The risks of investing in property

rentvesting

Rentvesting. It’s the new new thing. Buying an investment property while continuing to rent elsewhere.

Most do it with no intention of ever living in their purchase. For many it’s a way to hedge against ever rising property prices, in the hope that one day the sale of their investment property will provide a decent deposit for the home of their dreams.

There are benefits to getting on the property ladder for sure.  But property investing is not without its share of risks, and so if you’re considering taking the plunge you should make yourself aware of the key ones.

Here then are six risks you ought to consider when investing in property.

Concentration Risk

The single biggest risk in becoming a property investor is in putting substantially all your investment eggs in one building.   

eggs in one basket
Don’t put all of your eggs in one basket.

You are making a call that the investment property will give you a big enough return to cover the costs and debt you undertake to purchase it in the first place. That’s only the beginning however.

The property market is actually made up of many sub-markets, each with different risk and return characteristics. Should you buy an apartment, townhouse or house? Which suburbs show the most promise for capital appreciation? What about investing interstate or in a regional city instead?

Whatever your decision if you decide to conduct the majority of your investing in the property market, and prices fall, there’s a good chance you’ll be kissing those sweet capital gains goodbye. And yes, property prices can, and do, fall, sometimes spectacularly.

That’s because getting the benefits of diversification while only holding one or two investment properties is really hard.

And it’s why people who choose to invest in property should also invest in other investments that don’t move the same way as  the real estate market.

Liquidity Risk

One of the major risks with property investment is liquidity, or the ability to convert some or all of an investment back into cash at short notice at a fair market price.  With investment property, you could work yourself into a hot sweat trying to convert your investment into cold, hard cash in a hurry, but it just not going to happen.

liquidity

No one is ever sure how long it’ll take them to sell a property, and by the time they do, the market sentiment could have shifted.

At a minimum from the time you engage an estate agent to the first auction attempt could be 8 – 10 weeks. Even if successful at the first attempt, settlement can still take a further 2 – 3 months.

And it’s not like you can just sell one bedroom or a bathroom to get you out of a jam. With direct property, it’s all or nothing.

Interest Rate Risk

Interest rates on investment property loans move with general market rates, reflecting the rates at which lenders can themselves raise funds plus a margin to cover the varying riskiness of loans to individual borrowers.  

Property is highly sensitive to the prevailing interest rate environment.

Rising rates tend to dampen activity in the property sector (and thus prices), while falling interest rates encourage activity.  

In addition, interest is a cost of funding an investment property purchase, so if rates rise more or faster than the rental yield (rent as a fraction of the cost of the property), you’ll have to hope that the value of your investment property keeps rising to provide a decent total return upon sale.

Legislative Risk

All investing involves dealing with future uncertainties, and one of those is how the laws affecting your investments might change during the time you hold them.  

property law

Property investing is especially sensitive to legislative risk, particularly potential changes in the tax laws that might affect the demand for property.

Abolishing negative gearing for example, as has recently been debated, would significantly alter the dynamics of the investment property market and might impact on existing property investors.

Tenancy Risk

Investment properties typically involve finding people to live in them, but often that process can take longer than expected because not every applicant is the perfect tenant.

tenancy risk

Property is a unique asset in that as soon as you buy one, you’re not necessarily making money from it. Until you have a binding lease agreement with a suitable tenant, it’s all expenses and no income.

From then on, investors have both rights and responsibilities when it comes to their tenants, and working cooperatively with both an estate agent and the tenants will save all parties lots of heartache over the term of the lease.

Gearing Risk

Gearing involves the use of debt to buy an asset while only contributing to a portion of the purchase price. In property investing, it’s fairly common for investors to borrow 80% or more of the cost of the property.

If everything works to plan, gearing can magnify the gains from property investment.

Many investors choose to gear aggressively to maximise the difference between interest paid and rental income received (i.e. the negative gearing effect).

For those using variable rate loans, a rising rate environment will result in the negative cash flow getting progressively larger, and at some point becoming unsustainable. The Global Financial Crisis of 2007 – 2009 was precipitated by exactly this scenario in the US.  

Summary

At the end of the day, there are a lot of risks associated with investing in property, and these are just a few of them.

Ultimately you have to decide if the lack of diversification and the other risks associated with buying and owning a rental property are worth it. What’s right for someone else may not be right for you, so do your own research and take your time.

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