02/08/2012
They’re double D’s that everyone’s looked at – due diligence. Whether it’s late, caffeine fuelled nights poring over suburb performance graphs or a simple drive through a neighbourhood, most investors realise that a little research is required on any properties or suburbs they buy into. There’s just one part most forget: themselves.
“A lot of investors come unstuck from failing to analyse their personal finances properly,” says Michelle Coleman of Buzz Finance. “They rush into new purchases without checking to see whether they can afford to expand the number of properties they have. Then they find unexpected problems down the line and they aren’t prepared for them.”
These problems can vary from the incidental to the extreme. From stock market crashes to international debt problems to bosses waving pink slips, the recent string of financial events has shown us that anything can happen.
It is for this very reason that stress testing is so important. Like an engineer would with a bridge, an investor needs to regularly test the structure of his portfolio – gauge its strengths and weaknesses – to see where it’s vulnerable and how much extra weight it can take on.
Test all the possible scenarios
“The key is factoring in the unexpected from the start,” says George Kafantaris, Metropole buyer’s agent. “Most people don’t visualise how their property portfolios will look into the future, say in five or 10 years time. They only have vague goals, like wanting to retire. What they really need to be doing is materialising their goals. What will the value of their properties be? What will their net worth be? Once you have these numbers, you know how much you’ll need to spend.”
Turning property goals into concrete objectives also has the benefit of allowing investors to better plan, says Kafantaris. “How do you know you’re ready to take on another property? It’s by looking at how much it might cost you to own that property over 12 months or a longer period of time.”
Kafantaris adds that much of what happens to an investor and their real estate portfolio in difficult times will be predicated on how they planned ahead. He says that it is vital for investors to put in place cash buffers to account for any shortfalls that might occur.
“You’re keeping money aside for a string of situations that are likely to crop up at one time or another – a vacant property, tenant troubles or maintenance issues. If you have this money already in place, it will be much easier for you to react to any of the changes that might happen to your properties.”
Test your finances
Coleman says that deciding just how much funds you’ll need to put aside for a rainy day will depend on the person. “How much should you buffer? That’s the hard part. There is no one way to do it. It depends on your lifestyle. Some people could earn $100k a year, but blow it every weekend.
“With the large amount of differences in people’s expenses, I always say you need to have a minimum of six months of full payments. Then if you lose your job, you have about six months to get back on your feet.”
She adds that while many financial planners might recommend having a two or three year buffer, this is not always realistic. “If you’re able to save that much money, that’s great. For most people that would be very hard. For people with a fluctuating income – business owners – it might be more necessary.”
Any investor that doesn’t have access to about six months worth of payments, whether it be through equity, savings or a line of credit, should question whether they might be overleveraging themselves, says Coleman.
It doesn’t take a genius to recognise that the more an investor leverages themselves, the more they will be exposed to potential hardships should things go awry.
Canadian real estate mogul Greg Romundt believes that overleveraging is a risk investors can never be too careful to avoid.
“The problem with having huge leverage is that if the markets close down or turn bad you face wipe out,” he says. “The secret to making money almost in any investment, but particularly in real estate, has almost everything to do with staying power. It’s one thing to make lots of money, it’s far more important to protect the capital that you have.”
Test for interest rates
One of the best ways of protecting yourself is to stress test for how interest rates might affect your ability to pay down multiple mortgages.
Kafantaris advises always keeping a firm ear to the ground. “Interest rates never go up overnight and if you’re keeping track of their movements, they shouldn’t land you in trouble.”
Before purchasing, an easy way for investors to plan against rate increases is to plug in an interest rate that is higher than the one they are likely to pay. If there’s still a possibility of getting cash flow from a much higher rate, an investor will already have a 2% to 3% buffer built in before they’ve even bought the property.
“The thing about interest rates is that they eventually go up over time,” says Coleman. “You’ve got to plan for the worst case scenario. That’s why people who can afford a 20% deposit are sometimes better off putting down a 10% deposit and using the rest as a buffer because there are many other costs, including insurance, to consider. It’s not just about keeping the loan down, you want the buffer up. Then you’re prepared for rate rises.”
Test possible tenant troubles
Another scenario that investors need to stress test for is tenant problems. Tenants can affect a property portfolio in a number of ways, the simplest being that they don’t renew, leaving the owner faced with a vacancy. More serious problems occur when tenants destroy property or refuse to leave after due notice has been given.
A widespread view among property investment advisors is that owners should plan for a vacancy period of one month out of each year. “Again, you’re not looking at the best scenario, you’re looking at the ‘what if’ scenario,” says Kafantaris.
Reserve funding may also be required to evict tenants, which at the most extreme, may include legal costs. This means that in addition to calculating a potential accelerated vacancy loss, investors also have to ensure they have sufficient funds to go through paying a lawyer or paralegal for removing a person from the property.
Tenants also pose the risk of damaging property, which makes landlord insurance something of a necessity.
The different insurance policies available to investors cover possible rental problems to varying degrees. What they offer usually depends on factors such as the type of property, the quality of tenants likely to be living in it and the area it is located in.
Typical landlord insurance cover normally protects you against defaults on payments and damage that leaves the property untenantable. Some schemes also cover your legal liability as a landlord in the case of the death or injury of a tenant.
Test the property type
Kafantaris warns that, in measuring how much reserve funding they will need, the biggest mistake many investors make is buying the wrong type of property.
“Every property has different maintenance issues, despite the fact that the features of the property are what sell it. Too many buyers don’t check to see how much it might cost to fix recurring problems. They don’t look to see where their street’s storm water drains are and they don’t check drainage issues. They rely purely on the information given by the seller.”
Coleman says the age of the building usually determines how much maintenance it will require. “On homes that are a couple of years old, you can probably budget for 1% of the yearly rental income to be spent on maintenance each year. For new buildings this will be less of an issue and very old buildings may require more maintenance than that.”
