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Understanding the Risks

Property Investment risks

Many landlords have enthusiastically embraced the world of property investment over the last few years attracted by the potential high rewards and lifestyle. Before looking for investment property how many of us have ever stopped and really thought through the potential risks of investing in property?

Property Hawk has taken a step back in order to examine the most significant commercial risks any landlord takes when they invest in buy-to-let property.  Only by understanding these risks can a landlord make a balanced investment decision about their property portfolio and their overall asset allocation.  So prior to finding a buy-to-let (BTL) investment property and landlord needs to understand the risks.  The main investment risks to a landlord are outlined below:

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Fall in capital value of property

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 property 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.  Whilst property prices should continue to go up over the long-term landlords need to factor in the potential for short term falls into their investment calculations.  Have a look at our long-term house price forecast.

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 property investment means that small falls in the value of a landlord’s investment can lead to a disproportionate fall in a landlord’s 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.  This risk is particularly prevalent where a landlord has an interest only mortgage and therefore the size of the mortgage does not reduce over time.

Performance

A 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 the types of residential property.  Therefore buying the right property in the right area could dramatically affect a property investor’s returns and their risk of maximising their returns.

Rent levels & voids

One of the biggest risks to a landlord is an income shortfall bought about by a failure to secure as much rent as the landlord’s original investment plan had anticipated.  This could be for several reasons: firstly, being unable to secure a tenant and therefore not receive rent; or alternatively receiving less rent than was originally anticipated.

The way landlords should manage this risk is that when they are calculating their likely annual rental income generated by a particular investment they should take a cautious approach on their expected rental levels.  Many newbie landlords have been caught out by believing the over generous rental projections provided by letting agents employed by developers selling 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 always factor in a period of rental void into their investment projections.

Inflation
Many landlords may not appreciate this but inflation is actually a property investor’s best friend.  This is because generally a property investors biggest cost and largest liability is their buy-to-let mortgage.Inflation has the effect of reducing the size of a borrower’s loan over time.

How does this work?  If inflation is running at 5% per annum then it is reasonable to assume that the investment properties real value will stay the same by also rising at 5%.  However the size of any BTL mortgage used to purchase the property remains the same.  This means in effect that the real value of the BTL loan has actually shrunk by 5% in real terms and in relation to the value of the residential investment.

The risk to a potential buy-to-let investor is that inflation is not as high as projected or worst still could be 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
Once a landlord has a residential investment property they have certain responsibilities to their tenant as well as certain legal obligations as a landlord.  In recent years the government has introduced a number of additional bits of legislation aimed at further control of the private letting sector.

These regulations mean that what a landlord can do is restricted which potentially reduces their financial returns.  Some of the legislation such as HMO  licensing and the Energy Performance Certificate (EPC) have a cost of compliance.  The risk to a landlord is that the government introduces even more restrictive regulations which will add further to a landlord’s costs or reduce their investment returns.

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 regime could find that their investment returns are severely impacted on as a result of changes to the tax system.  An example of this is the government’s intention to replace Taper Relief with a flat rate of Capital Gains Tax.

Risk aware

Landlords that are fully aware of the business risks that they are taking will be able to ensure that they factor in these to any future investment decisions and weighing the competing factors of risk and reward. It is the fact that as investors that we are without the perfect information about future events on which to base our investment decisions that forms the very basis of the investment risk that we as property investor take.  An appreciation of these limitations should encourage landlords to manage their risk by making decisions based on ‘realistic projections’.

My projections
My personal long-term projections for the investment variables are based on my experience as a landlord and the research conducted for the Landlords Bible.

They are:

Inflation: +2.5%
Property price growth rate: +5% (real rate of 2.5%)
Rents: +3%

In making any future investment decisions landlords should remember the 3 Pillars of buy-to-let and make sure that they do a rigorous investment appraisal.

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Finance and Tax on Rental Property

Rental Property Regulations

Investing in BTL Property

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Legislation of Letting Property

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