When caution is too risky

There’s method in my madness when I say there’s risk in your caution.

Many of the clients I see are reasonably cautious and don’t believe in taking large risks. However the actions they may take to avoid risk can often have exactly the opposite effect and place their financial situation into jeopardy.

With the increase in property prices over the last 18 months, there has been an increase in the options available to buy property. Some of these options include buying new houses from developers who produce them specifically for property investors. They suit some people but not everyone. They can be highly attractive to many budding investors however, especially when they are presented with clever marketing techniques. They are brand new so maintenance should not be an initial concern and they will attract good tenants, the depreciation allowances are high (and this is usually heavily emphasised), the properties are promoted as specifically designed for the rental market by experts, the company will organise all the legal issues, provide tax advice, organise finance and manage the property for you on an ongoing basis. You merely purchase the property and then leave it to the experts.

On the face of it, this sounds like a secure risk free way to invest, especially if you haven’t owned a rental property before. Investors think they will buy such a property then be a little more adventurous with subsequent purchases.

However the nature of these properties may mean that subsequent purchases may not be able to occur for some time if at all. Aspects of this type of investment that are not normally considered are options for proactively increasing capital gains and rental returns, two key elements of a property investment.

Typically these investment properties only achieve rental yields of 4% to 5%. This means that the investor invariably needs to top-up the investment as they are negatively geared. If interest rates move up the investor could find themselves having to pay out a lot more than they can afford or worse still selling the investment at the wrong time. There are tax deductions to help offset negatively geared properties, however this does not get around the fact that the properties need extra funds to keep them going. This means that capital gains are a requirement for the investment to actually work.

Here is where the second poor aspect of these seemingly easier investments comes into play. There is little opportunity to increase the value of these properties apart from the usual market movement. The developer does everything from the landscaping to the letterbox. Nothing else needs doing so there is no opportunity to improve and add value. If the market goes up that is OK, but if it goes down then you can have a serious problem.

Investors who have either limited equity, limited income or both, are not suited to this type of investment. The promoter may find them finance for this property but after that they will have problems raising further finance due to low equity or cashflow or both. This is not the worst of the situation however, because if market conditions change for the worse, they have no fat in the system to meet the changing conditions. Their reduced equity or cashflow situation could see them in a mortgagee sale situation.

I am not saying that these types of investments are wrong for everybody and they don’t need to be from a promoter. Investors may find themselves in the same situation buying an ordinary property with low yield and no improvement for adding value. To make this type of property work you often need a high income or high cash reserves and preferably both. The vast majority of property investors simply do not fit into this category. If you want to reduce risk, look at your financials and see where you are strong and where you are weak. After you have done this, then purchase property that improves your weakness and allows you some respite should market conditions turn for the worse. This type of strategy also puts you in a better position to continue buying property and avoid the risk of not achieving your goals. This isn’t the easiest strategy as these other types of investment involve more time and effort to find and secure. However when you are considering avoiding risk with property investments, you mustn’t confuse “easy” with “low risk”. All the best with your investments!

Andrew King