While investors and property advisors can do much to manage, monitor and enhance the performance of residential investment properties, there are some variables, which are outside your direct control. We outline many of these below and emphasise that contingency plans should be reassessed regularly.
The performance and status of local and national economies exert a significant influence on capital growth, supply, demand and the costs associated with servicing debt. Whilst no investor or property advisor can directly mitigate the risk posed by volatile economic conditions, you can alleviate its effects through the correct selection and underlying strength of each asset in the investor’s portfolio.
Even a well-chosen asset may show little or no growth during a recession or soft economic period. Prime assets tend to hold their value in an otherwise falling market or show little if any downside. As market conditions improve, it is the prime asset that will resume growth ahead of the wider market. This is why it is important to select the investment property carefully and, as much as you can, make sure it is one which may be considered to be a prime asset, that is one which shows all of the growth drivers are present.
Interest rates and monetary policy
Along the long-term journey of investment-property ownership, interest rates and monetary policy will almost certainly change in response to broader economic circumstances. Whilst investors cannot control or influence fluctuations in interest rates and monetary policy, they can take positive steps to minimise their impact.
As described earlier in this module, building flexibility into the loan structure is one important way of managing the impact of external conditions. Another safety net can be created by actively reducing debt when interest rates are low. When rates rise, irrespective of the fact that only the interest component of the loan can be claimed as a tax deduction and despite the well-meaning theory that non-deductible principal repayments should be applied to gearing up on other investments, the reality is that this very rarely occurs. Instead, those funds are often used for consumer spending on items that have no intrinsic value or which depreciate quickly!
The greater the proportion of the asset an investor owns outright, the less exposed they are to the vagaries of economic and interest rate fluctuations. Regular debt reduction should form part of every contingency plan and should be factored into the investor’s strategic planning. Many investors achieve this effectively by combining regular principal and interest payments on their loan and applying part of their annual tax refund to a lump sum capital repayment.
Proactive switching between a fixed and variable interest rate at appropriate times in the economic and interest rate cycle may also add to the building of net equity.
Soft rental markets, reduced rental demand and higher vacancy periods
Investors can minimise the impact of soft rental conditions in a number of ways, primarily through presentation and price. Particularly in a soft market, appropriate presentation and a willingness to meet the local market on rent remain the best ways to optimise returns and occupancy.
Lease terms are another way to lessen the impact of a soft rental market. For example, the lease-renewal date should coincide with annual peaks in demand for the local rental market. Local market conditions will vary from state to state and are likely to be different in regional areas compared with metropolitan ones.
Negotiating a longer lease than the standard six-month or 12-month tenancy can also provide investors with peace of mind. A reliable tenant who is paying a market rent may prefer a two-year lease for the financial security it confers, even if the rent is marginally below what may be optimally achieved. It is far better to have a property tenanted and cared for, than having it vacant and financially idle.
However, while two years may help an investor over a soft patch in the rental market, it is generally disadvantageous to agree a tenancy any longer than this, especially as conditions begin to improve. Where you have identified a fast moving rental market, shorter lease terms will be desirable so that you do not lock your client into a lengthy period of lower than market yields.
The incidence of truly negligent or delinquent tenants is relatively rare. However, this is a contingency that needs to be planned for and managed as effectively as possible.
An irresponsible tenant is one who wilfully damages and/or neglects a property, who fails to pay rent, and/or who illegally vacates a property. This type of tenant often targets investors who manage their own properties because they are known to professional managers or are listed as a bad risk on national tenancy databases.
You should always encourage investors to employ a professional property manager, primarily because they have access to specialised legal representation and internal systems designed to provide assistance to the investor in the event of a serious problem.
A number of contingencies can be implemented to help lessen the impact including the following:
You should play a key role in helping the investor select and monitor the most appropriate managing agent. This selection process should incorporate obvious factors such as local market knowledge, familiarity with the type of property to be let and long-standing experience of thorough screening and selection of tenants.
Adequate landlord protection insurance should be an essential component of every investor’s risk management strategy. This insurance is specifically geared to the needs of property investors, is relatively inexpensive, and includes cover for loss of rent and wilful and malicious damage to property.
Comprehensive public liability and contents insurance should be taken out to cover these unforeseen events.
Significant devaluation of one or more properties in the portfolio
From time to time, property values may fluctuate according to market conditions. In itself, this should not be a concern provided movements are infrequent, moderate, and in line with top-performing locations and asset types.
If, however, an investment asset experiences a sudden, significant and/or long-standing drop in value that is atypical of the marketplace, you should re-assess the underlying quality of the asset against the key selection criteria outlined earlier in this module. You should also check the property’s state of repair to ensure that poor performance is not a direct result of under-capitalisation.
If the problem is identified as a result of poor asset selection rather than under-capitalisation and/or overall market conditions, the only remedy is for the investor to dispose of the asset. This is because the difference between the buy-in price for a prime asset and the stagnant or falling value of a poor one exerts an increasingly detrimental impact on the client’s ability to enter the prime investment market and build equity through optimal capital growth.
“… I bought this property because it’s around the corner from home and I can drive past whenever I want and keep an eye on things … ” —is the misguided rationale behind many poor investment decisions.
There is no place in residential property investment for emotion; it should be a business decision based on economics and astute asset selection. It is important, therefore, to ensure that diversification is built into the review and contingency planning process.
Increasingly, property markets are becoming highly segmented. This means that market sectors and locations perform differently from each other. Creating diversity within the asset class by acquiring properties across a variety of price ranges, geographic locations and states will help insulate investors from changes in market conditions, and smooth out the inevitable performance fluctuations that go hand in hand with all investment strategies.