In Part 2 last week, I wrote about what is meant by risk-premium-adjusted Net Return. This week, in Part 3, I would like to elaborate a little bit more on the concept of risk premium and its effect on the net return.
There are several types of risk premiums. One would represent the property’s risks towards natural disasters, such as flooding and earthquakes. Another might relate to the risks associated with the quality of property management of a condominium complex, including timely maintenance and repairs. And, there are risks of changes in government’s tax policies, especially in property taxes. Whether natural disaster-related or economic-based, risk premium refers to the extra percentage return that you, if buying, will require to accept the property-specific risks. Because the amount of risk premium required will depend on an individual’s personality and tolerance towards risk, one cannot say that the risk premium for this or that property is X%.
Having said this, however, what I often utilize is the return of a JREIT, that is well-diversified in terms of both geographical area and property type. JREITS are highly-liquid financial securities whose transaction costs are low. If, for example, a JREIT’s return is 5%, then you would want the risk premium to be at a minimum of 2% so that the after-leverage return of physical real estate will be at least 7%, given its lower liquidity and much higher transaction and maintenance costs. I would disregard from consideration any property offering less than 7%. Again, this is strictly my way of looking at things.
Of course, by the same token, even if the property is yielding 10% after tacking on 5% as risk premium, I may not be interested in that property if its risk profile is relatively much higher. As I mentioned earlier, the amount of risk premium that justifies taking on the risks is subjective and, therefore, depends on an individual’s risk tolerance and experience. This naturally means that the reasonable and fair price of a home is in the eyes of the beholder. Therefore, even if I might come to the conclusion that the reasonable and fair price of a certain home should be around 3.5 times the average household income, there might be another who would value it at 4.5 times the average household income.
In any event, most Japanese people might purchase a home only once or twice in their lifetime, so when making a final purchase decision, it would be very important not to overstrain, overstretch, and overdream, by calmly looking at the reality of the times. Please do not forget that taking a step back and taking a wait-and-see approach is also a viable option.