For many Australians, a good knowledge of investing in property and mitigating the risks goes hand in hand with looking after their financial future. Whether you have or you haven’t invested in property previously, you’ll want to have a good understanding of property investing concepts and strategies before you begin.
In this article, you will gain a broader understanding of property investing. For more in depth explanation, refer to our Essential Guide to Property Investing.
Property investment is a popular choice for wealth building, especially in Australia where our love of property has continued over decades.
Many investors have used property to improve their financial situation and set themselves up for later in life, but the road to buying and investing successfully in property is paved with complex strategies and concepts which can be difficult to understand.
Before you spend hundreds of thousands of dollars to buy an investment property, let’s start at the beginning and first explore:
- The fundamentals of property investment
- The risks associated with purchasing property
- How to mitigate these risks
The Fundamentals of Property Investment
What is investing?
The basic principle of investment involves using capital (cash or equity) to purchase an asset such as property with the goal of generating a return on the initial investment. This can mean different things to different people, depending for example on life cycle stage.
A couple just starting out with a young family will likely have different needs to someone approaching retirement. With time hopefully on their side, a young family might invest seeking long term capital growth and be prepared to forsake short term returns.
Someone approaching retirement however, may need to derive immediate and regular income from their investment, illustrating that property can generate investment returns in different ways to suit individual circumstances.
Returns usually consist of capital growth – being an increase to the overall value of a property – and rental income, less associated expenses.
It is often believed that good rental yields and superior capital gains are mutually exclusive but while difficult to find, opportunities do still exist. Many properties will of course provide only one or the other.
This is where knowledge is key in helping to identify properties which will deliver adequate cash flow to avoid financial stress while holding the property, and grow in value over time, either building wealth for additional investing or creating a solid nest egg for retirement.
A sound investing approach will usually seek to increase the likelihood of potential gains while decreasing exposure to risk. Property investors can achieve this by undertaking adequate research and due diligence, prior to and during purchase, which will see them avoid costly mistakes often made by inexperienced buyers.
Speculating vs investing
While it’s great watching the many reality TV shows about renovating and flipping properties for profit quickly, the truth is that property investing is an activity best suited to a medium or long term investment horizon.
What is Speculation?
Buying property in the hope of reselling it at a higher price in the near future is a dangerous game best left to those with deep pockets and a lot of experience. This practice is referred to as ‘speculation’ and it isn’t for the faint-hearted. Speculators know they can’t control the outcome and are prepared for the risk of suffering a loss.
Successful speculation needs to result in exceptionally high returns, as Capital Gains Tax (CGT) applies to any gain, and properties ‘flipped’ within 12 months of purchase do not qualify for the current 50% CGT discount.
There are significant costs and taxes such as Stamp Duty involved in a property purchase, and with a multitude of economic factors impacting on property values at any given time, it is impossible to predict the exact timing or degree to which growth will occur.
Having a medium to long term investment outlook is vital as investors will invariably experience market ups and downs and while ever there is no urgency to sell, having time on your side will allow you to ride out these fluctuations and realise your investment when the time is right.
Property sectors and associated risks
Among the different categories or sub-sectors of property are the following:
- Residential, e.g. houses / units or vacant land.
- Rural, e.g. acreage with house and land.
- Commercial, e.g. office, retail, industrial.
- Niche, e.g. student accommodation, hotel rooms or serviced apartments.
Different levels of risk and return pertain to each of the sectors.
There is no one single ‘property market’ so be wary of data that claims to broadly speak of the Australian property market, as that may have no bearing at all on the particular sub-sector or locality that you might be considering.
Characteristics, risk and return of property sub-sectors
There is no such thing as a high-return, low-risk investment in any class and it is important to understand the various risk and return levels of different property types and lending structures before making a commitment.
To help guide your investment decision making, it is helpful to understand your own tolerance for risk. This can be done by undertaking a risk profiling exercise which will shed some light on your personal attitude toward investing, your level of understanding of investment markets and what your possible reactions may be in certain market or economic scenarios.
