It’s easy to get carried away with fantasies about property investment riches and an ever-rising market – but investors need to be realistic about the risks of building a portfolio and understand just how much risk theirs is carrying.
Everyone knows that investment carries risk and property, of course, is no exception.
Despite this, property is often touted as a ‘safe’ asset class – the argument being that shelter is a fundamental need for society and not everyone wants, or can afford, to buy their own home.
Property is also often viewed as less speculative than alternative asset classes, such as shares, because it is a tangible investment – bricks and mortar that house our fellow Australians. Even if values fall, the physical asset will still be there – or so the argument goes. In many cases, this is true – if values in your suburb dip by even 20 per cent, you never lose 20 per cent of your floor space or land size.
Yet, more extreme collapses can, and do, occur. Throughout 2013, for example, there were stories of houses selling for US$1 in Detroit, Michigan in the US.
According to news reports at the time, numerous properties were selling for less than $1,000 and opportunistic Chinese investors started snapping them up – because surely prices couldn’t go any lower?
Even though it could be argued that these investments were financially risk-free – after all, they would have been bought without a mortgage – it was still a risk-laden strategy for these investors.
The city, after all, was still in serious financial strife and the population was rapidly declining. There was a huge risk that these investments wouldn’t do anything other than sit there and deteriorate – hardly a sound investment.
On the flipside, if you already owned one of these properties, and indeed had an existing loan, the house price collapse wouldn’t have been a ‘risky opportunity’ – it would have been a disaster with serious financial implications.
In most cases, the loan would have been worth more than the property’s current value – creating some alarming negative equity.
While no one is predicting a Detroit-style economic collapse anywhere in Australia, it is still important to understand that risks within the property market are real.
The argument that ‘the house will still be there, no matter what price the market currently dictates’, may suit some investors who are not easily rattled and have a sound and diversified portfolio. But first-time investors need to assess their risk profile and work out how comfortable they’ll be if things do turn sour.
Some property investors only envisage what could happen to their portfolio, and indeed their profits, if the market continues to improve. Many find it difficult to imagine what would happen if the market stagnated.
To adequately prepare for property investment and the associated risks, you need to consider all outcomes and how you would react under different conditions.
What is your risk appetite?
If you don’t adequately assess your risk profile and do enough research before you begin investing, you could end up purchasing a property that limits your ability to grow your portfolio.
If you buy a high-risk investment because you’re promised high returns, and it ends up costing you emotionally and financially, it could turn you off property investment for life.
So when it comes to your first property, the more research and analysis you do in terms of risk, the better.
You need to know how much risk is sustainable in your portfolio and indeed in your life.
The internet is riddled with anecdotes, formulas and analyses on how you can work out your risk profile. There are equations, calculations and quizzes that can tell you where you sit on the spectrum.
Realistically though, your own life so far, and your views on the future, can paint a pretty accurate picture of whether or not you’re a ‘risk taker’ and how comfortable you are with speculation, fluctuations and uncertainty.
Do you bet on sporting matches? Do you play games of chance? In social situations, are you a leader or a follower? Do you push your own ideas and seek adventure? How quickly do you make decisions? Do you then agonise and feel anxious about the decision and the potential outcomes? How have you reacted when you’ve lost money in the past? What about when you’ve won money – or earned a large sum in a short period of time? How much of your income do you spend? How much do you save? Do you have adequate insurance?
Even though property investment needs to be driven by the numbers and working towards your ultimate financial goals – and buying based on emotions will likely result in an ineffective and unproductive portfolio – you do need to be able to sleep at night and be comfortable with the level of risk and exposure in your portfolio.
Your experience with risk in the past – whether it be related to investing, your finances, social situations or how you’ve worked towards your life goals – should act as a good starting point for working out your risk profile.
Reducing risk in your property portfolio
There are various strategies, tools and tactics investors can use to mitigate the risks associated with investing in property – such as diversifying their portfolio (both in terms of location and asset type), educating themselves about the property market and sticking to ‘safer’, lower-risk suburbs.
