Emily’s Notes: Risk
You’ve heard the saying, “To win big you’ve got to bet big”? That pretty much incorporates the essential elements of risk right there: there are two sides to it.
“Risk” is not the same as “loss” because there is also the chance of gain. A symmetrical risk profile has a 50% chance of loss, but also a 50% chance of gain. A lot of folks tend to forget that last part.
For her purposes, Emily understood risk as a variation in the expected result. A low risk investment meant to her that the projected benefits are likely to occur. A high risk investment meant the forecasted returns are possible, but are less likely to happen.
A symmetrical risk profile has a 50% chance of loss and a 50% chance of gain. Some of Emily’s insolvent friends thought, “Well, that seems fair.” Fair is when, over a long enough period of time, the wins and losses even out and everybody gets their money back. But she is an investor and no investor seeks only to get their money back. She wanted the investments she made to be weighted very much in her favor. She wanted her money back and more besides. What Emily sought was asymmetrical risk: she wanted her chances of gain to be more, maybe much more, than her chances of loss. She sought low risk (it’s likely to happen), asymmetrical investments (her gains will far exceed her losses).
Warren Buffett, who doesn’t buy apartments but could if he wanted to, once said “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Emily did not know how Warren Buffett defined his terms, but she interpreted “a wonderful company” as one which provided asymmetrical benefits expressed in low risk, and that’s what she wanted in any investment she made.
Low risk is almost always a result of the existing investment (stock, apartment building) being in a market with robust barriers to entry. For any of a variety of reasons, it is unlikely a “wonderful” investment will face unexpected competition in the predictable future.
An example might be the only utility company in a growing area, but there are other possibilities. Sometimes industries are dominated by oligopolies (the majority of the market is shared by a small number of producers), and putting a little money in more than one of the top companies in that industry might work out pretty well. That’s what Buffett occasionally does. There have been 465 bank failures since 2008. Only a relative handful of big banks are left. The banking industry has become an oligopoly, and Buffett has taken positions in both Bank of America and Wells Fargo. It’s not likely BofA or Wells will wake up tomorrow to news of meaningful unexpected competition. Other examples of oligopolies might be UPS and FedEx, or Coca Cola and Pepsi.
In contrast to oligopolies, the local natural gas or electric utility company is a monopoly: the market is owned by one producer. As population migrates to the area and as industry’s needs increase, the demand for power can only go up. In her personal investments Emily favored the risk profile of a monopolistic natural gas or electric company in a growing area. Fixed costs being already in place, any increase in demand should go right to the bottom line.
The oligopoly’s profile can (but not always does) transfer to apartment buildings. Think of a market area where population is growing but for various reasons (environmental, political, or for some other reason) no new competitive apartment buildings are likely to be built. An example would be a fully developed small city with nationally recognized public schools. Resident’s children can attend these wonderful schools, and upon graduation have their choice of top universities competing for their enrollment. Non-residents on the wrong side of the city limits have to attend expensive private schools to get an equivalent education. As one would expect, this educational disparity would be reflected in property values. A family who buys in that city pays more for the home, but they also sell (or refinance) it for more when the time comes. An apartment building in that city would reasonably generate greater rents and market at a higher price than similar non-resident buildings: their lower risk profile could be monetized.
To continue this theme, the owner’s return on her money (rents, dividends) and return of her money (upon refinance, sale) are more secure. Because the chance of loss reduces the value of an investment (ie, the net income is capitalized at a higher rate to offset the purchaser’s assumption of greater risk), the wonderful company (or apartment building) with less risk from competition would be expected to sell at a higher price (lower cap rate) both when purchased and when sold.
Sidebar: Assume a building purchased at a 4% cap rate on a Net Operating Income of $100,000. Value at purchase: $2,500,000. Seven years pass and the market cap rate remains at 4%, but the NOI has doubled to $200,000. Future value: $5,000,000.
Compare to a building purchased at a 6% cap rate on an NOI of $100,000. Value at purchase: $1,667,000. The same seven years pass. The NOI has improved to $200,000 and the market cap rate remains at 6%. Future value: $3,333,000. Both investments have done well, but the one purchased (and later sold) at a lower cap rate has done better.
Neither the buyer nor the seller of an investment can have certain knowledge of the unknown future. That future is subject to the butterfly effect, and chaos theory informs us that there is risk in every interaction more complicated than a puppy’s love. Because the future is unknown, the ultimate results of the investment are also unknown at the time of the transaction. They could be either adverse or beneficial depending on the position taken and what happens next.
Say a real estate investor buys 20 or 25 units and immediately afterwards the market shoots straight up. For the rest of the year the buyer will be sure every foursome he meets on the golf course will know about the deal he got. You and I know there was no “deal” because at the moment of purchase the buyer paid full value. In truth, he paid more than any competing investor offered. That’s the only way he could get the building. Market related transactions occur on the margins, on the very edges of the price window. What made the buyer think it was a “deal” is something unexpected that happened after the purchase, something that was unknown by the market ahead of time (and consequently not baked into the price). The butterfly effect: maybe the Kardashians moved next door.
That was the buyer. The seller, as the counter-party, lost potential gain. If he’d kept the property another year or two, like his wife said, he would have really made out.
Overview: In Emily’s mind, apartment investments are by definition secure. Banks don’t lend $1 or $2 or $3 for every dollar of down payment the buyer contributes if the investment is risky. But, of course, not all apartments are equally secure. We’re using “secure” in the Buffett sense, meaning that barriers of entry make it reasonable to expect a steady and increasing stream of net income and the property is likely to appreciate over time.
Both net income and appreciation of an apartment investment are heavily impacted by its location. Given a favorable political environment, a poor location for income property is someplace nobody with any money wants to be. Obviously, that means that a better location would be where lots of financially secure people want to be. So the first thing Emily looked for is how crowded the area is – she googled for population density by zip code.
After density comes income. Is it better to own in an area where all the people are rich or where they are universally poor? Google for census data and look up per-capita income.
So at this point, imagine that an investor discovered a promising area that has a high population density and every person there is a trust fund baby who doesn’t care how much the rent is because the trust pays for it. Is that a good location? Almost.
There is also the matter of building restrictions. There must be significant restrictions. Not rent restrictions, building restrictions. If other investors can build new apartments to meet increased demand, growth in rental income will be disappointing. A good location for investing purposes is a place where population grows faster than the supply of apartments. That means area rents will go up faster than they would in an area with fewer building restrictions. It’s supply and demand at work. If you’ve missed some of the basic articles, guidelines on successful investing are in my book “Stairway to Wealth” available at LuLu.com.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate Klarise Yahya Commercial Mortgage Broker, BRE: 00957107 MLO: 249261 can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email info@KlariseYahya.com.