Risk management: Part 3 – Risks in property investing

Welcome back to my Risk Management series.

I’ve talked quite a bit about risk in this blog. Earlier in the series, we covered the basics of risk in Part 1, and personal risks in Part 2.

Today, in Part 3, we’ll explore risks that apply to a single asset class – residential property.

Property investing is extremely popular in Australia. After the second World War, prosperity reigned, and the Great Australian Dream propagated through the nation. A house on a quarter acre block became something everyone aspired to, and is, in a way, a measure of success. This dream persists today; the 2016 census data showed that owner occupied properties were the largest asset held by households, accounting for 43% of household assets. The same year, Corelogic estimates that there are 2.6 million investor owned dwellings across Australia worth approximately $1.37 trillion. Small scale investors own 83% of all investment property with nearly 10% of property investors owning three or more properties.

Over the long term property has delivered some significant returns – some might even say property returns trump shares. But before jumping in, one must thoroughly understand what they’re getting into. Lets look at some of the risks relating to property investment.

Vacancy risk

Most people invest in property to obtain a regular income, which usually comes in the form of tenants paying rent. This naturally becomes a risk in itself – what happens when the property is vacant?

Vacancies are a naturally occurring event in the property management lifecycle. Even the best long term tenants will eventually leave. However vacancy risk is more about extended vacancy, where the property will be vacant for a longer than usual period. If you do not have tenants paying rent, this leaves you, the investor, to pay the mortgage repayments and other property expenses out of your own pocket.

This could happen for multiple reasons – lack of rental demand in the area, for example, or no suitable tenants can be found.

Buy well. One of the best ways to avoid extended vacancies is to make sure your property will appeal to as wide a market as possible. For example, we choose to invest in well-maintained 3-4 bedroom homes located in middle to outer ring suburbs. These homes need to be close to shops, public transport, schools and recreation amenities. This ensures that our property will appeal to the widest possible demographic – families with children still living at home.

Be good to your tenants. A bird in hand is worth two in the bush. Happy tenants are less likely to leave, which reduces the chance of having a vacancy in the first place. We respond to maintenance requests promptly, and always consider all reasonable tenant requests for improvement to the property. Most landlords don’t include air-conditioning or allow pets; on the contrary we do both, as it usually results in tenants wanting to stay on longer.

Be flexible. Sometimes, despite all we do to avoid a long vacancy, it happens. Vacancy rates can change over time, and you might find that your suburb might turn into a renter’s market almost overnight! In this case it’s important to try and secure a tenant as quickly as possible. We’ve used two different strategies to do so – firstly by offering a couple of weeks rent free, but asking market rent, and secondly by dropping asking rent by 5-10% under market.

Property risk

Unlike shares, property is a real, tangible asset. Like all physical assets, property can be at risk of damage, either through natural (forces of nature) or unnatural means (malicious or accidental damage caused by a person).

Properties don’t come cheap in Australia. According to the Housing Industry Association, the average cost to build a family home in 2019 is $317,389, excluding land costs. Being such an expensive asset, we wanted to make sure that any risks are well and truly managed.

Good tenant selection. By now I’m sure you’ll notice my approach to risk management. My first step is always to try and reduce likelihood of the risk occurring, and I do this by making sure my tenant selection is spot on. Tenants are the second most important asset (after the property itself) in property investing, and you’d want a good, reliable tenant who will look after the property as if it was their own. Our property managers are very experienced and have stringent tenant selection standards. They also do regular, comprehensive inspections during the tenancy to make sure that the property is well-kept and in good condition.

Landlord insurance. Despite our best efforts, sometimes tenants turn out bad. In these situations we have landlord insurance to cover potential malicious or accidental damage caused by tenants or their guests. Our worst tenant caused almost $15,000 worth of damage in their attempt to modify the property to grow weed. Thank goodness for landlord insurance, which restored the property back to its original condition with no hassles.

Building insurance. Australia is a land of extremes. We experience natural disasters every year, sometimes multiple times. Fire, floods, cyclones, you name it. We take out building insurance to mitigate against the risk of property damage – the cost of rebuilding is so high that we could not afford to self-insure.

Overcapitalisation

Overcapitalisation occurs when the money spent exceeds the value added to the property. This commonly happens at the purchasing stage. Most investors tend to shop for an investment property using the same criteria that they would for their own home. Whilst it’s good to have high standards, keep in mind that tenants needs may not necessarily be the same as yours.

Investors are also exposed to overcapitalisation risks during the course of a tenancy – specifically when it comes to improvements to the property. Tenants may request non-essential improvements during their tenancy, or you may choose to renovate before putting the house on the market. It’s important to know how to avoid spending too much, lest you run the risk of overcapitalising on your investment.

