“I prefer property investing over shares. With property I can invest in something I can see and touch. It’s much less risky than shares”.
“You never lose money in real estate because real estate prices never go down”.
“I like real estate investing because you can negative gear with real estate”.
As a financial adviser there a few lines other than those above that concern me more, especially when I hear them coming from the mouth of a first time investor.
Everyone has a friend or family member that has quoted those lines to them and if it’s said often enough it must be correct, right?
If only it was that simple. Even the best property investment, if executed poorly, can turn out to be a money killer.
As Warren Buffett is famous for saying, “the first rule about investing is don’t lose money. The second rule is…. Don’t forget rule number one”.
When it comes to business or investing, the number one reason people go bankrupt or become hopeless investors is because they don’t fully appreciate the double edge sword debt can be. Importantly, you don’t need to go bankrupt for debt to have a detrimental impact on your financial well-being.
One of the biggest advantages of investing in real estate is that banks love to lend against real estate. This can give you more exposure to an asset’s price appreciation and therefore has the ability to enhance wealth in favourable times.
But it’s often the bad times that people don’t tend to plan for that bring investors unstuck.
How to manage the risks around borrowing.
Unless you already have a substantial amount of wealth, you will need to borrow funds, typically from a bank, to give you the capacity to make your first real estate investment.
All too often I hear people talk about capital growth, but the most important aspect to being a successful real estate investor is cash flow and remaining liquid. Capital growth will make you wealthy. Cash and cash flow, will put food on the table and fuel in the car. What’s more, the lack of it will put you on the streets.
As an investor in real estate, the aim should be to eventually own enough real estate so that over time the cash flows from rent allow you to live off those rents. That’s what makes for true financial independence, where your investments provide the passive income necessary to provide the lifestyle you desire.
It is also cash and cash flow that will help you navigate the downturns and prevent you from having to sell your property/ies when times get tough. And for long term investors, there will always be hiccups along the way.
Whenever I start planning a financial strategy for a client, I always start with the aim of ensuring that even in the worst of scenarios, a clients financial strategy will self-complete. What does that mean?
Well have you ever considered how you would meet your mortgage obligations if you were made redundant or suffered an injury or illness that prevented you from earning an income for a period of time? What about if you were laid-off because the economy was struggling and jobs were tough to come by? On top of that, what would happen if your tenant was laid-off and had to move out and because the economy wasn’t doing so well, it took a month, two months, three months to find a new tenant or you had to discount your rent heavily to find a tenant?
All of a sudden, you have one or no income supporting your family, paying the mortgage and paying the investment loan. Your ability to meet your obligations and to hold on to your properties is crucial to attaining long term wealth.
Unlikely scenarios you say? Well consider this, Australia has been in a period of economic expansion for over 20 years. Prior to this previous period, we averaged a recession every 7 to 10 years. The longer we continue to grow, the closer we get to our next downturn, and we are already well overdue.
There is no use being a property investor if you are forced to sell out at the bottom of a property or economic cycle, that will only ever mean that you are buying high and selling low. Time is a property investors best friend.
Whenever you invest in real estate, and particularly when investing off the plan, there are some specific risks that you face when using debt to fund your investment:
- Falling property prices – The risk that the property value declines from the time of contract to the time of settlement and you can not borrow what you thought you might have been able to.
- Rental risk – The risk that because there is a lot of new units in your apartment block up for rent at the same time, that you find it difficult to find a tenant in a timely manner or at the right price.
- Risk to your income – The risk that something happens to your ability meet your personal financial commitments i.e. you become injured and can’t meet your mortgage repayments.
- Rising interest rates – The risk interest rates could increase before you settle, impacting your budget.
Unfortunately all of these scenarios are out of your control. You don’t have the ability to stop any of them. Each one on their own, if not consider, could have a catastrophic impact on your financial well-being, let alone if they all happened at once.
But you can take steps to minimise the extent to which they impact your ability to survive such instances. The extent of damage these events inflict on your long term wealth creation aspirations or financial well-being, is actually your responsibility and you can do something about it.
Start by considering the following:
- Make a provision for valuation short falls – Try and leave at least 10% of the properties value in cash reserves and/or undrawn facilities so that you can meet any valuation short fall on settlement. The longer the construction phase, the longer prices have to potentially fall, so consider increasing this amount if construction is longer than 18 months. If you can’t handle this scenario you can’t afford the property.
- Draft a budget – I cant’ tell you how many people that I’ve met that didn’t even know they were spend more than they were earning. It’s crazy. Do a budget, but do it on the basis that interest rates on all your loans increase by 2% AND your rent declines by 10%. Make sure you leave sufficient fat in your budget to account for these factors. If you can’t handle this scenario, you can’t afford the property.
- Ensure you have appropriate risk insurance – Your family’s financial well-being is your responsibility. Your biggest asset is your ability to earn an income. Protect it! If you can’t afford insurance, you can’t afford the property.
- Keep 90 days to 180 days of net disposable income in a cash reserve – On top of your valuation short fall provision, ensure you have even further funds to get you through any period of unemployment or insurance waiting period. At a minimum this should be 90 days of net household income, but 180 days is preferable.
While it’s possible you may never need to fall back on these provisions, having them will ensure you give yourself the best chance of success.
More often than not it’s not the lack of winners that prevent people from succeeding, but rather the impact that one substantial loss has.
Losers make excuses.
Winners minimise losers. Note, that doesn’t mean they always avoid them!!