How to manage risk with your property investments and avoid buying a ´lemon´

Sooner or later many property investors make a mistake and buy a property that doesn't turn out to be as good an investment as planned. And, on occasion, may end up with an investment that they believe was a bad mistake and costs them money, at least in the short term.

In this article I'll review the possible risks when investing and discuss positive strategies that will help you minimise the risks and ensure that you don't make bad mistakes.

Good news to start with!

If you have made a mistake and invested in a 'bad deal', then let's start with the good news! One of the wonderful benefits of property investment is that the passage of time will transform most dud investments in something worth keeping. Maybe not 100% of the time, but certainly most of the time.

Example: Your rental income doesn't cover the expenses. This will be familiar to anyone who purchased at the peak of the market and invested in property with a relatively low rental yield. Now you find that there is a monthly shortfall. Not good. But wait a few years for the rent to grow and you'll be back in positive cashflow.

I'm not underestimating the challenge for some investors who may be struggling with the shortfall, the point I am making is that the passage of time can fix even bad mistakes.

What are the major investment risks?

Here are the major risks that can arise with typical residential property investments:

Fall in capital value
Fall in rental value
Lack of tenant demand - void periods
Tenant doesn't pay
Unforeseen expenditure
Rise in interest rate

There are four different ways that risk is managed:

In some cases you can do more due diligence prior to purchase which will reduce your risk after purchase.
You may change some of your investment parameters which will mean less property for you to choose from, but safer and more profitable deals overall.
Sometimes you will not be able to stop the event occurring but have to manage the result of the risk happening.
There may be steps you can take to provide a 'financial blanket' if the risk occurs. There will be a cost attached and you will need to balance this against the potential benefit.

As long as you make the right risk management decisions, then the profitability of your property portfolio will be much greater and any worry will be much reduced.

Eight principles of risk management for property investors:

1. Build a portfolio

As you grow a portfolio of property you will find that the risks naturally reduce. Say you have five properties. It is extremely unlikely that all your tenants will leave at once. And the rental across your portfolio may make up any shortfall. The biggest risk is when you have just one or two properties.

2. Complete Due Diligence

Make sure that your proposed investment ticks the boxes, which means completing proper due diligence. Axis completes extensive due diligence, using our internal due diligence checklist, on every opportunity offered to you. Always double check and ensure that the answers to your questions are satisfactory.

The key areas for your due diligence are:

Location - who wants to live there and why?
What is the level of rental demand in the area?
What rents are being achieved?
Is the market value realistic?
Do you know ALL costs and expenses of maintaining the property?

Issues like title, coal mining etc will be covered by your solicitor on purchase

3. Never have to sell

The worst possible scenario is being forced to sell in a depressed market. Then you can lose your shirt ... and your pants. This is particularly true in the early days of ownership. So keep some cash in reserve just for a rainy day and make sure you never have to sell except when you choose to.

If you can keep your property indefinitely, then you can ride out almost all of the errors made early on.

4. Be prepared to rent a little cheaper

Many investors try and stick out for the highest rental price. This just doesn't make sense. Imagine if you were asking £700 per month, but had one property empty for three months. Suppose a £50 reduction in rental meant it could have let right away.

What are the consequences of this? You've lost £2,100 of rent! It will take more than three years to recover it assuming you get the extra £50 a month, and the most likely result is that you will have to drop the price anyway to get the property rented.

It's highly unlikely that you will have to worry about void periods if you are realistic about the rent. Taking the advice of a local management company will help.

5. Opt for fixed interest rates

For the first couple of years at least, when the rent mainly only just covers all the outgoings, many investors like to fix the mortgage rate so there are no surprises. You can typically do this for a period from 1-5 years. We recommend a two or three year fix unless you are willing to carry the risk of increased mortgage rates.

6. Take out tenant insurance

You can get competitive insurance which will cover the rent if the tenant doesn't pay. If your portfolio is large enough then this may not be an issue, and generally our clients' experience is that this is an infrequent occurrence. But for peace of mind you can insure. All insurance is a balance of cost versus benefit.

Looking at my own portfolio I choose not to have insurance. Over the last five years it would cost me more in insurance than I have lost in rent. But the numbers are quite close and it could have gone the other way.

7. Buy below market value

Buying below market value (BMV) is a core concept which we believe massively reduces your risk of investment in multiple ways.

Purchase your property at 15% to 35% below genuine market value and you create a buffer which provides an additional element of security just in case you do have to sell. This is one of the most important elements for reducing risk and we cannot emphasise it enough.

Buying BMV reduces the risk of losing money if you have to sell quickly. It locks in profit when you buy. It increases your rental yield and therefore positive cashflow. Finally it reduces the amount of your mortgage and your mortgage payments because you borrow less.

8. Make sure the rental yield delivers positive cashflow

My personal pet hate is subsidising a property every month because there is negative cashflow. It can be a disaster. If you go into this scenario when you buy, then you could be even worse placed if rents drop or the mortgage or other expenses increase. Even worse if all these things happen!

So our advice is to ensure you have a healthy rental yield that gives you good positive cashflow. Part of achieving this is to put a deposit down on the mortgage. This is a fundamental problem with No Money Down (NMD) deals - the level of gearing (at 100% or more) is simply so high that there a big risk of moving into negative equity and negative cashflow.

What rental yield is high enough? Probably enough to cover the mortgage and all essential outgoings, plus a margin of safety for unforeseen events like repairs or 'one off' service charges etc.

Summary

If you follow these eight principles of risk management outlined in this article I believe that you will minimise all risks and may go years without any major problem!

On the other hand, take no notice at all and you really do run the risk of getting into trouble.

If you'd like to talk to us about safe, prudent but profitable investment then please contact me - information below. And if you'd like Axis to help you build a prudent but profitable portfolio then we'd love to help.

Rod Thomas FCA

Axis Property Investment
Web: www.axispropertyinvestment.com
Email: rod@axiscontact.com Tel: 01273 447 300

Posted in Successful Investment