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Risks: macro and micro pitfalls in property investment strategies
Last Updated: January 25, 2016
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.
Risk can be linked to internal or external factors and has two main sources: either the country where the investment is located or within the project itself.
Macroeconomic risks depend on the country
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.
Reference point: The best way to evaluate this risk is via credit ratings provided by global agencies like S&P or media specialised in market intelligence. The Economist Intelligence Unit , market intelligence branch of the British weekly newspaper, rates Austria, the UK, Germany and the USA as countries with the least risk and Afghanistan, Belarus, Ukraine (among others) as highest risk.
Risk metrics: the main factor to look out for is rising inflation. Risk is at its lowest when inflation is under 5% per annum and peaks when it exceeds 100%. Real estate markets are “safe” from inflation as rental rates are revisited monthly or annually and pegged to the retail price index whose dynamics are in line with inflation. Rates that are frequently revisited means that the property is sensitive to inflation, either rising or falling with it. For instance, in one scenario, inflation is rising and so are rental rates – but in a different scenario, inflation is falling, the rates are revised and so is the revenue from the investment.
Effects: inflation is the barometer for a country’s economic health. When it is strays from acceptable levels, currency, imports and exports, lending, purchasing power and consumer ortenant morale are all affected.
Property types by sensitivity to inflation
Sensitivity to inflation
Long-term residential rentals
REIT (Real Estate Investment Trust)
Short-term residential rentals
Reference point: another important factor is currency volatility. Any major fluctuation, up or down, can cause serious disbalance in the national, even global economy. This is particularly noticeable in commodity-dependent markets.
Risk metrics: Markets are at highest risk when the currency rises or falls by more than 20%.
Commodity-focused economies like BRICS countries are particularly vulnerable for volatility, like Russia for example whose currency is suffering from record-low oil prices. Political instability, insurgency or warfare also affect currencies like in Ukraine. Finally, central bank decisions or poor economic management, like in Hungary, can lead to extreme changes in value.
Five volatile currencies in 2014
Sources: fxcm.com, investing.com
Effects: aftermath of currency fluctuations include falling GDP, slowing production, shrinking exports and lower purchasing power, particularly if any of these drivers drops by more than 10%.
Negative population growth or mass movements of people also have an impact on local and national real estate markets. For instance, residents of East Germany move to the more developed and promising western regions. This is why all of Germany’s “Big Seven” cities, leading investment destinations, are located in the West, with the exception of Berlin. These markets are considered stable, thus less risky, latter are considered as less risky markets for real estate investments (except for small towns in the Ruhr Area that faces resident outflows due to lacking jobs).
The political situation also materially affects the behavior of investors and their risk perception. According to results of Tranio’s Russian and CIS Buyer Activity Report 2015, these investors consider political and economic stability a priority when selecting an investment destination. This is why, despite the crisis, the UK, Germany, USA and France are witnessing above-average spending on commercial property.
Changes to legislation and taxation are also a risk for investors. Countries contemplating increasing the tax burden on investments or targeting foreign buyers as well as legal restrictions on construction and investments and limitations on capital flow lose investor interest. For example, strict new laws on money laundering and know your customer compliance in the United Kingdom and European Union require investors proof of funds source.
Microeconomic risks depend on the project
Investment strategies fall into two categories with separate risks:
1. Added value projects
Reference point: Added value projects encompass construction and redevelopment. Risks escalate in proportion to the developer's credit burden, so the more debt taken on, the higher the risk. All these possibilities can engulf returns, stripping the investor of profits or even causing losses. In worst-case scenarios like high debt to construction and material cost adjustments ratio, the developer or investor can ultimately incur losses.
Risk metrics: projected earnings are attractive (14–25% yields). Experienced developers expect to earn 15–20% (general scenario) or 20–25% (best-case scenario) upon exiting the project but plan for the following risks:
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.
Prevent risks: negative occurrences linked to development projects can be identified by a comprehensive due diligence in four stages.
Type of due diligence
Lawyers review the validity of documents and contracts pertaining to the property and project.
Tax advisors assess actual property maintenance costs, calculates the profits and tax charges.
Expert review of local development prospects and impact of existing and future competitors.
Expert review of the land or property's technical condition (usually conducted in purchase of old properties).
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.
Reference point: when investing in buy-to-let property, whether it is retail, industrial or residential, is dependent on the reputation of the area, the technical condition, financing and much more. Real estate and financial experts as well as keeping up to date with local media can provide exclusive insight into the validity of an investment.
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 include future 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.
The risk calculation
Risk is a choice that can pay off or put down an investment. Taking risks brings home higher yields, but also decreases liquidity and capitalisation rate growth potential. On the other hand, shying away against risk guarantees lower yields but, assuming the investor has chosen a popular property segment and location, often comes with property that is easier to sell on and better growth in value. Risk or lack of it are, in fact, two sides of the same coin, and were this coin to be tossed, success would largely depend on the quality of the due diligence and investment strategy.
changes in commodity markets
reducing GDP, slowing production and shrinking exports
decreasing purchasing power of the people
Social and political
political, economic, financial mismanagement
changes to legislation/taxation
negative population growth
buying overpriced land or property
discounted property sale price
negative impact of local development plans
property in bad condition
short-term lease agreement
high LTV ratio
So if you are considering investing in property, ask not “How big are the yields?” rather “What are the risks and how can I sell this property in the future?”
George Kachmazov, Tranio
Title: Risks: macro and micro pitfalls in property investment strategies
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