If we want to earn a greater return than a risk free rate, such as a building society rate or a government gilt rate then you have to accept a degree of risk. There is no such thing as a free lunch - I think we all understand that! Therefore the risk we are thinking to accept when entering or remaining in the property market has to be:
- Eliminated (where possible) and
I want you to apply this to any business investment – not only property. The key to long term business success lies within this chapter. You have to understand the risks involved, eliminate them where possible and manage the risks that remain.
The following mutually exclusive risks exist in property investment:
|Systematic Risk||Systematic Risk is simply the risk in being in the property market. The mere fact that you are in this market means that you will experience risk.|
|Leverage Risk||Leverage risk is the risk associated with borrowing. If you borrow money to buy a property then you have to pay it back – with interest! If you default on repayments then you can be out of business very quickly – and be declared bankrupt.|
|Specific Risk||Specific risk is the risk you face with the individual property and tenant. It has nothing to do with the property market or borrowing.|
They’re mutually exclusive as they operate under very different conditions. The property market as whole is dependent on demographics, the borrowing rates are set largely on global and home economies and your relationship with your tenant is individual. This means that you can tackle each risk independently. If you manage to eliminate any of risks then they will ‘stay down’ and not rear their ugly head and allow you to focus on the risks that remain. Well I will tell you now which following risks can be eliminated:
So you can see that both Systematic risk and leverage risk can be eliminated. Specific risk is an individual risk which can be managed – you will find out about this below.
Systematic Risk is the mere fact that you are investing in the property market. The property market is here to stay. People will always need to live somewhere. It may not be necessarily in your property but people will always need somewhere to live. This is the difference between this business and a new product business. With a new product you have to estimate the market in order to gauge demand. With the property market there will always be demand for somewhere to live and this demand will be here forever. So as long as you can ride the boom bust cycles you will ALWAYS win as property delivers a higher rate of return than the risk free rate.
Systematic risk is eliminated the same way systematic risk is eliminated in holding a stock portfolio. There will always be the stock market. There will always be businesses to invest in. The key to eliminating systematic risk is to invest in stocks that are uncorrelated. That is to say that if one stock was to collapse then it would have no impact on any other stock. This is called diversification. If you have a well diversified portfolio then the stocks held will have a near zero correlation with the others.
They way they do this is to invest in uncorrelated markets such as:
|Industry – i.e. Pharmaceuticals v Financial Services||If you invest in a number of industries that have a low correlation then if one industry suffers it should not affect your holdings in the other industries. In the example you could probably find a link between drugs and the financial services but it would be very small. These markets should act independently.|
|Area – i.e. Asian Markets v Atlantic Markets|
|If you invest in different countries then you can expect a lower correlation between stocks held in each individual country than if you invested in individual stocks within the same country. Now we all know the saying ‘if the US sneezes we all catch a cold’. But in this example the Asian market does have its own economy that does largely function on its own independent variables. If their was an Asian crash it should not largely affect your holding in the US.|
|Type – i.e. Stocks v Bonds||The bond market operates on different fundamentals to the stock market so there is a low correlation between the two. A well diversified portfolio will have a bond holding also.|
So how does this transfer to the property market. Well we have to look at the markets within the property market and ensure that your portfolio is well diversified. That is to say that your property portfolio is spread amongst several uncorrelated markets.
