Property investing: managing risk
By Sarah Mills
One of
the cardinal rules of property investing is to
manage your risk.
Generally the lower the risk associated with a
particular property investment, the lower the return
and vice versa. The key to successful property
investing is to maximise your returns while keeping
risk at an acceptable, manageable level. The extent to
which you balance these two competing imperatives will
depend on your risk appetite.
When investing in property, the risks you face include falling house prices, rising interest rates, tenanting problems and damage to the structural integrity of the house.
Insurance and other financial products, such as fixed loans, can help mitigate the risk associated with many of these problems. Other ways of mitigating risk include:
- Buying a property with a high yield that is likely to remain strong in the future, at a reduced price, or with potential for improvement.
- Researching your market carefully to ensure that no nasty surprises are lurking — such as the major employer is about to leave town.
- Diversifying your property portfolio. Should one area suffer a slump, another may still offer gains. This is called hedging.
- Buying in a fairly liquid part of the property market. It is very important when you are property investing to be able to sell quickly. More people can afford to buy less expensive properties. This means that cheaper properties represent the most liquid part of the market. We all remember how easy and powerful it was to become a slum landlord on a Monopoly board. Liquidity is one of the reasons.
- Ensuring your ability to service debt related to property investing is strong.
Borrowing risk
On top of these generic risks, there is another risk
over which you have considerable control — the amount
of money that you borrow. The more money you borrow,
the greater your financial power or investment
leverage. It means you have more potential to make
money from property investing, but also a greater
chance of losing money.
Leverage
When you use a wheelbarrow to lift more dirt than you
can carry by yourself, you are employing leverage.
Leverage involves using a tool to increase your power.
When it comes to property investing, your tool of
leverage is borrowed money.
Put simply, if you bought a rental property for $400,000 using all of your own money and it rose $50,000 in one year and you sold it, you would have made a return on your investment of 12.5 percent (excluding expenses). However, had you borrowed $300,000 of that money and used only $100,000 of your own money, the return from the exact same sale (excluding expenses) rises to 50 percent. You would have enough money to place a deposit on three more identical properties, yielding 50 percent on your total investment of $400,000, leaving you $150,000 better off than had you used your own money.
Not only that, theoretically, you may have been able to buy a fifth property as increased income from the rental flows from four properties may have been sufficient to service more debt. This fifth property would increase your capital gain by roughly another $50,000, leaving you with a total profit of $250,000 and $200,000 better off than had you used your own money.
But, going back to the wheelbarrow analogy, if you put too much dirt into a wheelbarrow, you may break your back trying to lift it. It can be the same with borrowing money. If you are too highly leveraged, you may not have enough cushioning to service your debt if the market turns against you. Should that happen, you would be forced into liquidation — game over.
Debt-servicing ratio
Financiers are prepared to lend you money so that you
can make extra money on the condition you can pay it
back. So when determining your borrowing capacity (how
much you can put in the wheelbarrow), they look at how
much equity (your own money) you have invested in a
property as well as the percentage of your disposable
income that can be put towards interest repayments.
They base their debt-servicing ratios on the
latter.
When it comes to property investing, most lenders' debt-servicing ratios allow you to commit up to 35 percent of your gross monthly income to repaying debt. If you cannot meet their criteria, your request for debt may be declined. This has significant implications for the type and number of properties you can buy, which takes us to the next subject, gearing.
Gearing
When you drive a car, you use gears to maximise your
power and speed (to give you leverage) through various
terrain. Hence, the practice of borrowing money to gain
leverage is called gearing. The degree to which your
investment is geared reflects the risk-profile of that
investment — the amount of equity you hold in the
property and your debt-servicing ratio.
There are two types of gearing — negative gearing and positive gearing. Decisions that will affect whether you choose to positively or negatively gear your property will include:
- How many properties you want to buy
- Your income
- Your purchasing capacity
- Property prices and yields
- Your tax position
- Your attitude towards investment
- Your appetite for risk
Negative gearing
Negative gearing occurs when
you borrow money to buy a property that has more
expenses than income. This means you lose money
every week. This loss can be partially offset by
some of your income tax being returned to you,
but there is still some money required from your
pocket to make up the shortfall. Buying a
negatively geared property just to reclaim some
tax is like spending $1 to save 47c.
Negative gearing is far more risky than positive gearing. The only real benefit is for those who are expecting an imminent rise in property values. These people are prepared to make a short-term loss on their investment because they believe they will gain a greater capital gain when they sell.
Positive gearing
This is the opposite of negative gearing and occurs
when a property yields an above average rental return
for the purchase price and/or expenses are lower than
average. This means that your return outweighs your
expenses, which means you have extra money (or extra
income) in your pocket each week.
That means that with each property you buy, your income increases, lifting your power to service more debt and invest in yet more property. So theoretically, the capacity of the positively geared investor to borrow money for more properties rises with each purchase, whereas the capacity of the negatively geared investor falls with each purchase.
Read more on positive gearing.
Risk-management demands a plan
When borrowing money for the purpose of investing
in property, it is essential to do your calculations
and create a plan that incorporates the
following:
- The level of equity you wish to maintain in your properties — keeping in mind that if interest rates skyrocket, you may be forced to liquidate.
- A comfortable price range for purchases.
- Calculations on how many properties you can afford — for example, how many negatively geared or positively geared properties you can support with your disposable income. Allow for interest repayments, tax deductions, purchasing costs, ongoing costs and a few grand for unexpected property investing expenses. There are excellent software packages in the market to help with this.
- The timeframe you are giving yourself for property investing — this should include a schedule of expected returns. For example, will you post steady returns, a quick capital gain or short-term losses and long-term gains?
- Re-do these calculations every 12 months because as prices rise, so does the equity in your properties, increasing your borrowing capacity.
This plan, like a business plan, can be very helpful when seeking funds from a lender.
- Property investing: financing
- Property investing: fundamentals
- Property investing: choosing a property