Thinking Of Buying A Rental Property? Consider Idiosyncratic Risk

In which I find myself very directly affected by the concept.

In my first-ever post for TheStreet.com, I featured a relatively new real estate-focused ETF which was designed to specifically track the housing market.

In the article, I featured that I was in the process of attempting to sell my own home. As it happens, my wife and I purchased our home over 15 years ago, for the purpose of assisting my aging parents in their later years. Now, though? We wish to downsize into a smaller place, travel more, and enjoy a greater level of freedom while both our health is still (relatively) good.

While an older home, it has a lot going for it. It is on one of the best streets in our community, located in a very small pocket with the best residential zoning the city offers. It has a fully-legal Accessory Dwelling Unit (ADU), easily rentable for over $2,000 per month. Both the main home and the ADU have been remodeled to what I would describe as a very nice standard. More than one realtor touring the property has made very favorable comments.

At the same time, it does have a couple of minor weaknesses. The bathrooms, while nicely remodeled, are a little small by current suburban-home standards. We don’t have a separate laundry room, but rather a stackable washer/dryer hidden in a beautiful pantry-sized closet, but in the kitchen. One woman touring our home was heard to say “Oh no. I’d go crazy in a couple of weeks if I had to do that!”

The bottom line? As I write this, it appears we are going to be able to close our sale. However, the final sales price will be, in my opinion, at least 5-7% below multiple recent comps in the area. You’ve doubtless read the many stories of homes that have commanded multiple offers culminating in insane overbids. Simply put, that has not been our experience.

Enter Idiosyncratic Risk

Why am I writing this? Is it a case of “sour grapes?” Perhaps, in some small way, writing about it makes me feel better, serving as a healthy outlet for over a month’s worth of frustration.

But, as a financial writer, it also gives me a nice opportunity to talk about the topic of idiosyncratic risk, sometimes also referred to as non-systemic risk.

What, exactly, is idiosyncratic risk? Here’s an excerpt from a definition that can be found at CorporateFinanceInstitute.com.

Idiosyncratic risk is the risk that is particular to a specific investment – as opposed to risk that affects the entire market or an entire investment portfolio. It is the opposite of systemic risk, which affects all investments within a given asset class.

I gave an example of this about 3 years ago, in an article featuring the benefits of investing in ETFs. You may recall the horrible accident that occurred in 2010 on one of British Petroleum’s (BP) oil rigs in the Gulf of Mexico. In the example, I traced how BP stock performed compared to the S&P 500 over the next 5 years. An investor who held only BP in their portfolio would have directly experienced the effects of idiosyncratic risk.

To minimize this risk, investors generally seek to build a portfolio of investments. Happily for me, they may read at least a few ETF Monkey articles in the process.

But Back To That Rental Property . . .

But wait a minute, we weren’t talking about stocks! The title of my article related to rental property. What gives?

As featured in a 2013 article in The New York Times, many individuals may find themselves enamored by the idea of buying a house and renting it. As I read the article, I couldn’t help but be struck by similarities between that year and our current environment. Historically low interest rates leave cash in the bank, well, worse than worthless because one is nowhere near to keeping up with inflation. Bonds? Not much better, not to mention taking on interest-rate and duration risk.

In such an environment, the appeal of owning a tangible asset, combined with a potentially rising revenue stream, can be attractive. If a $500,000 home can generate $30,000 in annual rent, that 6% return could look extremely attractive.

Here, though, is where idiosyncratic risk comes into play. Consider this, from Christopher J. Mayer, professor of real estate, finance and economics at Columbia Business School.

“There is a lot of idiosyncratic risk associated with rental income. That is the word that economists use for when a lot of things can go wrong, even if on average they don’t go wrong very often.” (Italics mine, for emphasis)

Those two italicized words, “on average,” get at the heart of idiosyncratic risk. The most obvious one is that you might find yourself with a “problem tenant.” But it goes further than that. You might encounter a foundation issue requiring an expensive fix, or a live electrical wire left buried in a wall that starts a fire.

Or here’s another one. A couple of years back, a wildfire swept through a neighborhood where a good friend of mine lived. Happily, her home experienced only minor smoke damage that was able to be remediated. Her immediate neighbor? House burned to the ground. Two houses, same neighborhood, but with dramatically different results from the same event. Idiosyncratic risk.

Related to that is the concept that the return you get on your single property will likely be no greater than other houses on the same street, or in the same town. If overall prices rise 5%, likely your property will rise about 5%. Put simply, you find yourself in the unenviable position of taking on greater risk for the same return.

Bringing It All Full Circle

Returning quickly to my home. There appear to be a few factors that have negatively affected my particular property. Interestingly, some of them appear to be a result of the COVID pandemic. Large flat lots appear to be the rage. While I have a beautifully landscaped, reasonably large lot, it has a slight upslope, with two levels. One set of parents who toured the home wanted to build a full-blown children’s play area, and our lot didn’t fit their needs.

For the same reason, I don’t have a swimming pool, and it would also not be particularly easy to build one on my property. The incredible irony about that? My realtor tells me that, 1-2 years ago, swimming pools were generally considered as undesirable in our area of California, due to the expense of maintaining them, liability issues, and the always-present threat of drought. Not now, apparently. It would appear that, possibly as a result of recent limitations brought about by the pandemic, the idea of private swimming pools and play areas is once again in vogue.

As a result, I have experienced idiosyncratic risk, in a very real way.

And it was exactly this that led me, in large part, not only to write the article mentioned at the outset of this one, but to invest in the featured ETF in my own portfolio.

And with that, we have come full circle. I hope this article has at least given you something to ponder. I’d love to hear your thoughts. Feel free to drop a comment below.

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And, as always, until next time, I wish you . . .

Happy investing!