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In every investment class, the price of an investment is significantly determined by risk. You aren’t going to buy Amazon stock at the same discount you can buy an unproven IPO. Does that make the IPO a better buy? No. It just makes the IPO a different risk profile. Price-earnings ratios and other metrics quantify the risk of stocks. Likewise, Moody’s ratings quantify the risk of bonds.
Rarely, however, do real estate investors quantify the risk of individual residential real estate investments. Instead, all prospects are typically measured by a universal percentage or expected profit margin. For example, investors often make the following statements:
“I need a $20,000 margin in order to purchase a flip.”
“I can only be all in at 70% of the after-repair value.”
“I need monthly rent to equal 1% of the purchase price.”
These are examples of real estate investors naively applying analysis without measuring risk. Does it matter if the prospect is in a popular neighborhood or a war zone? Of course, because the location affects the risk profile. Buying the better location at 80% of the after-repair value may be a better deal than purchasing the war zone at 70% of the after-repair value. Risk is one of the most important factors in the analysis, but it’s rarely measured in a quantitative way.
What affects risk? Thinking simply, risk in residential real estate is directly related to the local market demand for the property. A property that is desirable to the most potential buyers is the least risky, and property that is desirable to the fewest potential buyers is the riskiest. Given this, the least risky property is a three-bedroom, two-bath house priced at the market’s median price in a popular neighborhood. Here are some factors:
• The local housing market.
• The specific location’s desirability.
• The price of the house in relation to the median of the local market.
• The number of bedrooms/bathrooms (in a buyer’s market, a 3/1 has higher risk than a 3/2 because there is less demand for a house with only one bathroom).
• Amount of rehab required.
• Intangible factors.
Intangible factors are the characteristics of a house that are most important to a buyer in the median of the housing market. For your specific market’s intangibles, ask your real estate agent the five most important qualities a buyer values in a house. That can differ from market to market. For example, a two-car garage might make the list in Minnesota, but not in North Carolina. A pool might make the list in Florida, but would be a liability in Ohio. There are universal intangibles like yards, floor plans, parking and curb appeal. The more positive traits a property possesses, the more demand and, therefore, less risk.
This is why it’s naive to use the same profit requirement or all-in percentage (i.e., the 70% rule) for every house. A $15,000 profit margin on a low-risk property may be a better deal than a $25,000 profit margin on a high-risk property.
The first step is to identify the factors that affect risk level in your market. The next step will be to create ways to quantitatively measure them in your assessment calculations. In our franchise system, we do this with algorithms that take risk factors into consideration when calculating a max offer. You can build your own risk assessment by identifying the primary risk factors and assigning quantitative values to each when you analyze your next property.