for favorable returns, its ceiling is much lower. This stems from the higher purchase price. The fundamentals of this deal are to buy and operate netting monthly cash flow. The objective is to watch the market to obtain a strong exit price. The perk conservative investors enjoy is the certainty of reaching the projections with the safety of lessoned operational issues.
Relatively Safe Potential
The Core asset offers a comparable level of stability to the Core Plus, employing the same business model. The primary distinction lies in acquiring the property at a reduced price, attributed to minor upgrades required due to the property’s vintage. The slightly increased risk associated with having to make minor upgrades offers the potential for investors to realize a higher profit upon resale.
Reasonably Risky Potential
The value-add multifamily property presents a significantly greater upside potential. Operating within an older vintage, competing against Core or Core Plus properties, this business model holds immense value. The imperative to upgrade floors and cabinets, apply fresh paint, and enhance the units’ appeal provides investors with the opportunity to increase Net Operating Income (NOI). Upon completion of renovations, each unit can command higher rental rates, thereby increasing monthly cash flow. While the inherent risk is elevated, so too is the potential reward. The potential upside materializes through both month-over-month gains and the eventual sale of the property. Renovations lead to forced appreciation, surpassing the natural appreciation that occurs over time.
Highest Risk Potential
The essence of opportunistic multifamily real estate lies in uncovering hidden gems. The prevalent strategy involves identifying the least favorable property in a prime location and revitalizing it into something exceptional. By acquiring a property at a minimal cost basis and implementing extensive renovations, remodeling, and updates, investors generate sweat equity. The substantial increase in value resulting from this transformation enables investors to stabilize and reposition the asset to strategically sell at the peak of the market. While this approach entails significant risk, the potential for immense reward makes it all the more enticing.
Final Thoughts:
We circle back to the initial question. Is risk your friend or foe? To navigate the intricacies of risk, and find an answer, investors must examine their current risk appetite. They must consider both their personal tendencies and external factors that influence how much risk they are willing to take. While risk can lead to financial losses, it also holds the potential for significant gains.
The crux of this dilemma lies in the principle that if one assumes additional risk, there should be commensurate compensation. The risk-reward scale should tip in your favor. Without this promise of potential upside, the risk is not worth taking.
