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risk tolerance

Determining Your Risk Tolerance: High IRR or Security


Jul 17, 2020 by Liz Brumer

There are dozens of options available to investors who are new to investing in real estate. From passive investments like real estate investment trusts (REITs) or crowdfunding to more active investments like owning residential or commercial rental property -- all of these real estate investing methods have different risks and rewards. It's up to the investor to determine their risk tolerance and where they fall between investments with security but lower yields or higher risk and larger returns.

While there is risk in any investment, some investments have more risks than others but also have the potential to pay off big. Take a look at the pros and cons of both to help you determine where your risk tolerance may be and whether an investment with greater security or greater return is better for you.

High-return investments

While not always the case, most higher-yielding investments carry a higher ratio of risk. Risk comes in a number of different forms but could include property that is largely vacant or in need of major repairs in order to be stabilized, a risky neighborhood with high turnover rates or higher crime, or some type of default or distress. It could include companies that are in an oversaturated market, have too much debt or shaky books, or are simply being poorly managed.

Higher-risk investments are typically discounted in direct relation to the risk they carry. The riskier the investment, the bigger the discount. This means the investor has a greater opportunity to earn assuming all goes to plan, but it often also requires a lot more work as well.

Who higher-risk but higher-return investments are better for

Higher-risk and higher-return investments are typically best for those who have higher risk tolerances and are willing to put their money into an investment knowing they very well could lose their money if the investment goes south. No one wants to lose big on an investment, but there is always a chance the deal costs more than anticipated, the market struggles to recover for that sector, or the company as a whole just goes south.

Not all high-risk investments are money pits. Many pay off big time, and for this reason, the investor who is willing to give up security for the potential to earn high double-digit returns can reap the benefits. It's fairly common to see younger investors who still have time to recover from a not-so-great investment or the time and effort to put the work into making the investment successful take bigger risks.

High-security investments

Conversely, there are certain investments that are seen as more secure investments. These include investment properties that are already stabilized and operating to market standards, higher-quality buildings with more affluent tenants, or properties in a market that is and will likely continue to be in high demand. While these turnkey investments can provide stable income and return on investment (ROI), they are typically at a lower yield. The investor is trading returns for security.

Who higher-security but lower-return investments are better for

Generally, higher-security but lower-return investments are typically better for investors who are in or nearing retirement or simply have a lower risk tolerance. As we stated before, no investment is risk-free, and there is always a chance to earn less than anticipated or to lose. But investors who aren't willing to lose a large portion of their money on a higher-risk asset should stick to investments with lower yields but greater security.

How to know where an investment falls

There are a number of factors that will determine where you fall as an investor and ways to identify which investments meet your risk tolerance. To start, review your current financials looking at your retirement plan, investment funds, savings, and assets. Determine what your financial and investment goals are, and calculate exactly what type of return is needed to accomplish your goals. You may find that to meet your financial objectives, you have to take a more aggressive approach to investing, which may or may not align with your appetite for risk.

The good news is that there are investments that fall in between the two mediums, offering moderate and sometimes even high returns while still providing relative safety and security to the investor. It's simply a matter of knowing what to look for.

Whether you're looking at a REIT, crowdfunding opportunity, partnership, or investment of your own, understanding how to evaluate the opportunity, its market, overall supply and demand of that sector, and performance for the asset class is the first step to determining whether a market or company has the potential to grow and earn or has undesirable exposure.

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