10 investment property risks and how to minimise them
In this edited extract from his book, The Property Wealth Blueprint, Rasti Vaibhav reveals the main 10 risks associated with owning an investment property and offers tips on how to minimise them.Experienced investors know that risks and good returns go hand in hand – it’s a balancing act. If you can identify these risks, you can mitigate the threats and negative impacts they cause. I look at 10 substantial risks that every property investor may potentially face and analyse the ways to thwart, mitigate or embrace these risks.
1. Market risk (also an opportunity)
Market risk refers to the likelihood that an investment’s price may fluctuate. Price movement is constant and is governed by the factors that impact the overall performance of financial markets. While this is one of the biggest threats, it’s also a significant opportunity to build wealth.
The property market is cyclical and, at times, external factors may cause market-wide slowdowns or speedups.
The good news is that the Australian property market is not homogeneous. This means there are markets within markets, and they all exhibit different property cycles. Some property cycles are asynchronous (or uncorrelated), that is, when a specific market surges, the other one may collapse. Keeping track of the market’s cycle will help you avoid this risk. By gaining property exposure in the markets that are unsynchronised or are experiencing lesser correlated cycles, you may be able to examine the subdued impact on the overall portfolio performance.
How to minimise this risk
Diversify your property portfolio. Consider the following aspects to reduce the impact of market crashes:
Invest across different locations
Buy different property types (apartments, townhouses, units)
Focus on different demographics
Include budget variance
Buy the property below the market price. It gives you a safety net if the market slumps due to external factors.
2. Property risk
Property risks may include either natural (forces of nature) or unnatural threats (malicious or unintended damage caused by a person).
How to minimise this risk
Buying stable and sound properties. You should always conduct a proper building inspection and pest inspection before purchasing a property, which will expose any issues the property might have. The reports will also help identify if further investigation is required.
Maintaining the property. Conduct regular inspections and fix minor issues before they turn into big hassles. By maintaining the integrity of the structure, you will ensure it is stable and robust.
Buying adequate building insurance. Ideally, you should have your insurance in place as soon as the contract is signed to ensure that you are adequately covered. You can always buy insurance directly, however, a qualified insurance broker will help you review and select the best insurance cover to suit your requirements.
Buying appropriate landlord insurance. Picking the right tenants through the right property manager may not be enough. You need to make sure that you are adequately covered for any malicious activity by the wrong tenant. The rental default clause would also insure against rent loss.
3. Overcapitalisation
Property investment is one of the few asset classes where you can physically enhance its value by undertaking repairs or renovations. Improving a property is perfectly natural for an investor, but there’s a risk that the investor may overcapitalise – that is, spend more money than required or justified. In these cases, the investor may not be able to recoup the money they spent when it’s time to sell.
How to minimise this risk
Set your goals firmly and stick to your budget.
Research and understand the needs of the local demographics.
Commit to doing the bare minimum.
Focus on the must-haves and not on the nice-to-haves.
4. Vacancies
Buying a rental property doesn’t mean you will always be able to rent it out and collect rent consistently. There may be periods when the property is vacant. Vacancies are a naturally occurring event in the property management lifecycle. However, the vacancy risk is more about extended vacancies, where the property is empty for prolonged periods. This situation can be challenging if you rely solely on the rental income to cover your mortgage payments and other holding costs.
How to minimise this risk
Invest in a growing area that offers various amenities such as schools, hospitals, malls, and parks.
Look for a property located near the main road which has easy access to public transportation yet offers a quiet and relaxing atmosphere. Tenants usually prefer such locations.
Secure sufficient financial buffer to cover the mortgage and other holding costs if you fail to find a suitable tenant instantly.
Treat property investing as a business and your tenants as stakeholders. Happy tenants are likely to stay longer, which reduces the chance of having a vacancy. Respond to tenants’ reasonable requests quickly, especially if these are about improvements to the property.
Be flexible with your rent expectations as markets change over time. Consider reducing your asking rent by 5% to 10% if the vacancy persists. This will enhance the appeal of the offering and attract more lease applications.
5. Bad tenants
You can encounter many issues with bad tenants, including property damage, non-payment of rent and complaints from the neighbours or the authorities. Getting stuck with a bad tenant can be even worse than the risk of not having a tenant at all. Additionally, there is a risk of exposure to high costs and uncertainty associated with bad tenants.
How to minimise this risk
Select an experienced and proactive property manager who understands the local market and has stringent tenant selection standards.
Insist on regular and comprehensive inspections during the tenancy to ensure that the property is well kept.
Have competitive rental rates but avoid having meagre rental rates, which may attract unfavourable tenants.
Always have adequate landlord insurance.
6. Interest rate risk
An increase in interest rates will influence variable-rate mortgages adversely as monthly repayments will increase and as a result may strain your cash flow.
How to minimise this risk
The interest rate risk can be managed by opting for fixed-rate mortgages and prudent cash flow management. Another way to reduce the impact is to shop around and negotiate for the best interest rate. You can even take advantage of the promotional rates offered by different lenders. However, beware that changing the lender too often or having multiple credit applications may impact your credit rating. So, your first option should be to renegotiate with your existing loan provider and test if they can offer you an additional discount by quoting a competitor’s offer.
7. Cash flow
Cash flow is the net income that the property investor earns after paying off an investment property’s expenses, taxes and mortgage repayments. Negative cash flow is experienced when the costs exceed the rent collected. In such situations, you need to use other income sources to pay for the property. Therefore, cash flow risk has the possibility of generating a negative cash flow of a more significant magnitude than expected.
How to minimise this risk
Forecast your income and expenses and allow for contingencies.
Build a substantial property portfolio with sufficient cash flow to support your requirements.
Consult a property strategist to help you plot your long-term strategy and build your property portfolio according to your circumstances and risk appetite.
8. Lack of liquidity
A significant risk specific to real estate investing is that properties are illiquid, that is, they can’t be easily converted into cash. This risk manifests when an investor is forced to sell a property at an undesirable price due to their financial or personal circumstances.
How to minimise this risk
There is no easy solution for managing this risk, so you should embrace it by maintaining liquidity in your portfolio. However, it would be better to avoid it altogether by building a buffer of liquid investments or cash. When contemplating your acquisition, consider your need for liquidity and invest wisely.
9. Personal risk
Investment portfolios may be negatively impacted by several unforeseen factors, including loss of income due to injury, divorce or job loss. These are called personal risks.
How to minimise this risk
To mitigate this risk, you should constantly review your long-term strategy and invest in building a positive cash flow property portfolio. In other words, you should own a neutral-to-positive geared portfolio, ensuring that your investment portfolio doesn’t depend on your contributions. Though the individual properties can chase growth or cash flow, ensure that your overall investment portfolio doesn’t require too much of your cash to operate.
Another effective way to mitigate the risk is to insure yourself. All property investors should have life insurance and income protection. One of the obligations of investors is their ability to service their loans while growing their property portfolio. Similarly, for unforeseen circumstances such as death or injury, you need to ensure your family will be able to hold the investment properties.
Therefore, it is important to consult a qualified insurance broker and an accountant to receive advice on the type and level of covers required.
10. Foreclosure risk
This risk manifests when an investor can’t pay their mortgage payments on time for a prolonged period; they default on their loan obligations so the lender forecloses.
How to minimise this risk
You can manage the foreclosure risk by ensuring all your repayments are made on time. You should also have an emergency fund to cover a few months’ worth of repayments. Finally, parking cash in an offset account will reduce the interest you are charged and provide you with liquidity and flexibility at the same time.
View the article on Canstar here.
