Risk is inherent in everything we do, however not everyone has the same tolerance to the same level of risk. What seems crazy to you (e.g. a climb up the Sydney Harbour Bridge) is a thrill seeking experience for someone else.
Your risk capacity level will play a part in the strategies you use, the rate at which you build up your portfolio, your finance and much more. This is why it’s one of the first things you should think about when investing in property.
Begin by defining what “risky behaviour” means to you then discover how you can reduce the risk enough to let you sleep well at night.
How bad can it get?
One of the best ways to defeat your fears is to determine what the “worst case scenario” in a particular venture might be and decide if you can live with the outcome.
Use the following questions as a guide to determine your risk comfort level.
1. What am I willing to give up in order to build my wealth over the long term?
2. Is it possible for me to buy without emotion, focusing only on the financial returns?
3. How do I feel about borrowing the maximum amount I can?
4. Can I let a property manager handle the investment or do I need to be directly involved?
5. Will I want to sell at the first drop in value or can I accept that market fluctuations happen and that I’m investing over the long term?
Risk mitigation strategies
Now that you’ve got some idea of your capacity for risk consider some strategies you can use to mitigate the effects of any losses.
1. Buy different property types
Rather than buying only units or only homes, buy a number of different property types; basing your purchases on what the market demographic desires.
Look for – or create – unique properties that offer something extra (e.g. two car parks instead of one) that will ensure your product stands out from the crowd.
2. Buy in different locations
Each marketplace will have its own cycle. When you buy in different areas your risk is spread out, which means that the investments growing in value offset those which aren’t.
Buy in large metropolitan areas/suburbs, matching the strategy you use with the market conditions at the time of purchase.
3. Choose different types of buyers
If you focus on the demographics of an area and you buy in diverse locations you will automatically buy properties that appeal to a diverse type of buyer.
This is because your investment will have been chosen in accordance with what the area demographic wants and needs.
Income diversity is a good way to reduce risk as well.
In fact, the best scenario would be to have each of your tenants employed by different industries. If they all worked in the same industry and that industry had a downturn, you can see how your chances of losing out on rental income could be much greater than otherwise.
4. Watch for market changes and/or opportunities
Indicators of gentrification and increased infrastructure spending could mean changes to the market are on the horizon.
Ask these questions:
• Is the supply unable to keep up with demand?
• Are the prices in this suburb much higher than in surrounding ones?
• Is there potential for a ripple effect from growth in nearby locations?
5. Buy across different price ranges
Spread your investment properties across a wide variety of price ranges. This ensures that should you need to increase your cash flow you’ll have the ability to trade one of your lower priced assets.
Because a lower priced home will sell much faster than a higher priced one, allowing you to access your cash more quickly.
Also, your potential buyer list will be larger at the lower end of the spectrum than at the higher end.
Other ways to reduce risk
Create a sizeable buffer when you purchase a property. These monies should be only for ownership costs of that particular home.
Avoid cross-collateralising your primary residence with your investment properties.
Purchase investment properties in high demand locations that represent little risk of losing value (e.g. near water, close to the CBD, etc.)
You can get more tips on how to reduce risks at our next Seminar:
What is the worst that could happen?
Determine the absolute worst case scenario and decide if you can live with it should it happen.
So for example, perhaps your greatest fear is having to come up out of pocket for one of your investments because you cannot find a tenant for it.
Here’s how you can reduce this fear:
Assume your property has a positive cash flow of $20 per week. This is not an impossible scenario.
Should you have a tenant continuously you’ll have $1,040 after one year.
Now let’s say it rents for $200 per week. Take that $1,040 (which you have been keeping in an interest bearing offset account) and divide it by $200.
Your property can remain vacant for about 5 weeks before you have to add anything from your back pocket!
Now let’s have a look at how tax deductions make it even better:
If you’re in the 30% tax bracket reduce that $200 by $60 and you’re only owed $140, which adds more weeks to the time your property can remain vacant.
In reality, if your property is vacant for a couple of weeks you would drop the rent (to about $180 pw) to get someone in there.
Granted, you’re giving up your positive cash flow, however it’s not costing you anything either.
This is why a positive cash flow property combined with a good buffer can help put your mind at ease through shifts in the marketplace.
When the market moves again put your rents back to where they were…or even higher…to add more to your buffer.
Vacancies as a result of damage should be covered by your insurance, hence the reason it’s so important to get the right kind of coverage.
As you can see, a bit of foresight and preplanning helps mitigate both your fear of risk and the impact of actual risk incurred.
A “win-win” in my book!
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