Higher Risk-Higher Reward, at least that is how the saying goes. Be careful chasing big returns though as the probability of that higher return is not always level with the amount of risk being taken.
This can hold true in all investment vehicles, but let’s cover some examples in real estate investing.
Be Careful Chasing Big Returns
Example 1: Much higher than average cash on cash returns on rental properties out of state.
There are areas, both local to me and out of state where I can find rental properties that on paper are showing cash on cash returns upward of 20%.
You’d figure I’d jump at the chance of that no questions asked. However, that is the problem when we see a juicy return – we generally don’t ask many questions. Meaning, we skip a lot of due diligence.
Certainly deals like this can be found when researched properly, but often prudent research will discover the higher risk that comes with the property.
Say, for example, that a property is offering a potential 18% cash on cash return. Thing is – it’s in a high crime area or an area where employment is very weak.
What risk does this add? Is the 18% truly correct, given there is a higher chance you could see extended vacancies or have to evict? Possibly even deal with vandalization of your property?
The probability of seeing that 18% return is lower over the long-term than in other scenarios. It only takes one or two issues to cut your return in half. Then suddenly, you are getting a worse return than something that didn’t look as good on paper, but looked better out in the real world.
This is not to say you cannot have success in any neighborhood or area, regardless of status or environment. Just know your risks coming in and have a buffer built in to absorb those possible issues.
Example 2 – Giving Up Control of Your Investment
What I mean by this is when you see a high-return opportunity to invest in a real estate fund or syndicate.
Basically, you are just a financial investor. You have no control over the project or the management. It’s great as a passive investment and something I have done, but again no what you are getting into.
Just like with anything else. The highest offer of returns isn’t always the best offer. When you invest in something like this doing your homework up front is more important then ever as once you are in, you have no control over how the investment is handled.
So many crazy things can happen and the real estate market is always shifting. One change of the tide and a fund that is leveraged heavy offering larger returns go can bust in no time flat.
The point of this article is to be wary of your risk when chasing higher returns. Chasing higher returns is fine, just don’t get mesmerized by them. That is when you forget to do all your research and end up in a risky investment.
Asymmetrical risk is the goal in the end. More possible upside than downside.
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