Now when I say uncorrelated I mean significantly but not absolutely. Nothing is 100% uncorrelated. You can always find a link to something no matter how unrelated the two markets appear to be. The tern uncorrelated is used in a broad sense. The broad uncorrelated markets that exist within the property market are:
|Industry||Private v DSS Tenant||The DSS market will largely depend on the local council’s ability to operate efficiently and pay market rents. The private market will depend on employment rates and rates of pay. These are independent hence uncorrelated.|
|Single v Family Tenant||The single person market is fuelled by the property’s proximity to bars, restaurants and gyms etc and a high tenant turnover is expected. The family tenant is more concerned with the proximity to schools, parks and leisure facilities. The single person let and the family let operate under different conditions hence uncorrelated.|
|Area||Area 1 v Area 2||Significant un-correlation exists between regions. That is SE, SW, East Anglia, London, East Midlands, West Midlands, The West, Wales, NW, NE, Scotland & Northern Ireland. They operate to their own fundamentals.|
|UK v Overseas||Significant un-correlation exists between countries. They operate to their own fundamentals.|
|Type||Private v Ex-local Authority or low value homes||Its quite normal to see the prices of low value homes boom and the executive developments fall or vice versa at the same time. These markets act independently as the purchasers or tenants for each of these type of properties lead very different lives and have different jobs. If executive jobs are reducing but manual work is increasing then the above will happen.|
So to have a well diversified portfolio thus eliminating systematic risk you would need a fair mix across the portfolio of:
- Private and DSS tenants
- Single tenants and family tenants
- Properties located in all regions of the UK
- Properties located around the world
- Private properties and low value ex-local authority properties
Now I can already hear you saying ‘yeah great, but I’m not a billionaire to buy every type of property in every region in the UK and every country in the world!’ It would be nice to have a well diversified portfolio constructed as above but we have to live in the real world. What I am saying here that this is an ideal. You should always aim for this ideal even if you never reach it.
So lets assume you are not a billionaire but you do try to achieve a well diversified portfolio. If you want to do it quickly then you have to borrow as you will have to buy a number of properties in differing markets to achieve this. This then introduces Leverage Risk. This risk is the risk that you will over borrow and end up defaulting on your loan repayments and eventually go bankrupt.
The way to eliminate leverage risk is to acquire a well diversified portfolio immediately or over time without borrowing. You will not grow as fast as an investor willing to accept leverage risk but once achieved you will be sitting on a major cash generating machine. This method is really only suitable for people that are:
- Of high net worth – they have large reserves of cash at hand or have recently liquidised their poor performing property or stock portfolio and wish to buy a superior property portfolio for cash.
- Not Relying On a Property Portfolio – They have a high income already which they can live on and their income is also high enough so they can save and buy a property for cash.
- In receipt of a large inheritance or cash windfall – They have come in to a significant amount of money and intend to earn a rate in excess of the risk free rate such as a building society savings account.
- Managing a significant investment fund – if you’re in the privileged position of managing other people’s money collectively then you may not need to borrow to achieve full diversifaction as the fund will be large enough to spread around a large number of properties.
If you’re not in any of the fortunate positions above then the bad news it that you will have to accept leverage risk. The good news is that it can be managed along with specific risk.
Let me remind you of what leverage risk is:
‘the risk that you will over borrow and end up defaulting on your loan repayments and eventually go bankrupt’
This is the main reason why businesses go under. Even the big boys get it wrong such as Worldcom and Swiss Air as they did not manage leverage risk. If they had managed their debt then they would not have gone under – its called debt management.
To manage your debt you need to ACT prior to taking on new debt and REACT to the changing conditions during the term of the debt. The risks you face from debt and the actions and reactions you can do are:
|The loan amount is too big to pay in full and on time|
|Interest rates rise making the loan repayment too big to pay in full and on time|
Okay, so we know how to manage leverage risk, now down to the detail of managing specific risk associated with each individual property.
The Risks Involved In Investing In Property
The way to mitigate against the risks involved in investing in property and hence manage them is to take countermeasure actions. There are 5 specific risks that can happen to an individual investment property and the corresponding countermeasure actions you can take to manage these risks are:
|1||Cant find a tenant.|
|2||Get caught in negative equity trap.|
|3||The tenant does not pay the rent.|
|4||Major repair becomes due and can’t afford to carry out works|
|5||Buying a property you can’t sell|
Knowing, understanding and addressing all the risks you face in business is a hot topic. Risk and business go hand in hand so it is fundamental to grasp the whole notion of risk if you want to take business seriously.
You should examine your overall exposure to risk and see how well you are managing these risks. Remember – you can always do something to lower your overall risk. This chapter only touches on risk management. There’s a whole science out