Being aware of your own personal risk profile and understanding the difference between speculating and investing are fundamental to avoiding some of the pitfalls of purchasing property for investment or home ownership.
However, research doesn’t end when a purchase contract is signed, property owners must stay abreast of their legal obligations and be monitoring the property and broader economic environment for signs of potential risk.
The ability to recognise risks and take steps to either reduce or eliminate their impact is critical to the success of every property owner.
What is Diversification?
One common method of risk reduction used in wealth creation is diversification, which involves spreading investments across the four main asset classes of cash, property, shares and fixed-interest securities. In other words, not putting all your eggs in one basket.
The risk of owning multiple properties within the same geographical market is that the total portfolio may experience a downturn at the same time, limiting investors’ ability to leverage equity in order to buy additional properties in better performing locations.
As someone just starting out on your property journey, diversification is something to keep in mind as you progressively grow your property portfolio and other investments over time.
Diversification can be applied across different asset classes, but also within asset classes. In a property portfolio this could look like having a mix of property types (market sub-sectors) plus a geographical mix of property locations.
Diversification affords investors the opportunity to experience gains in one area which help offset under-performance in another, protecting and enhancing an investment portfolio’s overall performance and ability to access additional lending from banks.
What is Liquidity?
Liquidity refers to how quickly an asset can be bought or sold at a price reflecting its true market value. Cash is considered highly liquid as it can easily be converted into other assets.
Tangible items such as real estate are considered illiquid assets because of the time it can take to sell them, as with property this can sometimes be many months.
Liquidity factors into risk consideration as property purchasers must ensure they have an adequate buffer of funds available for emergency expenses in order to avoid financial stress which could lead to a forced sale.
A range of insurance options are available to property purchasers and these can be used to help minimise some of the risks associated with property ownership.
Policies worth considering are listed below:
- Income protection or salary continuance cover
- Trauma and TPD
- Life insurance
- Building and contents insurance
- Landlord’s protection insurance
Which policies to take out and the amount of cover required will depend on individual circumstances and it is always best to seek professional advice.
At a minimum, property investors must insure buildings and contents not only to protect their own investments but to meet lender requirements in most cases.
We’ve all heard of or experienced tenant horror stories where properties are damaged, or tenants have simply stopped paying rent. Landlords are strongly advised to protect themselves against these scenarios by taking advantage of inexpensive Landlord’s protection policies, the cost of which is tax deductible.
As a potential property purchaser, research is your best friend and should be viewed as essential to minimising the risk of potential mistakes such as buying properties:
- Above their true market price
- In low (or zero) market growth areas
- With zoning issues
- With high vacancy rates and no rental growth
- With poor cash flow
- In a bad neighbourhood
- Just because you’re fed up with searching
Engaging professional help
Solicitors or conveyancers, mortgage brokers and real estate agents are some of the professionals you will likely use to help you make informed property purchasing decisions.
These professionals help with everything from negotiating a sale price and arranging pest and building inspections to executing the Contract of Sale, getting a great interest rate and researching different types of properties. Experts in their field are there to provide you with appropriate advice.
Your team of professionals may also include accountants, quantity surveyors, property managers and qualified property investment advisers.
Whereas banking and insurance industries are regulated, the property industry is not. Unfortunately, this means someone with little to no experience can claim they are a ‘property investment advisor’.
Research is extremely important in determining the legitimacy, qualifications and experience of the people you engage to help you. Don’t just look at their website to make your decision. Check if they are registered with industry associations who may insist members operate in accordance with a particular code of conduct, protecting both the industry reputation and the consumer.
Last but certainly not least, never buy property from someone who is claiming to be a property investment advisor. There is a clear conflict of interest in this situation, and likely a hidden agenda which does not have your best interests at heart.
Taking responsibility for your own success in hand by completing educational courses and seeking professionals with the right skills, and no hidden agenda, is the best way to make informed decisions in relation to the purchasing of property.
While this article covers a few broader concepts, we also recommend taking a look at our property investment guide, which goes more in depth into property investment strategy and other important information.