Redefining Risk

A moment reviewing a topic too often avoided, nearly always minimized, and quite frankly - not given enough press time when it comes to making money grow: RISK

There are lots of pieces to totality of the RISK puzzle, and most risk exists - at the very end - because of the Human Factor. It is pretty risky that someone - from a bank executive to your business partner - will get tempted by the cash and BAM, the Human Factor just happened!

In real estate deals there are all kinds of risks: Opportunity Cost, Entitlement Risk, Development Risk, Financing Risk, Construction Risk, Timing Risk, Saturation Risk, In & Out-Migration, Local vs. Macro Economics, Saturation, Exposure, Path of Progress... yada, yada, yada. The Human Factor plays a huge role in all of this.

Many similar risks exist in traditional business and the investment in them that is required to make these businesses successful: Supply & Demand, Inventory Velocity, Management Risk, Competition Risk, Location, Cost of Goods, Cost of Overhead, Market Conditions, and many others.

Note: Please leave a note with some of the more critical risks I may have overlooked.

I have been reviewing investments personally, and watching as investors review investments... and concluded that too often investors are seeking a "NO RISK" investment.

All too often, I have observed as investors elect not to pursue a viable project because they perceive "too much risk".

Warren Buffet has been quoted, "Risk comes from not knowing what you are doing".

I have heard stated that Larry H. Miller of the Utah Jazz has achieved such tremendous success because of his willingness to risk everything.

Another thought provoking quote might be "The greatest risk is to risk nothing".

So of our the 2008 Stock Market debacle, is it fair to say that one of the greatest risks around is believing there is none? How many investments from the 401 K to the Mutual Fund have been presented as "No-Risk" or "Low-Risk" growth opportunities? I have personally witnessed clients attempting to paint me into the corner of telling them that the risk I just finished explaining, is not really a risk, LOL! (Sure, the home could go down in value because the market slows down and stated income mortgages are no longer available - but come on, that is not really a risk, is it? Is it?)

So how is this for Redefining Risk: If you can't easily identify your risk in an investment, it may be too risky. (Some might argue that this does not apply to certain situations, and I may sometimes agree... but consider WorldCom, Enron, CountryWide, Wachovia, GM and others... sometimes the greatest risk is believing there is none - and entrusting other fallable humans to direct the outcome of your money for you.)

The counter principle to this would be to identify the specific risks of each investment, and identify the mitigating factors - or plans to offset this risk. Here's some ways to do that:

1. Offset Risk with LTV or Price
2. Offset Risk with Value Added
3. Offset Risk with Runway
4. Offset Risk with Experience or Strategy

1. Offset Risk with LTV or Price.
This seems to be the only factor that investors really believe in... and I believe in the years to come it may prove to be THE RISKIEST of the ways to offset Risk. This strategy is kind of the same as using a hammer to address risk, instead of a scalpel.

Consider investors in a real estate deal who lend against a property and rely solely on Appraised Values to determine the amount they lend, and the worthiness of an investment. Lenders often change thier LTV's or Loan To Values when they are concerned about a deal being risky. (Loan 85% LTV when the market is good but only 65% or even less in a tight market.)

Naturally the underlying principle is that if you loan less against the value, then you decrease your exposure to risk, or the investment is "more secure". Let's carry this concept through... If banks and investors continue lending an ever lower amount against valuable, potentially performing assets - even with legitimate exit strategies, they rob thier borrowers of cash critical to making projects successful. What investment is riskier - a deal where you loan 50% loan to value and the borrower has no cash to do the deal, or where you lend 75% of the value of an asset, and the borrower has the cash to do a deal? With a well sourced and qualified exit strategy - who is to say that lending 90% and placing greater controls on loan proceeds would not be a more viable exit?

My experiences with Banks and Lenders is that they place far too much emphasis on Appraisal, and LTV, and credit worthiness of a buyer - and almost ignore the most critical issue: the FINAL Exit Strategy. (Who will buy this asset if my borrower does not perform? The LTV might be 20% LTV, but if the pool of buyers for the asset class is not buying, be prepared to own the asset... and take on all of the risk you hoped to avert as a lender...

2. Offset Risk with Value Added
There are lots of examples for how "risky" investments can be the strongest. A friend Scott Moyes loves to say, "if you walk into a foreclosed, dilapidated home, pet stains throughout, and smells like a combination of doggy doo and cigarette smoke... take a long slow whiff! That is the smell of money!"

So who cares if you pay "FULL PRICE" for this rundown home... add some value (new carpet, new paint, a month or 2 of work, and now you've got something.

This home is actually a metaphor for DEALS. Use exactly this principle to find investments with some smelly deal points that need a bit of work or polish... and spend time and money working through them - those can be your strongest investments.

3. Offset Risk with Runway.
This principle is Timing, Timing, Timing. A deal that looks too risky today may be the best deal you could do in 10 years. Tie the deal up with an option, obtain seller financing, or finance the deal with lots of time out in front of you and you will find that time really can heal a lot of wounds.

Take a property down in phases, or make the funding of the deal contingent upon the meeting of certain milestones. You'll be amazed at how much gets done when there is money in it for the parties involved.

Timing can also be your greatest enemy, and once you are all in a deal, move quickly. I have seen firsthand what happens when you miss a window of opportunity.

4. Offset Risk with Experience or Strategy.
Not to be confused with Value Added, there are several good examples of offsetting risk with experience or strategy.

Mortgage Companies have employed this principle for years - by charging Mortgage Insurance premiums to people whose Mortgage LTV's are too high. These insurance premiums formed a strategy by which the Mortgage Lender could be protected from the Human Factor. (People die, lose jobs, get divorced, etc.)

These same companies found a way to work around the system with the 80% first, 20% second, and voila - now second mortgages are trading for around .01 to .03 cents on the dollar - so a solid strategy can also outsmart itself sometimes. (These 80/20's have been bad for the second mortgage company - but may SAVE some of the first mortgage holders in a lousy market!)

Another example of offsetting risk with experience is simply that of having experience. If you have doubts about a deal, go get somebody with a lot of experience and do it with them! The experience they have is an important component to giving you experience, and can save a deal if times get tough.

Another Thought: Risk vs. Secure
Today's Blog is not recomending you jump into risky deals that won't work. In fact, as I sort of flushed out this principle in my mind, I think it important to clarify that you obviously always want SECURITY for your investment... but that Security is different than no risk. A strong viable company stock, or piece of land can have plenty of risk, and prove to be less secure than a signature loan to a guy hell-bent on paying you back.

In the end, maybe the only thing we can predict with certainty is that the unpredictable will happen... so just account for it!

I hope the next time you are presented with that perfectly crafted, "insider secrets", "pays three percent per month", No-Risk plan that simply cannot fail, remember that it probably will.

But if you find a deal with some real risk on it... a deal with a viable, measurable exit strategy but some real risk as well, and the risk is sitting there growing hair - take a real look at the deal. Carefully measure and plan for the means of offsetting those risks - and if there is a real plan for resolving the risks, jump in!

And do me a favor - the next time you get pitched that perfect plan, tell the guy selling it "Not enough risk". He will probably think you are crazy.