UNDERSTANDING THE RISKS

When investing it is essential that the property investor understands the risks of that particular investment.  When it comes to investing in residential property there are risks to a potential landlord.  The main ones are as follows:

Where do professional landlords go for their buy-to-let insurance?

Fall in capital value

In the UK property values have seen incredible increases over the last decade and there is a general assumption by landlords and investors that property investing is a one way street.  That is values can go only one way and that is up.  Potential property investors only have to look at the Japanese property market or look at residential property prices from the early 1990’s in the UK to understand that residential property values can fall as well as go up.

Gearing

The biggest risk for a property investor comes from the fact that most residential investors potentially finance their residential investment purchase by borrowing part of the purchase price with a buy-to-let mortgage

This process of landlords gearing their investment means that small falls in the value of a landlords investment can lead to a disproportionate fall in a landlords capital or equity (the deposit).  A potential property investor should be aware of this and be prepared to take on this risk during their investment.

Performance

One characteristic of the residential market in the UK in recent years has been its varied performance.  After a general rising market in the UK during the 90’s and early part of the millennium.  The market has been characterised by huge variations in the performance of local markets and even types of residential property.  Therefore buying the right property in the right area could dramatically affect an investors returns and risk of making money.

Rent levels & voids

One of the biggest risks to a landlord is an income shortfall because of a failure to receive as much rent as a landlord’s original investment plan had indicated.  This could be for several reasons: firstly, being unable to get a tenant and therefore not receive rent or alternatively receiving less rent than originally anticipated. The way landlords should manage this risk is that when they are calculating their likely annual rental income they should be cautious on their expected rental levels.  Many newbie landlords have been caught out by believing over generous rent projections provided by letting agents on behalf of a developer that sold the landlord their investment property.  Unconnected local letting agents’ projections on rent levels are more likely to be credible and a landlord should always do their own research as well to ensure the accuracy of the projected rent.

Even worse than not receiving the rents that a landlord originally anticipated is when the landlord’s investment property is unlet and therefore the landlord suffers what is called a letting void.  The average void period according to the Association of Residential Letting Agents (ARLA) was 24 days in the 4th quarter of 2007.  A landlord should factor a period of rental void into their investment projections.

Inflation

Many landlords may not appreciate but inflation is actually a property investor’s best friend.  This is because generally a property investors biggest cost and largest liability is the buy-to-let mortgage that was used to finance the investment.  Inflation has the effect of reducing the size of a borrowers loan over time.  How does this work?  For example if inflation is running at 5% per anum then assuming the investment properties real value stays the same by also rising at 5%, whilst the buy-to-let mortgage remains the same.  This means that the real value of the BTL loan is actually shrinking by 5% pa.

The risk to a potential buy-to-let investor is that inflation is not as high as projected or worst still is negative as was the case in Japan for many years.  This so called deflation would effectively increase the value of a landlord’s loan.  Deflation is very unlikely in the U.K. but it is always a risk.

Regulatory risk

One a landlord has a residential investment property they have certain responsibilities to their tenant and certain legal obligations.  In recent years the government has introduced a number of new bits of legislation aimed at further control of the private letting sector.  These regulations mean

Tax

Tax rates are not static.  The government has absolute powers to alter them.  Therefore a landlord that makes a residential investment based on assumptions of a certain tax environment could find that their investment returns are severely impacted on as a result of tax changes.  An example of this is the government’s intention to replace Taper Relief with a flat rate of Capital Gains Tax