It is always a challenge to confidently price real estate. The concern generally heats up when fundamentals are at their cyclical low and cash flow forecasts are in question.

But even in the best of times, the goal for investors is to earn returns at least as good as or better than the rest of the market on a risk-adjusted basis. Still, who can predict what the future will bring?

An investment decision is essentially a choice between consumption in the present or postponed consumption for a future time. Investment in the broadest sense means present sacrifice for expected future benefits.

Since the present is relatively well known and the future is uncertain, investment decisions represent certain sacrifices for uncertain benefits. In the case of real estate investment, these benefits generally take the form of future cash flows (rental income) and/or appreciation in property values.

However, psychic returns, which is a positive feeling induced by ownership of real estate, is also sometimes considered as a form of benefit derived from real estate investment.

The general investment rule is: the higher the risk, the higher the return. Having said that, investment risk means how much the returns vary from what you expect.

Of Shares and Cash
Shares are the riskiest asset class. Share prices are volatile, which means they can rise and fall significantly in the short-term. However, over the longer term, they have been the better performing asset class.

Cash is the least risky asset class with little risk of capital loss. However, the returns are also the lowest.

Everyone has their own personal preference when it comes to investing. You may be prepared to take more risk in order to pursue higher gains over the long term, or you may be more comfortable with a lower level of risk and a lower, more stable rate of return over the long term.

Risk is defined as the variation in the expected future benefits; return is the amount of inflow generated by the investment each year. Generally, the higher the expected return the higher the risk of the investment. (See figure 1).  The fundamental issue is whether the extra return is worth the increased risk.

The Risk-return Trade-off

The two basic sources of financial returns from owning real estate are the annual cash flow from operations (usually in the form of rent), and the cash flow from disposal of the asset at the end of the ownership (typically, a sale).

However, estimates of both the annual income and the receipts from disposal, which are necessary in order to determine the value of the investment, are usually not precisely known due to uncertainty regarding the future. Hence, risk is an integral part of investing.

The main types of risk that an investor must analyse in making an investment are:

This is the possibility that the investment will not generate the expected level of net income due to changes in market conditions. The value of investments may decline over a given period simply because of economic changes or other events that impact large portions of the market. Asset allocation and diversification can protect against market risk because different portions of the market tend to underperform at different times, i.e. different locations or different types of properties. Market Risk is also at times referred to as ‘Systematic Risk”.

 

This is the possibility that price increases will be greater than expected and result in a decline in purchasing power. It also relates to the probability of loss resulting from erosion of an income or in the value of assets due to the rising cost of goods and services.

This is the possibility that the government will change policies or laws that affect the investment. Legislations by the government could significantly alter property ownership, transfers of ownership or business prospects of one or more companies, local or foreign, adversely affecting your property investment. This may occur as a direct result of government action or by altering the demand patterns of investors.

This is the possibility that the investment will not generate sufficient income to cover debt obligations.

The goal of any investor is to form an investment portfolio that has the highest possible expected return for a given level of risk. Alternatively, this may also be interpreted to mean that the investor seeks the lowest possible investment risk for a given expected return.