A guide of how to minimise common real estate investment risks
By Zarah Mae Torrazo and SSB
Like any other investment, real estate also comes with its own set of risks. Read about the most common ones that Australian investors face and how to minimise/counter them.
Real estate continues to be one of the most popular investment choices for building wealth in Australia.
According to CoreLogic, residential property is a $6.7 trillion asset class in the country, which is significantly larger than any other class and is regarded as the most secure investment.
It may be the top investment pick among Aussies, but is real estate investing safe?
Just like any investment, real estate investing has its own set of risks. Regardless of whether you’re buying commercial real estate or residential rental property, there’s always a chance you’ll lose money on your investment, and a first-time or inexperienced investor could easily end up over their head.
Being proactive and educating yourself as to where these risks lie can save you a lot of time, money, and stress in the long run.
We run through the most common real estate risks and the ways investors can minimise or reduce them.
Common risks that Australian real estate investors face and how to mitigate them
1. Market risk (or systematic risk)
No market is safe from fluctuations. All markets have to face several ups and downs related to the economy, interest rates, or any other market trends.
Unfortunately, real estate investors can’t fully protect themselves from these risks, but there are ways to lessen its negative effects.
One common way to lower this risk is to buy different types of properties in different states. In Australia, cities tend to have their own boom and bust cycles, and having assets in multiple markets reduces risk from market downturns in one centralised market.
However, while buying properties in different locations might diversify market risk to a partial extent, if the wider real estate market crashes, diversification is unlikely to alleviate the systematic risk successfully.
Market risk can affect all investments in an asset class in a similar manner, such as in the event of a market-wide price crash. As such, market risk cannot easily be mitigated through diversification.
To further protect yourself from market risk, try to invest in one or more areas that are not related to the real estate market. Investing in a mix of asset classes is the best way to spread your general investment risk – this could be in government bonds or stocks that are within industries that can perform well, independent of the real estate market.
2. Specific risk (or unsystematic/business risk)
Equities investors and fund managers are highly familiar with specific or business risk, being the measure of risk related with a particular stock or security. Also known as unsystematic risk, this typically refers to the risk associated with a specific issuer of a security.
Businesses in the same industry may have similar types of business risk, and issuers of stocks or bonds may become insolvent or lack the ability to pay the interest and principal for bonds.
Specific risk in property investment is somewhat different. In real estate, an investor is exposed to systematic risk when they invest in real estate that doesn’t allow them to meet their financial goals.
It could be that they invested in a loss-making investment property or one that delivers sub-optimal rental income giving rise to opportunity cost. This can be due to a number of reasons, but it’s generally because of high vacancy rates or because they haven’t accounted for unforeseen costs, like maintenance.
One frequently invoked strategy of property investors to reduce this risk is to acquire different types of property in different states.
Careful, detailed due diligence and research of any property purchase also tend to reduce (if not eliminate) specific risk.
3. Liquidity risk
Liquidity refers to the ease with which you can gain access to the money you have within an investment.
One disadvantage of real estate investments is the lack of liquidity compared to other types of investments (e.g. mutual funds), which can force the investor to think long term.
To mitigate this risk, it’s advised for investors to understand their own personal financial situation and plan for a holding period that is comfortably longer than expected and create strategic exit timelines.
This liquidity risk in Australian property can also be reduced by investing in capital city suburbs with eminent demand and constrained supply, so investors will not suffer a loss when facing the pressure to sell.
4. Interest rate risk
Interest rates inevitably rise and fall, so every property investor should be prepared for when this occurs – because as the interest rates rise, so will your mortgage payments.
Therefore, it’s important to understand how the setting of the Reserve Bank of Australia (RBA) interest rates influences your own mortgage rate. Be sure that you can afford potential increases in interest rates and that when a rate increase does occur, you’re not at risk of being under financial stress.
The risk can also be mitigated through the use of fixed-rate mortgages and prudent cash flow management.
5. Inflation risk
Also known as purchasing power risk, it is the possibility that the value of an asset or income stream will be eroded as inflation diminishes the value of a currency.
The risk is the potential for future inflation to cause the purchasing power of cash inflows from an investment to decline.
Inflation risk is best countered through investing in assets that tend to increase in value over time, such as real estate, dividend-paying stocks or bonds, each of which has a growth component allowing them to outperform inflation over the long term.
The good news for property investors is that well-located Australian real estate is well recognised as a highly effective inflation hedge over time.
The key is to buy in areas where there are multiple growth drivers – things like economic growth, jobs growth, wages growth, increasing populations, etc.
6. Natural disaster risk
This is often a risk that is rarely thought of, but the threat posed by natural disasters is an important one to consider for any Australian property investor.
When natural disasters occur – whether they’re bushfires, heavy floods, earthquakes or cyclones – the health and safety of people is the first priority.
But these events can also create catastrophic effects on the economy and the property market in various ways.
The obvious impact is the badly damaged properties and infrastructure that require large amounts of money to rebuild or repair. Additionally, natural disasters can create a loss of confidence in the location for potential buyers, too, hurting the demand in the affected market.
While there’s virtually nothing that can be done to prevent natural weather events, rental property owners can significantly lower the risk of being financially exposed to substantial damage or total losses by taking out a landlord’s insurance.
By taking out cover, landlords can safeguard their investment against a range of natural disasters and risks, including storms, hail, floods, cyclones and bushfires.
Additionally, landlord’s insurance offers protection for tenant-related loss and damage. This means if a tenant defaults on rent or causes damage to the property, landlords may be able to recoup costs through their insurance policy.
7. Personal risk
If life takes an unexpected turn for the worst and you are unable to earn an income – such as in the event of illness, unemployment or life-changing injury – mortgage protection insurance ensures you are still able to make your mortgage repayments and reduce your property investment risk over the long term.
Real estate is a massive asset class, and its popularity with Australian investors is well-deserved. However, the property investment game is not without its own set of obstacles.
If you invest in real estate with the right knowledge and perspective, it could be not only a fruitful investment but also an enjoyable journey combined with the pleasure of ownership of a hard, tangible asset that no other asset class can match.
An investor who practices prudence and diligence before investing can benefit from the safety, security, and low volatility of this asset class while avoiding undue risk.
Disclaimer: The information provided in the above article is general and should not be perceived as investing/personal advice. It is highly recommended to consult with financial advice from a suitably qualified adviser.
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