Continuing the theme of summer supplements and looking at something different. This week I wanted to get on my soapbox about an absolute favourite of mine but also something I consider extremely important and valuable. I only wish someone had taught me about this when I was a teenager or young adult! The subject is risk pricing and expected value.
For me, this encapsulates the whole of property and success. I’m talking about today, and investing going forwards. Think about the landscape from the advent of the housing act 1988 and the true birth of Buy To Let (there were landlords before this of course and luckily a few are still around and share their wealth of experiences on socials and via giving talks/working with organisations like the NRLA). Fantastic capital growth outstripping inflation. Relatively stable prices (a couple of notable exceptions in 90/91 and 08/09). Super yield. The figures show an asset class that has outperformed all others (and I’ve shared that analysis before).
When the underlying does very well, it is hard to lose money. The benchmarking (another concept not widely understood) that should take place should be against the average returns and whether you have beaten them. Perhaps use a REIT as a vehicle for comparison.
Today, there are some differences. It is likely that time will continue to be kind because the structural housing problems in the UK are nowhere near solved and arguably, today, are the worst they’ve ever been. But yields are lower and operational costs have never been higher. With zero risk interest rates at basically zero absolute returns are likely lower – if inflation stays low this is less of a problem but that has been discussed extensively on here this year!
So onto the pricing of risk. This is where the value add can really kick in. A simple way of translating this to property would be planning uplift. If you have to transact on a piece of land without planning (let’s say it is in auction at the right price) then the person who understands the probability of success of planning the most is likely to win in the long run above all others. This isn’t nailed on because luck plays a part – and on one individual transaction is not material. When you get into dozens and then hundreds of transactions then the mathematics crushes everything else.
The mathematically inclined will look at the expected value. The best planning consultants I’ve had the pleasure to meet and work with understand this concept very well. You can ask them for a probability of success.
A good deal might look like this:
Worst case scenario, 10% likelihood, 10% gain
Likely scenario, 60% likelihood, 30% gain
Best case scenario, 30% likelihood, 60% gain.
You would then add these together and multiply out:
10% of 10% = 1%
60% of 30% = 18%
30% of 60% = 18%
Expected gain 37%.
Note that none of the scenarios actually means a 37% gain so this is a mathematical concept not one reality.
However if you ran the same scenario 1000 times and your numbers were right you would on average find your average gain was close to 37%.
There is much more to property development than this of course. The best will find solutions where others cannot. Maximising gain and/or maximising probability of success.
Of course there are deals where the worst case scenario is a breakeven or a loss. This is where bankroll management then comes into play – but that might be another one for another day.
Happy summer Sunday folks!
