Risky business

Some investors have learnt to mitigate certain risks associated with investing in property by diversifying their portfolio, educating themselves about the property market and sticking to ‘safer’ or lower-risk suburbs.

Other investors may think property is ‘safer’ than other asset classes, such as shares, because even if values fall, the physical asset will still be there. In many cases, this is true – if values in your suburb dip by five per cent, you do not lose five per cent of your floor space or land size until prices recover.

Yet, more extreme price collapses can, and do, occur. Throughout 2013, we heard stories of houses selling for US$1 in Detroit, Michigan in the United States.

Indeed, according to news reports, numerous properties were selling for less than US$1,000 and opportunistic Chinese investors started snapping them up – surely prices couldn’t go any lower?

This of course, is a risk-laden strategy for these investors – the city is still in serious financial strife and the population is declining. If you already owned one of these properties, however, 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 to work out how comfortable they’ll be if things do turn sour.

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 well turn you off property investing for life.

So when it comes to your first property, the more research and analysis you do in terms of risk, the better.

“First-time investors tend to not be educated about property,” says Positive Real Estate’s NSW head coach, Todd Polke. “They tend not to have a strategy and they tend to not know how to do proper due diligence to find that first deal.

“That first deal can make the biggest impact on your overall portfolio because if that first one goes poorly, often people don’t have another level of cash or access to income to do a renovation or buy another investment to keep themselves moving forward.

“So the key is, before you go into your first deal, make sure you spend time getting educated and understanding what you’re comfortable with. Make sure you have a strategy and know the outcome you’re working to create. Make sure you know how to do your due diligence to understand the risks and to make sure this first deal is going to have a big impact on your portfolio and your financial life.”

How do you get started though? How can you establish how much risk is sustainable in your portfolio?

If you don’t understand the risks and the numbers, you’re just running blind. When this happens, your portfolio becomes really limited.

Comfort levels

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.

Mr Polke, however, says people should already know where their personality sits in relation to risk.

“Often, people will tend to know whether they’re more of a conservative person or whether they’re more of a risk-taker or a go-getter,” he says.

“People often know from their personal lives what level of risk and level of comfort they’re happy and unhappy with.”

Mr Polke says that even though property investing should always come back to the numbers, and decisions around purchasing property for investment purposes shouldn’t be driven by emotions, understanding your risk profile will involve listening to your instincts.

“It’s got to be about the gut feel,” he says. “It’s got to be about the ‘sleep at night’ factor. So when you go into a property deal, if you’re going to be sitting up stressing about it and losing sleep over it, it may not be the right deal for you.”

Clayton Daniel, a financial planner and principal adviser at Hillross Silverstone, says understanding risk in relation to property is all about weighing up the pros and cons.

“Risk profiling is ultimately a trade-off between chasing higher gains over the long term and getting a limited amount of uncertainty in short spouts,” he says.

“It’s generally accepted that property is three-quarters risk to return. Property is considered a ‘growth’ asset. We have seen massive gains in the property market over the last 40 years.”

Some 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.

Mr Daniel says first-time investors need to consider all outcomes, and how they would react.

“If property were to stagnate for 10 years, how would you as an investor feel about that? If you have negatively geared the property and are losing $10,000 a year, for example, without seeing any capital growth, would you be able to continue to hold the investment?”

Staying safe

Mr Polke says first-time investors should steer clear of high-risk purchases, such as mining towns or anything that promises ‘fast’ rewards.

“I don’t think first timers should jump straight into high-risk strategies because their first investment property is the foundation of their wealth creation,” he says.

“You’ve really got to start building that foundation nice and strong before you go and start trying to speculate or gamble in the marketplace.

“The ‘get rich quick’ thing often fails for first-time investors. Sometimes they can win, but more often than not they don’t because they don’t know what they’re doing.”

In order to stay safe and build a solid foundation, both Mr Polke and Mr Daniel say you need a financial buffer before you begin investing.

“You’ve got to be able to mitigate the risks of vacancy factors and financial changes,” says Mr Polke. “It adds to the ‘sleep at night’ factor.

“You’ve got to think about risks outside the property market as well. If something happens to your health or work or family, a financial buffer can help you weather the storm.”

Mr Daniel agrees and says there are a number of things you can do to minimise the risks of mortgage stress.

“Firstly, your cash flow should be able to handle the current repayments, and at least two interest rate rises – or 0.5 per cent more,” he advises.

Mr Daniel says if you are particularly risk averse and know you’re going to stress about repayments, you should lock in some of your loan.

“You could lock in half of your money, so you can predict and prepare for repayments. Knowing what your outflows are during periods of low or negative growth can certainly help stem the tide of anxiety,” he says.

Warren Dworcan, director of Rate Detective Finance, says first-time investors should be engaging professionals in order to get an understanding of their present and future circumstances.

“Financial and property experts should help first-time investors get an understanding of their financial circumstances and what their intentions are for the future,” he says.

According to Mr Dworcan, risk is all about change and coming to grips with the ‘what ifs’, so first-time investors shouldn’t leave themselves open to too many variables.

“They need to be in a position where they’re not over exposed to the market and where their lifestyle won’t be impacted greatly if things change. First-time investors shouldn’t be in a position where they’re too uncomfortable,” he says.

Mr Polke agrees and says first-time investors can’t possibly know everything they need to know about property, so engaging professionals will help mitigate some of the risks.

“I wouldn’t try to fix my own car. I know how to put some petrol in it, change the oil and pump the tyres, but that’s it. I’m done after that,” he says.
“It’s the same when it comes to property. If it’s not something you’re involved in on a regular basis, how can you be expected to know all the things you need to know?”

Other investors may think property is ‘safer’ than other asset classes because even if values fall, the physical asset will still be there.

Diversification

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 may be balanced by a gain on another.

Mr Daniel, however, says that for first-time investors, diversification can sometimes be an unattainable goal.

“Of course, in a perfect world, a fully diversified portfolio is the best way to manage the investment risk of a single asset class, like property, falling. But for those entering the real estate investment market for the first time, that can be quite a stretch,” he says.

First-time property investors can’t always diversify and spread their risk because, in most cases, they may not have a lot of cash left over after their first purchase.

On the contrary, Mr Polke says the more you understand the numbers and the risks associated with these numbers, the more quickly you’ll be able to diversify away from just the one asset.

“If you don’t understand the risks and the numbers, you’re just running blind,” he says. “When this happens, your portfolio becomes really limited and your ability to grow it is stifled.”

Indeed, Mr Polke says if you are already struggling with money, purchasing your first property won’t be the quick fix some people hope it will be.

“If you can’t manage your finances,” he says, “how will you be able to manage an investment?”

Factors affecting your risk profile

Life stage:

A report from AMP estimated in 2012, those on a ‘low income’ (average of $1,160 per week) spent an average of $285 per child aged 15 to 17 per week. Your life stage can thus impact the level of risk 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, more risky strategies are less likely to bother you.

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 impact the kinds of risks you’re willing to take.

Income:

Your income, and in particular its stability and security can greatly impact 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 impact how many financial risks you take.