Understanding risks a prerequisite to maximizing return

When I decided to write this column about risk, I went looking for source material. I found zillions of Internet sites that address risk. These ranged from very sophisticated academic papers about statistical methods of determining the risk for stock portfolios to the other extreme -- a guy who claimed he could eliminate your real estate investment risk if you just sent him money.

The following is taken from a variety of Web sites, plus my own experience and opinion.

Risk is the probability that something different from what you intend will occur. Going hand in hand with risk is the risk/reward ratio: The higher the risk, the greater the reward, and vice versa.

In making any decision, you need to correctly assess risk and reward. For stock portfolios, corporate real estate and large real estate investment portfolios, there are statistical methods that can analyze and quantify risk. But small real estate investors are on their own because every property is unique and their portfolios are too small for these analytical methods to work.

Small real estate investors can take steps to assess and reduce risk. Start by looking at the different kinds of risk over which the investor can exercise varying degrees of control. For instance, the risk that a property has a defect is largely eliminated by doing a thorough property inspection before purchase.

Risk can also be reduced or eliminated through insurance. The risk of a problem with the title to the property can be eliminated through title insurance. The risk from fire can be reduced by buying fire insurance.

However, market risk -- fluctuation in the market -- is another matter. You can study the market demand and availability of supply for a rental property very easily. Just go look at what is available and the activity in the market. So you should know how a property will perform at the time you buy it.

Predicting how a property will perform in the future is harder to do. This depends on a lot of factors, and you need to know the major ones and how likely they are to change. Future rent levels are based on supply and demand. This requires analyzing the economic outlook, possible threats to the economy, and the likely future demand for your property.

You have lower market risk the more standard your property is because it fits the needs of more possible tenants. For example, a general warehouse of standard size, doors and ceiling height has far less risk than a unique property that is anything but standard and requires a tenant who needs the unique features of that property.

Risk is also associated with your investment strategy. It is generally safer to buy and hold for a long time than to buy with the intent to maximize your return by selling after a few years, then buying another property to keep returns as high as possible. Buying and holding means you have to weather the ups and downs of the market, but eventually you will own the property free and clear when the debt is paid off. The rate of return is lower than selling and reinvesting, which has greater risks -- availability of financing, interest rate changes and market conditions.

Not doing something has risks too. It is riskier to keep a unique property instead of changing to a more standard property.

Some risks seem remote, but happen. Here are three such risks I have seen occur in Anchorage. The local government redesigns your street and seriously impairs your property. A crisis in the insurance industry causes your property insurance costs to rise dramatically. Property taxes go up unexpectedly.

In the investment world, risk is not something bad always to be avoided. It is inherently part of performance. The important thing is to understand the risk. An investor has to accept a business risk and the chances that things might go wrong, because the only way to get ahead is to take risks. If there is no risk, there is no return.

Chris Stephens, CCIM, is a local associate broker specializing in commercial and investment real estate.