Assessing the risks of investing in real estate
Given the hundreds of thousands of dollars needed to purchase any property, investment in the property market might seem to be the playground of the wealthy who have so much spare cash they do not know what to do with it all. However despite the high buy-in cost, many average people are using property to increase their wealth with the aim of financial freedom.
We have all heard the stories of young men and women who have somehow managed to buy hundreds of investments and are now floating around in a swimming pool sipping cocktails living off the rent. How did they do it? Is there some hidden trick to buying bargain properties? What is their secret? The decision to purchase one property can be so nerve-wracking, least of all buying multiple properties.
Whilst you wont need hundreds of properties to achieve your goals, the reality for todays investor is that having just one investment property is probably not going to be enough to create a passive income stream that will create the financial freedom you desire. We need to get beyond the crippling fear of risking our comfortable position that causes us to not buy our first investment property.
Let's consider risk at this moment. Investing in anything comes along with a degree of riskiness as the value is prone to change. You become subjected to the movement of the market the moment you sign a contract. What if the values decrease? What if you lose your tenant? What if the interest rates go up? These are all worthwhile questions to consider but with some pragmatism.
The most risky move of all in my opinion, is not investing at all. We cannot discount that not investing also creates a risk factor, because if you choose not to invest you will be risking possible gains that you may have benefitted from if you did choose to invest. If you choose not to invest you must rely solely on any other source of revenue you have, for most people this is their primary employment. But what if you don't want to work forever? What if you want to retire from work early? What if you become injured or ill and can no longer work, without a secondary income stream, you must rely on savings, superannuation or a pension. This lack of a secondary income stream is risky indeed and cannot be forgotten in the assessment of risk when deciding whether to invest.
Let's discuss the other risk factors in buying property previously mentioned. Market fluctuations are part and parcel with buying investments and property is no different. The real estate market in most parts of Australia has been seen by investors as a safe and reliable way to take advantage of market fluctuations. Whilst a down-turn of prices may be seen as a negative aspect of investing, it is an up-swing of prices that builds wealth for investors. Fluctuations are seen as a normal part of the property market and are to be expected. See the graph below to view the median prices in the past decade.
What if the market goes down after you purchase your investment? Does the value really matter to you if you are not selling? In one way yes, your net equity position may be lower that when you purchased however if you can hang on to the property and service your debt until the value recovers, you will not suffer an actual loss. We can see from the past 10 years of median price data that most decreases have been quickly reversed and gains are what was seen next.
Shouldn't we then buy at the lowest point in the market? Yes, and if you know when that moment is, please tell me. The trouble is we only know that the market was low when we look back in hindsight. All we can see at the time we are thinking of buying is how expensive it is. Are we trying to speculate the market and buy low and sell high within a short space of time? No, this may be risky and the costs of buying and selling must be factored in. This is the domain of property developers and renovating flippers who have no choice but to buy and sell in a short space of time. For most people however, the safest way to invest in real estate is to plan to invest for the long term. Real estate has long been known to be the safest form of long term investment and does not require any special knowledge or skills. If the market does decrease, buy another property. Capitalise on the down turn and buy more investments and expect an upswing. If history is anything to go by, you won't need to wait long.
What if you lose your tenant? You won't have any rent coming in so you will be making the entire payments yourself. You need to be able to manage in this event for a short while. Have backup funds saved up for this rainy day. Whilst a vacancy cannot be entirely avoided, you can protect yourself against this impost by doing a few things right such as; keeping the rent reasonable. Tenants can easily shop around while they are living in your property and if they see better value elsewhere they may decide to up and go. You would have been better off keeping the rent fair or even a little lower than the market price. In this way your tenant will know they are getting a good deal and will plan to stay on. They will be more likely to look after the property as well as they consider it to be home. During the advertising and letting of the property, if the rental amount appears to be good value, you may obtain multiple applicants and you can select the one you think will be a good long-term tenant. When you consider the missed rent on a vacant property that is priced to high, after a couple of weeks you would have been better to offer it at a lower amount. Your tenant will appreciate the good value they are getting and they are helping you become more wealthy so give them a break with a fair monthly rental amount.
What if the interest rates go up? Investment interest rates fluctuate as do the values in the property market. So do we only invest when the rates are low? No, we need to focus on our goal of financial freedom and continue to invest in property. If we waited for the ideal time to buy investments, we may find ourselves waiting too long and missing the market. Don't let yourself be paralysed into inaction waiting for the perfect or bargain property. When interest rates are higher or going up, this dynamic can present even more opportunities to investors for better buys as some sellers will be keen to sell. Naturally you need to work your sums on higher interest rates being a possibility in the future to safeguard against having to sell if you cannot meet your obligations of a loan.
When you weigh up the risks of investing against the risks of not investing, the decision seems much clearer. Taking in to account the tenants contribution of rent toward your loan payments, the potential tax advantages of owning investment properties and the overall safety of property investment when carefully considered, property investment is a very good option indeed.
Disclaimer: This is an opinion piece and is not intended to give financial or investment advice. It is recommended to obtain financial and taxation advice prior to making any investments.