Risks: macro and micro pitfalls in property investment strategies

Risk assessment is crucial in developing an investment strategy. In terms of property, risk determines both the budget and expected returns on the project.

• low risk = low yields: the investor pays more per dollar of expected revenue in exchange for reliable earnings and secure capital.
• high risk = high yields: the investor earns more per dollar invested, but incurs higher chances of a negative event which could, in extreme cases, lead to capital loss and negative yields.

Country risks are primarily linked to changes (often violent) in the economic, political or social situation. These can include changes in political leadership, legislation, currency or financial crises as well as social unrest within the population.

• added value
• buy-to-let

• Land/property can be initially overpriced.
• Construction/repairs can be delayed or exceed the initial budget.
• Resale property price can be lower than planned.
• Sales (e.g. property units) can be slower than planned.

Other risks can even emerge before construction begins, particularly if the construction permit is refused. Investments directed into redevelopment, capital repairs or construction can only be launched once authorities give approval to the acquired land or property. However, generally the raised funds are budgeted to cover risks linked to the lack of permit or delays in its delivery.

• Location is the most important feature: a central location or a reputable neighbourhood reduce risks and guarantee liquidity in case the investor needs a rapid and efficient exit with minimal value loss. Risks includefuture development of the district or current changes (expansion of the transportation network, establishment of new amenities etc.) that can gradually increase the capitalisation rate on the property or conversely decrease it. For instance, a person who buys an apartment overlooking a picturesque view of the Central Park in New York City would initially safeguard the investment as there are few apartments with such view and there will be no new developments.

• Technical condition: poor condition of the property, insufficient equipment/engineering capabilities/systems or inability to upgrade current features (e.g. heating, plumbing, telecommunications, etc.), bad interior planning, structural issues, poor access and local amenities all impair competitiveness on the market, bring down property value and affect rental demand. Although old and shabby properties can yield decent return at a given moment, they are always riskier than buying a building in good condition.

• Tenants and lease contracts ignite or mitigate the risks. The least risk comes with middle class tenants (residential property) or leading companies (commercial premises) as well as property on long-term lease with a current tenant. Short-term lettings bring in higher yields but do not guarantee full occupancy and while an expiring lease comes with potential to increase yields, it runs the risk of losing money if a tenant is not found quickly enough or if the market situation changes.

• Rental rate: average rental rates are more attractive to potential tenants, thus incurring less risk. Higher rates bring in higher yields but are harder to find tenants for.

• Property use: property with only one authorised purpose ties the investor into one particular activity, which may be affected by macroeconomic changes or restricted interest due to its nature. For example, retirement homes bring in above-average yields but do not reconvert easily, nor are they cheap to upgrade if they no longer meet new standards for senior care. Multipurpose property or the possibility to change the property use contain less risk (e.g., transfer hotel property to residential stock or vice versa).

• Debt and leverage: generally, the higher the LTV ratio, the loan to value of the property, the higher the risk. The capital raised should earn profits that exceed the costs for its use. The investment is incurring increasing losses as the debt ratio goes up if the yields are lower than loan payment. While leverage does boost operating returns, particularly if the investor can agree with the bank to pay the interest accrued on the loan with minimal coverage of the principal debt, if the property price goes down when the loan agreement is due to be renewed, the bank will demand proportional additional capital to secure the loan and an additional guarantee collateral or margin call.

Experts predict that interest rates, that are at an all-time low in many countries, will rise in 3 to 5 years and when they do, property will lose value.

• Remote property management: foreign investments remove the investor on direct management of the day-to-day operations, undermining control and clear insight into how it is managed. While it is better for investors to have control operations, in this instance, the only way to reduce risk is to engage a property management company.

• Transaction structure and taxation can also present risks for investors. There are various structures to minimise taxes that can boost yields but lack transparency and increase holding risks for example shareholder loans or registration via third party companies. These strategies attract the attention of tax authorities who may demand additional taxes and penalties if not structured correctly. The increased transparency requirements for the global banking system, OECD and countries can lead to double taxation in cases of non-compliance with these new measures. For example, the new rules of Russia on Controlled Foreign Corporations have lowered the taxation thresholds for revenue earned overseas and even include profits earned by companies owned by family members of their citizens.