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Risk ManagementTHE IMPORTANCE OF RISK MANAGEMENT IN REAL ESTATE INVESTING:
Too many people, both investors and “owner occupants”, have acquired property at a discount, only later to find out that the property was worth substantially less then what they owed, “never mind what they paid. “ How can these mistakes be avoided? What should the role of Risk Management be in the Investment Decision Making process? In recent times we have read about how the major financial institutions (banks, insurance companies, mutual funds, hedge funds, major investors etc.) of the world have literally been brought to their knees. The world has faced a liquidity and financial crisis as a result of their poor decisions. One must ask, were all of these people stupid or misinformed? Didn’t they all have Risk Departments? Of course they did!! Unfortunately, their management and operations people greedily focused, obviously, only on anticipated huge profits, without regard for the exposure they were assuming. In order to successfully invest in real estate or any other investment, for that matter, I believe it is necessary to adhere to three basic precepts which became known as the FISCHER AXIOM: You must first establish a time horizon in which to forecast and measure the eventual annual rate of return on the chosen investment. The reason is that without a time horizon the actual return on investment has no meaning. For example, one might want to earn a minimum of 25% on the investment, but if it takes 20 years to achieve that return, one would not consider it to be a successful investment. You must establish a minimum acceptable annual rate of return for the chosen investment. This is essential as there has to be a target return for evaluating the probability of success for each investment. Most importantly, one must evaluate each investment as to what its value would be under the worst possible circumstances. The objective would then be to invest in properties at, or below, this worst case scenario value. Only in this way, will you be minimizing your exposure to potential adverse market or fiscal conditions. It’s not important that by evaluating investments in this way you might eliminate the vast majority of opportunities, some of which might be successful in the long term. What is important is that the investments that you do choose will have the highest probability of profitability with minimal potential for loss.
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