Do you really need fancy fixtures in a property you don't live in? Image by mynemesis2011 from Pixabay
Do you really need fancy fixtures in a property you don’t live in?
Image by mynemesis2011 from Pixabay

Set clear priorities. When evaluating a potential investment property, we have a checklist of ‘must haves’ and ‘nice to haves’. The ‘must have’ list is pretty short – basic finishes, well-maintained, location close to transport, amenities, and schools. Nice to haves are fancier – Caesarstone benchtops, air-conditioning, hardwood floors. We base our price negotiations on the must-haves and not the ‘nice to haves’. If we can get a property that ticks all the must-haves in our price range – great. If we can get a property that also has some items in our nice to have list – even better. But we won’t pay a cent extra for any nice to have items.

Keep it simple. We keep everything simple when renovating or replacing items. If the house is in good nick, a coat of paint or installing new carpets is all we do. If the bathroom or kitchen needs work, we do the bare minimum. If appliances need to be replaced, we look at generic brands instead of top-of-the-range ones. Pools are a no-go, and so is solar.

Market risk

Market risk refers to the risk that an investment may face due to swings in the market. Given that most property investors tend to concentrate their holdings in a single market, market fluctuations can be especially concerning if price crashes occur.

Diversify. Diversification is often the best way to mitigate against market risk. We intentionally diversified our property holdings in very different suburbs across two different states. I must admit though, that the individual property markets we’re invested in are somewhat correlated with each other. When one market rises, so does the other, with a slight time lag. The main goal of diversification is to ensure that assets are diversified across markets that have low correlation – so by this definition, we have not truly diversified. However we also hold other asset classes like shares, so in a way, we have diversified our overall portfolio such that we are not overly exposed to property.

Liquidity risk

Liquidity risk refers to the marketability of an investment and whether it can be bought or sold quickly enough to meet debt obligations. Liquidity risk is realised when an investor is not able to sell an investment property when desired due to lack of potential buyers.

Property is an illiquid asset. Unlike shares, it takes a long time and a lot of effort to move property. It is not easy to sell a property, let alone sell quickly. This could place the investor in dire straits if the investor is desperate to convert the property into cash.

Buy well. It’s not an easy risk to manage, so we’ve adopted an avoidance approach. Purchasing a property that appeals to the broad market gives us the best chance to offload the property, if we ever need to sell.

Operational risk

Operational risk can be summarized as human risk – business operations failing due to human error. This could be due to breakdowns in internal procedures, people and systems. Humans are fallible. We make mistakes. Therefore in every service industry where human interaction exists, operational risk is likely to be higher.

Property investment is one such industry. Tenants must be managed. Rent must be collected. Maintenance will need to be arranged. Each and every single element involves some form of human interaction – and by extension, a potential failure point.

Outsource property management to a professional. We mitigated this risk by using professional property managers who are reputable and reliable. We chose a full-service package where they handle all the day-to-day management with virtually no input from us. They will only contact us if the property requires a repair above a certain dollar threshold. They also manage the leasing process end-to-end. Being interstate and working full-time prevents the both of us from self-managing our properties efficiently; in our case, this approach is the best option for us.

Interest rate risk

Interest rate risk refers to the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. Although this typically happens with fixed income assets (e.g. bonds), it could also affect property.

With investment property, the interest rate risk lies in mortgages, specifically with variable interest rates. The cost of debt capital can increase or decrease at any time, which affects the interest the borrower pays.

Fix the rate, but hedge your bets. Use this strategy cautiously. Fixed rate offers certainty – in that you know exactly how much your interest rate will be for a period of time. It doesn’t offer guarantees, though. Variable rates can move up as well as down. You may find yourself in a situation where you’re locked into a higher rate when the variable rate drops. We personally hedge our bets – half of our loans are fixed, the other half variable.

Manage cashflow. Interest rates can move at any moment, without warning. In the past the Big Four banks have moved together with the Reserve Bank of Australia, but not anymore. Out of cycle rate changes are common these days. We keep a big enough cashflow buffer in our budget so that we can absorb the impact of sudden interest rate hikes.

Keep an eye on the market. It also pays to regularly compare loan offers. If we see that another bank is offering a lower rate, we’ll ask our bank to match it – and we’re not afraid to take our business elsewhere if our bank refuses to budge.

What’s next

You’ll find many people on the internet singing the praises of property investing and why it’s the best asset class in the world. There’s an collective voice, just as strong, extolling the virtues of shares. Many debates have been had about which is better. Both are right, and both are wrong. The correct answer is whatever you feel comfortable with, after thorough research and understanding the risk versus return dichotomy.

Stay tuned for the next instalment in the series, where I explore investment risks that apply to shares.

What other risks apply to property investing? How have you approached them? Please share your thoughts and strategies in the comments below.

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