Your Life in Property - Chapter 7

The Management of Risks

In common with any other form of investment, property has risk associated with it. Clearly, rises or falls in capital value occur and if an investor seeks capital growth to generate profit then a whole list of risks could be listed, based on micro and macro economic and political factors. Remembering the example of the roulette wheel in Chapter 1 with the gambling stakes being paid by the tenant, the rise and fall in capital values is very well hedged against, as long as the investment is held.

In keeping with the rest of this book, we will focus on the profit generated through monthly cash flow from rental payment. There are 3 primary risk factors posed to this income stream and are as follows.

Risk 1 - The Property Lays Empty

This is the one that really keeps me awake at night! It really is not the idea to purchase property and let it stand empty for any extensive period. Not only does the income stream stop completely but also security of the property, maintenance and validity of building insurance become questions. So what can be done to mitigate this risk?

Prior to purchase, the critical factor will be to determine the level of rental demand in a particular area location and in the type of building being considered. This is a critical piece of work that can reveal an apparently suitable property in terms of yield reward to be an overly risky investment. Discussions with letting agents on the ground and research from the web will be the key. Some questions to be answered at this stage:

• What's the typical population in the area? Are they tenants or owner-occupiers?
• Is the population growing, shrinking or stable in the area (key question)?
• How many properties have been let successfully in the last 6 months? How long did it take to let the properties?
• Do tenants stay longer or shorter than the average in the particular location?

Hopefully, by asking questions such as those above, you will choose a good location in terms of rental demand in which to invest. Post-investment, keeping your property let and producing income relies heavily on the relationships you have built-up as we discussed in Chapter 5. Having a good relationship with your letting agent and / or tenant will ensure that communication is regular and friendly and each of your interactions are a "positive" experience for all. Enjoying these relationships will tend to improve how quickly a letting agent will let your property and also how long a tenant may stay at your property.

In addition, the level of rent set can effect the length of time your properties stay voided. Setting levels at the market rate but offering some incentives such as a parking space or 1^st month rent half price can be very effective in a competitive rental market. Additionally, setting rental levels just below the market rent (say 5%) can be an effective method to attract a long-list of prospective tenants in a area or sector where price sensitivity is high.

Risk 2 - The Property Falls Down

Well, that would be very dramatic! This section deals with non-routine maintenance tasks and costs. Clearly a lot of work can be completed prior to purchase to offset some of this risk. Activities such as:

• Instruct a comprehensive survey to highlight any significant faults. Price these faults into your offer price or walk way.
• Determine the construction type used. Is it a building structure that should be durable against time? Does it have any particular features (i.e. flat roofing or non-standard building construction) that make it vulnerable? Do any of the major items require imminent replacement (heating, windows for example)?
• If buying a part of a building with common parts for other users, how well are these common parts maintained and looked after?

Once purchased, during the course of ownership only general routine and corrective maintenance should be required if the property is well-managed. It is worth making a list of these activities and when they should be carried out (and what time of year, for example external work should be carried out when the weather is favourable of course). You may employ someone to carry these tasks out but make sure they are completed by regular inspections to the property yourself. This is always a good use of your time and can highlight any other issues at the building that you were not aware of (or potential properties for sale near yours!). In terms of planned maintenance, a building of typical construction in good management should cost around 1.5% of its value each year to keep in a good standard. Some years will cost more and some less, depending on the tasks undertaken in that year. Finally, insurance can be taken at various levels against varying risks. You should consider your attitude towards risk, and your cash holdings held against these risks, when deciding which insurance cover to take.

Risk 3 - Financial Risks

The biggest single outgoing for many investors will be the monthly payments required to service their loans. The good news is that there are many ways to reduce your risks in this area.

Type of Mortgage – At the most flexible (but also most risky) end of the standard mortgage range is to be placed on the bank's variable rate. This does what it says and varies with the prevailing market conditions, often from month to month. For an experienced investor this could be a good choice as the variable products often offer full flexibility to over pay and pay off the loan or lock into another product when the conditions are deemed advantageous. At the other end of the spectrum can be found long-term fixed rate mortgages with terms up to 30 years. A longer fix often suits less experienced or more risk-adverse investors as they are able to plan with more certainty what their cash flow is likely to be for a long period. These products are clearly less flexible and can be costly if redeemed though sale or equity release.

Between these 2 products lie a million and one other type of finance deals which are fixed, variable or somewhere in between (capped / collar). It is wise to take proper financial advice in this matter but worth considering before you do what kind of investor you are and what level of risk you are prepared to take with fluctuating repayments.

Additionally, the method of mortgage repayment can be set at the outset of the agreement to suit your needs. The first type (interest-only) involves paying only the interest of the loan each month and leaving the capital borrowed to be repaid by another vehicle or eventual sale of the property. A repayment mortgage will ensure that the capital element is repaid by the end of the term of the mortgage. Sometimes the repayment element is constant through the term of the mortgage or it can start very low and increase as time goes on (and your rental returns increase).

Finally, it will be wise (crucial!) to hold some cash reserves against the level of your investment to ensure you can sustain a cash flow in the business. The cash flow will be affected if you suffer void periods or significant unplanned maintenance tasks. The amount of cash you hold will depend on your attitude to risk, the type of your investments and their rental history. It is important to keep some of your holdings in cash as equity in assets, in particular property, can be illiquid (difficult to get hold of) and can depreciate in value just when you need the reserve. As a rule of thumb, I like to keep between 4-8 month's gross rent from across our portfolio in cash at any one time. Even though our borrowings are big, this financial cushion enables me to sleep very well at night.

Activity 6

What are the main risks you see in growing a property business? How risk adverse an investor do you think you will be? List the measures will you take to offset your risks, based on your risk profile.