The myth of risk

Commonly held perceptions dictate that there is an inherent continuum of risk associated with different investment vehicles, with low risk investments at one end and highly speculative ventures at the other. Most believe that any investment can be placed somewhere along this continuum, and that in general, the higher the risk the greater the reward.

Somewhere along this spectrum sits property. Within the property sector, houses are considered “safer” than vacant land, while commercial and industrial real estate is considered riskier, as values can fluctuate more. Then there’s “common wisdom”, which suggests that properties in capital cities are less dicey than in regional areas.

The innate problem with this approach is that while we are taught to evaluate the level of risk in the investment itself, as well as general market risk, there is a critical factor missing – you the investor.

Imagine you are considering undertaking a small residential property development. Is this risky? In isolation, this question is impossible to answer because we don’t know enough about you. Have you ever invested in property? Have you completed a development? If you have zero knowledge about residential developments, or you’ve never owned an investment property, no matter how good the deal seems a development is a risky proposition.

Essentially, it’s impossible to distinguish discussions about risk from an assessment of the investor. You could turn to a trusted advisor to help make up for your lack of knowledge, but the only way to unfailingly lower your own investment risk is to become an expert in a particular area. How do you know you’re an expert? You have to consistently outperform the market in the given investment niche over time – preferably a couple of investment cycles.

An element of risk is inherent in any investment, but the truth is that you the investor, are the biggest risk variable of all. Over the years I’ve seen people make a lot of money out of real estate, but I’ve seen just as many people lose money. The difference is generally in the individual’s skills, contacts and expertise. Sophisticated investors manage to obtain higher returns without taking a higher degree of risk, which is the exact opposite to what conventional wisdom tells us.

Let’s consider the primary factors that determine the degree of risk associated with an investment.

1. Expertise
Your experience and network of contacts can be your biggest competitive advantage or your most potent risk factor. Investing in your speciality area allows you to achieve a higher return because, as an expert, you will be able to find opportunities the average person can’t.

What contacts do you have who can help you make an informed decision or let you know about an opportunity before others? What do you know about an investment opportunity that others don’t, about timing in the property cycle, or a change in government legislation? For instance, a visit to the local council might uncover plans to re-zone a particular area, allowing multiple units on a site where before you could only build one dwelling. This in turn can make the property more valuable and the investment less risky.

Real estate is what I call an imperfect market. If real estate was a perfect, liquid marketplace, you wouldn’t be able to buy property considerably below value. Information, contacts and expertise help you in an imperfect market – they make the investment less risky.

2. Control
The more control you have over your investment, the lower your risk. When you buy shares you have no real control over their destiny. That’s one of the reasons I love real estate – I have control over my property. I can add value through renovations or redevelopment, change property managers if I am unhappy with their service, or furnish the apartment if it’s appropriate.

3. Transparency
Is all the information about your investment disclosed? The more you know, the lower the risk. When you invest in shares or property trusts, you have partial disclosure. There are guidelines as to how publicly traded companies should report to their investors, but if these worked well, there wouldn’t be as many stock collapses as have occurred over the years.

4. Liquidity
Liquidity means the ease with which you can recover your money by selling the investment and converting it (or part of it) to cash. The greater the degree of liquidity, the lower your risk.

Real estate is not as liquid as shares or trusts, because even though you can sell your property it takes more effort and time. Smart investors never sell properties to release cash – they refinance and draw down on unused equity.

Your own liquidity is another major risk factor. Property investors buy the necessary time to see them through a property cycle. The more buffer you have, either as a line of credit or cash reserves, the easier it is to weather a storm. Without a sufficient buffer, especially in more turbulent times, you’re at risk from things such as interest rate hikes, extended vacancy periods, etc.

5. Returns
Investors gain returns from their investment property via:

• Cashflow – the rent you receive.
• Capital growth – the increase in the value of your property.
• Forced appreciation – the value increase you “manufacture” by undertaking renovations or redevelopment.
• Tax benefits.

The more secure the returns, the less risky the investment will be.

6. Is your principal at risk?
Is your financial outlay secure if the investment fails? An initial cash investment (your principal) in a bank term deposit is considered very secure, whereas if you buy shares it’s possible for the company to fail and the shares to be worthless. With property you generally have to put down a 20% deposit, so if it drops in value by more than 20% your equity (deposit) would be wiped out.

The overall median house price in Australia has never fallen more than 5% in one year, even through wars and depressions. But I have come across many investors who have had their equity wiped out. Some highly geared and bought at the top of the market then values fell, while others paid too much buying off the plan and on completion, the value of the property was less than what they paid. Occasionally the value of individual homes has fallen over 20%, especially in outer, interest rate affected suburbs or regional areas.

The more secure your principal, the less risky the investment.

7. Are you personally liable?
When you make an investment, do you have to provide a personal guarantee? This gives others (usually the banks) the right to pursue you if things go wrong. If your liability extends beyond the asset itself, such as when you are personally guaranteeing the loan for a property bought in a company or trust, your personal assets could be at risk.

In this instance, if things go belly up and the bank sells your property and can’t recover all it’s debts, they’ll chase you for the difference. Often the bank requires you to take out mortgage insurance for such an eventuality, but this protects them, not you. The mortgage insurer pays the banks, then chases you to pay them back, with interest!

Obviously, the more you are personally liable, the higher the risk to the investment.

8. Market risk
Some risks are inherent to certain markets. For example, if you invest in tourism you are subject to your investment market collapsing if there is a natural disaster, war or disease; Bali’s economy almost crumbled after the bombings and the Asian Bird Flu crises.

When weighing up risk, consider what impact general economic changes to that marketplace could have on your investment.

9. Risk spectrum
This is the risk specific to the particular investment. Is it the right property, in the right suburb, at the right price and at the right time in the cycle? When assessing risk, most investors only look at the last two factors – the market and specific investment risk. They rarely focus on the other factors, which in many ways are more significant.

You will have your own risk spectrum and it will be different to mine. My suggestion is that whenever considering an investment, don’t look at the investment alone – look at yourself too.

Remember, you can change your risk spectrum by developing expertise, to make wealth creation a long-term, low risk and high return investment.

What type of investment choices are low risk, medium risk and high risk for you? Tell us by leaving your comments below.

Michael Yardney is the director of Metropole Property Investment Strategists, a best-selling author and one of Australia’s leading experts in wealth creation through property. For more information about Michael visit www.metropole.com.au and www.PropertyUpdate.com.au.