Analyzing Risk and Expected Value of Real Estate Investment Profitability Before Committing To Purchasing an Asset
6ayzjknbgc In the statistical world, or more specifically the world of probability, the term ‘risk of ruin’ is usually defined in terms as the threshold chance that someone’s risk of loss exists(relative to their current financial/investing pursuit), in as much that if they were to suffer large and prolonged losses over a period of time, their capital base would be eroded to the point where it would be highly unlikely that they could continue their financial endeavors with any chance of success. This article is not a primer in statistical probability, but for the sake of this article it is helpful to understand what this term means a bit more to see its application for today’s modern real estate investor.
Investopedia.com defines risk of ruin in the following way:
What Does Risk Of Ruin Mean?
The probability of an individual losing sufficient trading or gambling money (known as capital base) to the point at which continuing on is no longer considered an option to recover losses.
Risk of ruin is calculated by taking into account the probability of winning (or making money on a trade), the probability of incurring losses, and the portion of an individual’s capital base that is in play or at risk. Also known as the “probability of ruin”.
Investopedia Explains Risk Of Ruin as follows:
Risk of ruin need not result in bankruptcy (although it often does), but rather the point at which continuing on would be unwise. It signifies a risk more relevant in trading and gambling, where there is a high probability of losing an entire bet or trade.
Now that we understand what the term actually means, let’s get to the interesting part. Risk of ruin is most often used when discussing events which relate most closely to probability and earning money based on some element of chance, something we also know affectionately as gambling. Gambling carries with it the connotation of seedy, smoke filled casinos and other assorted personalities, so why would we be interested in this term if we are talking about real estate investing? Real Estate investing isn’t gambling…is it?
Enter Poker as a Metaphor for Real Estate
When chips, cards, and money get involved in some type of game, people immediately assume that gambling is what is going on. However, gambling usually refers to games of ‘chance’; that is, the idea that the outcome of such games are independent event horizons that have no effect on each other. For most people, since Poker involves cards and there is some element of randomness(known as chance or variance), there can be no skill involved and Poker becomes another form of gambling. However, since Poker offers a unique element known as ‘folding’, where a player can choose to not become involved in a hand or wager money based on the cards they received, in reality Poker becomes more of a strategy game than its casino cousins like Craps and Roulette, which are true forms of gambling. In Roulette, you lay down your money and when the wheel spins you win or lose – you can’t say ‘well, my number didn’t come up so I am going to take my bet back so I can use it and potentially win on the next spin.’ In Poker, you choose the hands selectively that you think will be profitable for you(known as having a positive expected value) and in doing so you essentially evaluate the likelihood of winning – premium hands(such as tow Aces or two Kings) are strong hands and really do set you up for success, while as other weak hands may not have a positive expectation, and may lead to a potentially unprofitable result. Good Poker players pick their spots carefully, and recognize that Poker becomes gambling only if you choose to put your money into the middle of the table when the outcome/profitability is governed by the cards alone. The best players in Poker try to mitigate any chance of a random outcome through a combination of skill and critical information gathering. And good Real Estate investors do the same.
Now, knowing this, we need to discuss the idea of risk of ruin as it applies to today’s modern investor, specifically, the new investor. New investors frequently look at real estate investing as a fertile ground where bountiful riches await, and they are eager to ‘get their money in’ as quickly as possible, often without knowing the probability or profitability of the potential outcome. Ironically, it is in this way that real estate investing can become all too much like gambling.
How Risk of Ruin Relates To Real Estate Investing
Professional Gamblers who want to avoid going broke exercise something called bankroll management. Bankroll management is simple – determine the amount of money you have to gamble with, identify that number, set those funds aside and work within those limits to increase your bankroll over time. Natural downswings do in fact occur, but gambling within the specified bankroll and setting specific loss limits for sessions(and being disciplined to stop and take a break from a losing session), theoretically, prevents a gambler from going broke. Now, bankroll management from a practical example works like this – suppose a Poker player has $1000 as their bankroll. If he goes to the Poker table and plays in a game where the minimum buy in is $1000, he is way over their bankroll and his risk of ruin is extremely high. One losing session and he cannot hope to become profitable because he has no capital with which to invest in future sessions. By not exercising good bankroll management, our player has doomed himself to bankruptcy, because he simply choose to not exercise a practical approach to the volatility that exists in endeavors that have some element of a random outcome. Had our player played in a game that was within his limits(say, a $60 buy in for example) he would still have $940 left after a losing session and the possibility for future gains still exists as a realistic possibility. Our gambler’s Risk of ruin in that case was low.
