21 Apr How do I minimise the risk in property investing?
|Reducing Risk in Property Investment
One of the most compelling reasons for you to invest is the prospect of not having to work your entire life! Bottom line, there are only two ways to make money: by working and/or by having your assets work for you. If you keep your money in your back pocket instead of investing it, your money doesn’t work for you and you will never have more money than what you save. By investing your money, you are getting your money to generate more money by earning interest on what you put away or by buying and selling assets that increase in value.
With any type of investing there comes a certain element of risk. This could be investing in the share market or a particular business opportunity, and property investment is no different. Property can lose value and its ability to earn a rental income. Successful investing is all about identifying and managing risk to reduce the impact it may have on an investment.
What are the main risks in property investment?
1. Market risk (macro and micro)
2. Specific risk
Market risk relates to the environment and location the property is being purchased in and has two tiers, the macro and micro. On a macro level, the market risk relates to such things as the economic climate as well as the health and stage of the market you are buying in. On a micro level, the market risk relates to suburb factors such as infrastructure, demographics, vacancy rates and affordability.
Specific risk relates to the actual property you are purchasing and includes such things as location, build quality, inclusions, layout and rental yield.
An investor must analyse both of these risks to ensure a sound investment.
Analyse Risk at the Macro, Micro and Property Levels
Sound Property has developed an innovative research model that involves a ‘top-down’ approach across three tiers of research. The 15 Key Investment Drivers (Fig. 1) identify the biggest influences for growth and rental yield and help avoid any costly mistakes. Many property investors can get caught in ‘comfort investing’. This involves starting at the property level, usually in their street or suburb with familiar surroundings, and trying to justify it as a good investment. Whilst this may be the more comfortable option, if any of the higher level investment drivers are working against them, such as purchasing in the wrong market cycle, or in an area with low economic diversity or with high vacancy rates, the investment performance may be affected and risk enhanced.
Fig 1. 15 Key Investment Drivers
1. Macro: The macro level assesses Australia as a whole and its various capital cities. One of the biggest risks on this level is market cycle. An investor needs to invest counter-cyclically or buy at the bottom rather than the top of the boom. Often this will go against what the media and other people are telling you to do and takes courage to invest in this subdued period. Markets go through periods of expansion and contraction and it won’t be long before a booming market corrects. Also on a macro level, it is basic economics that if people are in jobs (i.e low unemployment), there is a shortage of property (i.e supply vs demand) and interest rates aren’t too high, then an environment conducive to growth is established.
2. Micro: Micro level drivers relate to suburb specific influences. Two major risks to assess on this level are vacancy rates and affordability. If there are low vacancy rates, excess demand and affordability through strong incomes and low interest rates then it creates an advantageous market for price growth. The vacancy rate is the percentage of available rental properties on the market at any one time. If a property market has a high vacancy rate it could mean two things; 1. There are higher than normal supply levels or 2. There is low rental demand. High vacancy rates can mean there is not a lot of competition in that particular area which means it could be difficult to attract a tenant. A general rule of thumb is to look for property markets that have less than a 3% vacancy rate. A 3% vacancy rate is considered a balanced market with healthy mix of supply and demand. Anything under a 3% vacancy rate is considered an under supplied market and ideal for investors looking to reduce risk.
Cheap areas are often an easy target for an investor due to their lower entry prices, however two of the main market risks in these ‘cheap’ suburbs are unemployment and the relative affordability of mortgages due to lack of income. It seems pretty obvious if people don’t have jobs and are not earning enough you are not going to see them cope with rental increase or have the ability to push prices up. The debt ratio (i.e mortgage repayments/incomes) should ideally be below 30% to reduce risk on the micro market level.
3. Property: The property level is where it is important to assess the specific dwelling and its match for the local demographic. For example, it would not be advised to buy a one-bedroom unit in a suburb removed from accessible amenities and known for families that desire houses. It will lack demand and therefore growth. Instead, look for features that will attract owner occupiers as this is the group of future purchasers buying with emotion and pushing values up. Conversely, avoid high-rise and investor only developments, as these can be more volatile, higher risk of oversupply and restricted in growth. Another way to mitigate specific risk is to conduct pre-purchase due diligence on the property including building and pest inspections from an independent building inspector.
>>TIP: Employ a ‘top-down’ approach by starting with the Macro level first rather than the Property level. This will ensure that your investment has the best chance of performance, reduced risk and will not be negatively impacted by these higher level drivers.
When it comes to any type of investment, there will always be an element of risk involved. Rather than avoiding risk and leaving your savings in the bank, identifying and managing both the market and specific risk of property will ensure a sound investment.
More information on reducing risk can be found here or contact Sound Property on 1300 655 899.
This article is provided for general information only and does not constitute personal advice, as it does not take into consideration your personal circumstances. Please consult a licensed tax or financial advisor before making any decision to invest.