With an ever-changing real estate landscape, risk assessment is becoming more and more important when buying a house or apartment.
How do we define risk?
Risk is defined as ‘a situation involving exposure to danger’. In real estate, this is the difference between an investment being a financial (or mental) burden or one that positively contributes to your portfolio.
Thoroughly understanding your property risk can help ensure that your investments are safe.
In general, the real estate market has low equity and cash flow risk if you can hold on for the long (long) term, around 20 – 30 years. The long-term investment is a cornerstone of real estate investing. Whatever happens, you will enjoy a relative growth of money, more than you would if your money is sitting untouched in your bank account!
Although the above statement is true, you do not want to be financially vulnerable in the short or medium term. Poor short/medium term performance can change long term plans and prevent you from adjusting your property portfolio as needed.
Considering investment vulnerability reminds me of a classic Warren Buffet-ism: “Risk comes from not knowing what you’re doing”
The same applies to real estate, whenever you invest for the short or long term, you need to understand what you are doing; otherwise, you could jeopardise your financial security, and long-term outcomes.
We often get asked how we assess risk and investment in a property, and which property is a stronger investment. To best illustrate this point, let’s compare a few examples:
Property one – House – 4.5 bedrooms, 2.5 bathrooms, 2 lock-up garages
Property two – Apartment, on level 6 – 2 bedrooms, 1 bathroom, 1 car parking spot – with park and water views
*Alternate images have been chosen to protect the identity of our customers
After conducting an in-depth risk analysis, we selected property one – the house as the better investment.
Before recommending the house to our client, we examined the following factors: suburb, house position (and surrounding infrastructure), configuration, asset-class and price percentile. These all measured as low short-term equity risk and low short/medium term cash flow risk.
This means that whatever happens to the property market, the property will likely generate substantial returns every year or within a reasonably short-term period. In reality, this translated into a significant profit margin for our clients in the long term.
Several of the apartment buyers contacted us after purchasing off the plan and requested advice before settlement.
Unfortunately, they had not conducted any kind of risk analysis.
The Investment company consultant and agent provided marketing material to support the sale. The view was an optimistic long term forecast of the suburb transformation, growth, new upgrades to infrastructure in the area, together with the attractive project photos and graphs. The marketing material was well designed – it was colorful and presented a lot of data, implying that accurate research had been done for the buyer.
I ran an in-depth risk analysis on one of the two-bedroom apartments on the 6th floor. The analysis revealed that equity risk is very high with a medium-high cash flow risk.
No agent or property consultant mentioned to the purchasers that 1500 such properties were expected to be in supply over the next 5 years in this and other local construction projects within the suburb. This represents more than 40% of the existing stock. This results in extreme over-supply in housing, which delivers negative capital growth and a flat market in the long term.
Some units will be lucky and find tenants that can bring 4.5-5% rental yield; however, it will likely be temporary. As more apartments become available in the area, chances of occupancy will decrease.
Additionally, we considered other factors in our risk assessment. A 2-bedroom unit isn’t a preferred asset-class and doesn’t have suitable configuration to the suburb considering the demographic of potential renters. Also, the price of each 2-bedroom unit was, on average, higher than a 700m2, old 4-bedroom house.
Of course, I can understand the buyer’s perspective here – superficially, this seems like a real find! A brand-new apartment, with a view, and building amenities appears super attractive – it’s close to main beaches and a fast commute to Sydney for only $550,000-650,000.
Where else could you find such an opportunity in Sydney?!
When considering property risk analysis, there are some numbers that should not be ignored.
For me to recommend this purchase to my clients, the unit should cost 50% less than an old house, which is not the case. This comparison can be made between any established assets, even similar 4-bedroom houses in surrounding suburbs. The example above is one extreme case.
We apply the following rule when assessing property risk:
Within one suburb, seeing variations in price range of 10% within a specific asset class and configuration is a good sign.
This means that properties that are priced incorrectly, with the wrong property configuration, or mis-matched asset-class for the suburb will not make a good investment. At best, they will be a pretty piece of real estate that you hope will pay off. If you are purchasing properties with one or more of the above factors, these will be associated with higher risk (equity and cash flow). This can negatively affect your portfolio and may create difficulty in gaining equity within a reasonable time to sell or offset your money loss with another asset.
Remembering back to Buffet’s quote – without a detailed understanding of your investments, you are likely to fail.
Unfortunately, many real estate professionals and sellers refuse responsibility of the product they are selling. Real estate for a long-term investment is quite forgiving, but why wait for forgiveness when you can avoid short- and medium-term pain with thorough risk analysis and planning?
High Equity Risk:
High equity risk means that over the first cycle (7-10 years), you are likely to make ZERO growth, and over the next property cycle you might only make 20%. This means that over a total of 20 years only 20% growth will be made. During this time, you might have a low cash flow risk, but it will not change the fact that your money didn’t work effectively over a long period. The 3rd cycle might see you make 50%, which is too late in the investment cycle.
The same house, with short term low equity risk is likely to make solid growth year on year or over the short term. That means in the first cycle (7-8 years) the property may grow by 60% growth and at the end of the 2nd cycle (20 years) the purchase would have double in value – twice.
Understanding these factors, you can see why we recommended purchasing the house in our case study above.
Whether investing in real estate, shares or blockchain, all investments have inherent risk – but understanding risk and return will bring you to better results. Understanding risk assessment is equipping yourself with better tools to adjust your property portfolio and achieve significant wealth for you and your family.
Unfortunately, there is no easy way. You cannot buy a property out of a brochure, and you shouldn’t only listen to seller appraisals. Moreover, no company will give you accurate general medians in Australia or each state’s historical capital growth when they have a stake in the deal!
This buying approach is too risky and not the right way to increase your wealth.
Investinproperties Pty Ltd is a trusted buyer’s advocate. We act under a real estate license and have more than ten years’ experience in the Australian investment market. We have helped many investors who have turned into loyal clients over the years, utilize the risk validation system and detect suitable assets with short-term low equity risk. Our results speak for themselves.
Our services are suitable for both first time and experienced investors.