Conservative property investors, those who are unsure of their appetite for risk and first-time buyers would likely be better off steering clear of high-risk purchases, such as mining towns or anything offering ‘fast’ rewards.
One of the key ways to reduce risk within your property portfolio is to always have a financial buffer in place. This will reduce the chances of you getting caught out in the event of unexpected costs (such as repairs and maintenance) and will cover the shortfall in rental income if you experience any vacancy periods.
The costs associated with property investment also don’t stop if you encounter other financial or personal difficulties. If you lose your job, become unwell, go through a divorce or have cash flow issues within your business, you can’t simply stop paying your mortgages and the other costs that come with owning a property portfolio.
Imagine if one of these life events occurred while you were also experiencing a vacancy in one of your properties. How would you cover the mortgage repayments? A financial buffer will help you weather the storm and continue meeting your financial obligations.
In addition, you need to be prepared for the costs associated with your portfolio to rise. Interest rates in Australia have been at near-historic lows in recent years, but in many instances they have started to rise – particularly for property investors.
You need to be prepared for interest rate rises and know that you can still meet your financial obligations in the event that your monthly mortgage repayments change. In the early 1990s some homeowners were paying upwards of 17 per cent interest on their mortgage. Even though that may not be a likely scenario this decade, it’s important to remember that interest rates aren’t set in stone and there is always the risk that they could change.
In addition to monitoring your cash flow, you can also reduce the risks associated with interest rate fluctuations by locking in a fixed-rate on your mortgage – however, this is something that comes with its own risks and considerations.
The more you know about property investment, your finances and your goals, the more prepared you’ll be for all risks and outcomes. Investing in a financial education and employing a team of experts around you can thus be an effective way of reducing the risks associated with property investment.
Seasoned investors who have benefited from using industry experts often say that they wouldn’t attempt their own surgery or try to fix their own car – so why not utilise experts in the field to help you make the most of your investments?
How to diversify your portfolio to reduce risks
Diversification is an important part of mitigating risk within your property portfolio. Indeed MoneySmart, an initiative by the Australian Securities and Investments Commission (ASIC), says that diversification is “the best tool you have for overcoming investment risk”.
According to MoneySmart, diversification minimises your chances of unsustainable losses because a loss made on one investment can be counteracted by a gain on another.
First-time property investors obviously can’t always diversify and spread their risk because, in most cases, they may not have a lot of cash leftover after their first purchase.
The more preparation you do at the front end of your property investment endeavours though, the more prepared you’ll be to make your second purchase, reduce the risks and grow your portfolio.
Factoring diversification into your plans will help you move more quickly and minimise the risks associated with property investment.
Property investors have different options when it comes to diversification and can spread their risks in the following ways:
• Diversifying the types of properties they purchase (eg, houses, units, villas, renovation projects, subdivisions)
• Diversifying the locations within their property portfolio
• Targeting different types of tenants (families, young working professionals, short-term stays, etc)
• Diversifying the loan structures they use and accessing a range of different lenders
• Diversifying the assets they invest in (eg, shares, cash)
Factors affecting your risk profile
• Life stage: Do you have children? How much do they cost you? Are you planning a wedding? How much of your income is disposable? How close are you to retirement?
• Attitude to money: Are you good at saving or do you live week to week? Your attitude to money and how comfortable you are with the idea of ‘diminished’ savings can affect the kinds of risks you’re willing to take
• Investment experience: If you have experienced big losses, you may be more risk averse than others. On the flip side, if you’ve weathered a market downturn, riskier strategies are less likely to bother you
• Income: Your income, and in particular its stability and security, can greatly affect your risk profile. If your income or employment isn’t guaranteed, you will obviously need to take this into account when looking at investing
• Insurance: Australians are often described as ‘under-insured’. How much insurance you have, and your knowledge of what it actually will and won’t cover, can affect how many financial risks you take.