How well do you understand risk?

This week, I want to revisit the topic of Risk. There are a lot of people out there who might be interested in property, but are held back by the idea of risk, and the potential to lose an awful lot of money.

When it comes to your property investments, it’s really important to understand risk and the impact it can have on a potential deal, so you can mitigate it from the word go. After all, investment of any kind is all about managing the risks. They’re everywhere, after all.

What’s your risk mindset?

Before we look at the types of risk you might come up against, it’s important to determine what kind investor you are – are you a gambler, or are you an analyst?

The Gambler will pile into a deal very enthusiastically, only seeing the big pile of money at the end and all the upsides… but never the downsides. In an uprising market they do very well, primarily because they’ve thrown caution to the wind and jumped in with both feet, but the potential to lose everything in one fell swoop can be huge, because they’ve not done their due diligence properly.

The Analyst, on the other hand, will analyse a deal to death. If you’re an analyst you can be pretty sure that you’re not going to lose a lot of money throughout your career… however you’re unlikely to make a tonne either! What happens a lot of the time with this type of person is Paralysis by Analysis: they get so caught up in analysing every single potential risk and outcome that the deal ends up getting snapped up by a Gambler type (or by someone who’s even just a little bit more risk tolerant).

You have to find a happy medium between the two – don’t go in all guns blazing, but by the same token don’t get left behind by kicking the tires of a deal too much. The key is to understand each type of risk, so a/ you’re aware of it, and b/ you can take steps to mitigate and manage it.

Risk versus reward

One of the things I’m always telling my coaching cohorts is to look for asymmetric risk, and be on the positive side of it if you can. That means you should look for deals where there’s a great big upside, and (if possible), a small downside.

For example, say you’re borrowing 100,000 and whilst you could make 50K from the deal, there’s also the potential that you could lose 50K: it’s kind of balanced in the sense that you could make or lose the same amount.

An asymmetric risk would look like you borrowing 100,000, with a good chance that you’re going to make 50K, however you’ve managed to limit the downside the potential of only losing 5K. That’s the kind of thing you’re aiming for.

Asset Risk

Of course, it’s all well and good to know that risk exists, but it’s vital to know what each type looks like in the first place. Firstly, let’s take a look at Asset risk, which concerns the general age and condition of a property or a building.

Say you’re looking to buy a property and you're looking at different options on the market. You see a brand new house that’s just been completed: you know it’s got spanking new appliances, the latest building regulations, it’s well-insulated and doesn't have lots of drafts. That’s a pretty low risk deal because everything is so new.

Now, say you’re looking at a 1950s fixer upper. You might think to yourself that it's a lot cheaper than that other house and therefore it's a better deal, but you’d be forgetting about the risks associated with the age and condition of the asset.

Obviously, if you go in with your eyes open you can see that the place may need a complete redecoration, but what about if you have to upgrade your windows because older houses have poor (or non-existent) double glazing? What about the things that aren’t immediately visible, like settlement cracking, or bad electrical circuitry? That kind of refurb will cost you.

So how can you mitigate asset risk?

Carefully examine the property before you buy, whether that’s you walking around with a careful eye or hiring an engineer to come in and do a proper survey or inspection. Think about a sinking fund: putting money aside each month to keep in reserve, so you’re not left scrabbling around trying to find the cash to pay for an unexpected repair.

Tenant Risk

If you’re renting out a property, poor tenant selection can really cause you problems.

It’s easy for a potential tenant to paint a very pretty picture about how great they are. Then they get into the property and completely change: people who at first seemed like an ideal tenant, but then suddenly stop paying the rent, or damage your property.

It's really important to understand the financial resources of your tenant. You're putting a lot of money into this asset, so you have to rent it out to somebody who pays you on time.

The worst thing you can do is put the wrong tenant in there and they start damaging the property and you end up having to try and get them out. This costs you a lot of money: not only money out of your pocket, but also opportunity lost because you're not able to do anything else with the asset while you're dealing with that problem.

So, how do you mitigate against this kind of tenant risk? The best way to do it is having rigorous tenant selection protocols and being disciplined when it comes to due diligence.

One tip I’d urge you to consider is that when you’re checking their references, don't contact the immediate landlord (the one that they're currently with and moving out), but instead contact the one prior to that. If these tenants do happen to be a nightmare, you might find that the landlord they're currently with is desperate to get rid of them, and the only way to do that is to fob them off onto another landlord, so you may not get the most truthful reference.

If they've long gone, the last-but-one landlord might likely to be more truthful and warn you off a potential problem.

Leasing risk

Now, this might seem very similar to tenant risk, but it’s slightly different in that instead of the risk being the tenant themselves, the risk here is of buying a property to rent, which then stands empty for longer than you’d planned.

In the past, I’ve bought properties which have have sat vacant for years. I tried every trick in the book to try to get tenants to rent them, but the properties were just not in areas that did well – and it was a major headache. You have to understand the area that you’re buying in.

Is it a well-to-do area? Is it working class? Does it have any crime? Are there any local issues that could have an impact if you’re renting the property out, or if you’re going to try and sell in the future??

Financial Risk

The next thing to consider is Financial risk. These are the risks that are inherent around your banking and any loans that you've taken out to buy your property. When you borrow money, you obviously have to sign a loan agreement, which has various terms and conditions.

Even though they may be boring to read, it's vital to know what your obligations are and what kind of rights the bank has if you break those obligations. Make sure you know what rights the bank have over your property and over you.

The real risk with a financial risk is increasing interest rates. If you can, consider fixing your interest rate, to lock in a set payment level. This means you don't have to worry about fluctuation. It can be a difficult decision to make at the time, because fixing your rate is always more expensive than just going with the variable rate: say you’re paying 3% variable but decide to fix your rate, and you’re offered 5% by the bank. Why would you pay 5% fixed when you’re getting this great 3% now? ?

The problem is that a year from now, that 3% could have risen to 5.5% and you would have been better off going with the 5%. A fixed rate can be costly, but the advantage is that at least you’ll know where you're going to be for the next couple of years in terms of payments.

Economic Risk

Economic risk is basically market risk - something that you have no direct control over but will still have an impact on your pocket.

Economic market risk can often influence property prices as well. Supply and demand imbalances force the prices up or down and affect affordability. If inflation is increasing and interest rates go up, accordingly, people will have less money to spend so won’t be able to pay as much for property, potentially pushing prices downwards.

You have no control over any of this, but if you're aware of it, you can at least protect yourself. Just remember that global events are never flagged in advance.

Always assume there’s a possibility of some sort of event driving prices down and consider where you stand in that event. Do you have a risky portfolio? Are you heavily borrowed? Do you have a low cash flow? Bear all of this in mind and plan for a worst-case scenario.

When it comes to risk, the above points are really the tip of the iceberg. Tune into episode 160 of the podcast for a deeper dive on the topic, and if you’d like to know more, why not consider joining one of my programs? All the details are available here , and if you’d like to know more, just get in touch.?