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Investing does not overlook or reassess the fact that the expected return on investment and the risks associated with an investment are closely interlinked. The higher the investment risk, the greater should be the return requested by the investor. The higher the investor’s expectations of return, the greater the risk he must be prepared to take.
The risk associated with investing is not a single concept but consists of a large number of different sub-risks.
General investment risks
Market risk is the chance that the value of an investment may change due to the unfavorable market events, such as the macroeconomic reasons, political or social instability, due to the behavior of investors etc. Such events may lead to changes in real estate prices and volatility. Diversifying the investment portfolio into various asset classes, industries and regions of the economy can reduce the market risk.
Liquidity risk refers to the adverse situation at the time of the liquidation of investment. For example, there might be not enough buyers of real estate at the exiting time or at the price level expected by the seller. Liquidity risk may lead to the extended exit period. However, if the investor is forced to exit the investment, it could lead to the reduction in expected returns as well as to the occurrence of direct loss. Such an event might also lead to unexpected additional costs, such as extraordinary real estate evaluations, additional sales costs etc. The realization of liquidity risk may lead to significantly longer exit time unless the investor is willing to sell its investment at a considerably lower price.
When investing in another country or in another currency, there is a risk that an investor may suffer losses due to unfavorable changes in currency exchange rates. Currency risk can easily be hedged using various risk management methods and instruments.
Inflation risk is a situation where the inflation rate reduces the real rate of return or real value of the investment.
Legal or regulatory risk arises from the fact that the legislative acts regulating the asset, investment activities or taxation of earned income may change during the investment period. For example, the government may change the tax laws that govern the taxation of income earned by the investor.
Political risk or country risk is the chance of investment value changing due to the political changes or instability in the country. Radical changes in the economic or legal environment (such as nationalization), internal political affairs or social crisis situations (such as civil unrest) are all examples of political risk.
Interest rate risk
Changes in interest rates may significantly affect the value of real estate investments. High-interest rates have generally adverse effect on real estate prices, and vice versa.
Concentration risk can occur in a situation where an investor’s investment portfolio focused on just one asset class (for example, shares) or economic region (such as Greece. The concentration risk can be avoided by reasonable diversification.
Crowdestate risk rating
Crowdestate has a risk rating for real estate investment opportunities that looks like this:
Crowdestate Rating is an expression of investment opportunity’s aggregated risk level, calculated as a sum of qualitative and quantitative evaluations of opportunitiy’s different parameters. Amongst other criteria, Crowdestate Rating considers investment opportunity’s capital structure, financial leverage, location, stage, cash flows, teams’ track record, collaterals etc. A1 is very safe, C5 very risky.
The above-mentioned rating expresses Crowdestate’s subjective view on each investment opportunity’s total risk level. Crowdestate Rating does not account for specific investor’s risk tolerance and is not meant to serve as a replacement for individual due diligence. Crowdestate Rating has no relations to ratings issued by international rating agencies nor to their rating methodologies.
Investor and risk tolerance
If the so-called ordinary person would define the investment risk as a partial or total loss of the invested capital, then the financial experts suggest that the investment risk is treated as the difference between the expected and actual returns, or even more broadly, if the investment does not achieve a persistent target.
Risk tolerance is the personal perception of each investor, how much he/she is willing to endure in the investment period as a result of a change in the value of the investment (both in growth and in decline). The risk tolerance is individual and depends on many factors – the investor’s age, education, wealth, etc. For example, as the age grows, the investor’s risk tolerance is usually reduced.
Usually, investors are assigned a risk tolerance of three:
- conservative (want to avoid risk or risk a little, even if the return is very low)
- moderate (accepting moderate risk to achieve moderate returns)
- aggressive (wanting higher returns, even if the risk is high)
Questionnaires are used to identify risk tolerance, focusing on the following issues:
- How much of your investment are you ready to lose?
- Would you be able to continue your habitual life, if the value of a particular investment was reduced by, let’s say, 20%?
- How long is your investment horizon?
The longer your investment horizon (and the time it takes to reach your desired goal by investing), the higher your risk tolerance is generally.
- What is your emotional ability to withstand losses?
- Can the temporary decline in the value of investments during the investment period (even if the prospects are very good in the long run) cause you so much stress that it will affect your everyday life?
Not all people are able to withstand the changing values of property that comes with investing and get into panic and stress.
An intelligent investor will consider the risks associated with each particular investment regularly and the suitability of the investment with its own risk tolerance before each investment and during the investment. If you’re sure that investing in real estate is something for you, you can join Crowdstate here!