If the objective of an investor is to maximise the return on invested capital for an acceptable level of risk, we need to address two questions. Firstly, what increased risk does an investor incur to achieve these higher returns? Secondly, how do we manage these risks so that the increase in return outweighs any increase in risk?

Risk, in investment terms, is loss of capital; the greater the possibility of losing part or all of an investor’s capital, the higher the risk. Some property investors will have negative equity in the property the day they settle because of the high costs associated with buying property (stamp duty, registration costs, borrowing costs, legal fees). The risk with gearing, is the investor’s ability to hold property long enough to be able to experience sufficient capital growth or income to offset the initial purchase costs and any further monies incurred to support the property. It is also the ability to choose property in an area which subsequently grows enough to make any cash input along the way worthwhile and to subsequently outperform other asset classes or investment opportunities.

Provided the investor is able to hold the property long enough for the capital growth to offset purchasing costs, holding costs and selling costs, they will be able to sell the property, pay out borrowings and receive a full return on their invested capital.

The question of risk associated with gearing is one of cash flow, capital growth and time.

Cash flow

For property investors who gear their investments, their cash flow and thus their capacity to hold the property, can be affected by changes in three areas: rental returns from the property, increases in interest rates on borrowings and changes to their personal financial circumstances.

Rental return

Property investors who gear their investment rely on the net rent from the property to assist in paying the loan repayments. Loss of rental income will have an immediate impact on their cash flow and hence their ability to hold the asset.

Strategies for managing the risk include:

  • Correct asset selection
  • Tenant selection
  • Correct managing agent selection
  • Being realistic about net rental returns prior to purchase. Investors need to plan for realistic vacancy periods and expenses such as owner’s corporation fees, insurance, rates, maintenance costs and management fees
  • Provide a cash reserve to cover unexpected vacancy periods or maintenance costs
  • Take out landlords’ insurance to protect against loss of income from non-payment of rent by a tenant and/or to cover any repair costs for damage caused by a tenant.

Increases in interest rates

If an investor has borrowed a high proportion or all of the purchase price for their investment property, an increase in interest rates will have an immediate impact on their cash flow and thus, their ability to hold the asset. The increase is tax deductible and therefore, will be partially paid for by the tax saving.

Strategies for minimising the risk include:

  • Allow for an interest rate increase in initial planning. The more conservative or risk averse an investor is, the greater the allowance buffer
  • Fix the interest rate on some or all of the borrowings, giving the investor certainty for the period of the fixed rate
  • Provide a cash reserve to cover periods of higher-than-expected interest rates.

Changes in personal financial circumstances

A decrease in an investor’s income or an increase in their commitments will impact on their ability to hold the asset. Life occurrences such as loss of income due to redundancy, illness, disability, having children or a downturn in profits need to be provided for and planned. Similarly, changes in personal circumstances that result in increased commitments also need to be anticipated.

For those unexpected life situations that can’t be anticipated, a cash reserve should be set up to cover any cash flow shortfalls.

Strategies for managing the risk are:

  • Planning in advance
  • Ensuring investors have adequate income protection insurance to cover temporary and/or permanent loss of income from accident or sickness
  • Provide a cash reserve to cover periods of unexpected loss of cash flow.

 

 

Activity

Russell and Janet intend investing in a residential property. They plan to borrow the full purchase price plus costs using their home and the investment property as security. This will leave them with a cash reserve sufficient to fund the shortfall on the property for three years.

Russell and Janet’s employment is secure, they have adequate insurances to protect against loss of income, they have been realistic about the net rental income they will receive and are confident about their levels of financial commitment.

  • Briefly summarise the potential financial risk and rewards of Russell and Janet’s strategy.

 

 

 

 

Activity

 

Name three strategies that will help a potential investor minimise the risk associated with rising interest rates.