Now, today’s modern investor doesn’t think of real estate investing as gambling, they think of it as making an investment, and the caveat here is that often the inexperienced investor will think NOTHING of committing to a debt service payment on an investment property which is so high relative to their current income and financial resources it is akin to our gambler in the above example playing at a table with a $1000 buy in. Inexperienced investors tend to generalize and assume everything will go smoothly, or WORSE, be told that such a thing will happen by an unscrupulous wholesaler who is just trying to make a quick sale, and take their word for granted. The risk of ruin in these cases is so high that it is only after the new investor is on the verge of bankruptcy that they realize that something happened which probably could have been avoided – but by then it is too late.
A Simple Example To Illustrate
Suppose we have a new investor who wants to buy his first investment home to supplement income by renting the property to a paying tenant. Before he considers the money that potentially will be generated through the investment he must first identify the potential risks involved with purchasing an investment home knowing that, assuming he doesn’t have the capital to pay cash outright, financing carries with it debt service and that debt service needs to be paid on a monthly basis, lest the investment become jeopardized or the investor’s financial situation collapse in attempting to service it. Suppose our ‘would be’ investor brings home 2k every month from his full time job. What is an appropriate mortgage payment for an investment property the investor can realistically tolerate, assuming that an extended vacancy arises which keeps the investment property from producing income?
Experienced investors understand that this question cannot simply be answered by looking at one’s take home salary and figuring out a number, but simple rules which help mitigate the risk of ruin certainly apply. Ideally, the investor should not be ‘investing’ more than 10 – 15 percent of their net monthly take home into long term unending debt service which is front loaded with interest. Why such a low number?
Risk of ruin.
Assuming 15% of 2k as a benchmark for debt service, our mythical new investor would be carrying a mortgage payment of about $300/month, money which was typically used for discretionary income but now must be permanently committed to covering the debt service of a mortgage placed against an investment property. However, while a $300/month mortgage payment would indicate an investment home in roughly the 30k range(which represents a very entry level type of rental home, at least in Memphis where I live) the investor here is exercising a manageable amount of risk – and in doing so the expected value of our investor’s profitability is positive. A profitable outcome is expected. Our investor can tolerate a few months of vacancy because he has purposely kept his risk of ruin low.
Consider however, another investor who wants to make his first purchase and has the same level of take home income, 2k/month, but finds a deal they ‘can’t pass up’, which costs 100k. Assuming 30 year financing and an estimated payment of 1k/month as mortgage debt service, our investor in this case has committed 50% of their income to debt service which will have to be paid in the case of a vacancy. And it is in situations like these that I find new investors so frequently coming to me these days, asking me to resell their investment property for them before they go bankrupt. Usually these stories are pretty much the same – “real estate doesn’t work – I got ripped off by so and so who told me this would be a great investment”, but the finger of blame cannot be pointed by unsuccessful new investors who find themselves in these situations without first looking in the mirror and discovering that the problem first and foremost began there – inexperience and a lack of appropriate education coupled with a lack of understanding of the idea of risk of ruin allowed these people to put themselves into the predicament they found themselves in from the start. They are the reason for their own undoing.
As you grow as a real estate investor, new and costlier(with potentially more rewarding) investment opportunities will come into your focus. When looking at these, before you sell yourself on the financial upside of a potential acquisition, be sure to ask yourself about the catastrophic effects of risk of ruin and if such a potential investment is putting you into a threshold of an adversely high amount of risk. In doing so, you are doing yourself, your portfolio, and your family a great service which shows you choose to invest only after careful and thoughtful analysis, using risk of ruin as a measuring tape of risk tolerance to prevent losing all of your accumulated assets and to insure continued and sustainable financial growth.
Real estate was never meant to be gambling…but only YOU can determine if it is or isn’t.
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