Direct ownership of an investment whether real estate, shares or fixed income assets is appealing for many investors. It cuts out managers and advisers and gives the investor a greater feeling of responsibility over their assets and potential earnings.
This added control comes at a price. Real estate, shares, and fixed income instruments are all complex, risky assets. Buying them directly places the burden of asset selection, acquisition, management, and exit entirely on the shoulders of the investor. If you have the time and financial acumen to execute these responsibilities well, then direct investing can be very rewarding. If you don’t, then you are adding risk to already risky asset classes.
Let’s take real estate as an example. Direct ownership of real estate as an investment has never been more popular. Availability of debt, tax incentives, and its apparent simplicity have made property the investment of choice for many people. Is it that simple, though?
The risk of real estate investments
Owning real estate presents a number of risks:
- Market – property prices can move up and down significantly due to a variety of economic factors beyond your control;
- Legality – property ownership is subject to a raft of complex laws;
- Asset – every property is different and comes with its own idiosyncratic risks;
- Regulatory – the tax incentives available may change in the future;
- Liquidity – property is a large single asset which can be hard to sell quickly;
- Concentration – most people can only afford 1 or 2 properties which necessitates placing all of their eggs in few baskets;
- Cashflow – the holding costs of direct property can be significant, rendering net income modest or even negative; and
- Leverage – most people need debt from a lender to buy property.
Some of these risks – such as market risk – are unavoidable and require making an assessment as to whether the expected returns justify such risk before investing. Others, such as asset risk, can be reduced (but never avoided entirely) by doing due diligence beforehand.
Doing your due diligence on property investments
Below is a basic due diligence list for property selection:
- Establish a clear set of criteria before you buy that matches your investment strategy and risk appetite;
- Identify a budget that you can comfortably afford even in a down market and/or at higher interest rates. A 25% margin for error on both is not a bad guide, more if you are using high levels of borrowing;
- Are you investing for yield or capital growth? If you are negatively gearing, it’s the latter. What have average yields and growth rates in the area been in the last 20 years?
- Consider the nature of future population and employment growth in the area to assess demand and likelihood of capital growth;
- Research availability of new residential land and property development to assess supply;
- Look at historic sales volumes across different property types in different economic cycles to assess liquidity;
- Understand planning and zoning laws and regulations and possible changes impacting the area;
- Look at current and future infrastructure and its impact on the area;
- Consider environmental risks from flooding, bushfire, wind and industrial contamination;
- Consult local market, building, engineering and/or legal experts to assess risks associated with specific properties;
- Using your research write a checklist of attributes you want your property to have and assign points to weight them from most to least important. Set a minimum score prospective properties must meet to make your shortlist.
This is reasonable due diligence before you start searching, but the real work starts once you have a short list of targets and start due diligence at the asset level. One of my former hedge fund colleagues used to refer to due diligence as like peeling an onion: you keep peeling back layer after layer; the more layers you peel the more you reduce your risk.
Once you acquire your property, you should actively monitor its performance by taking into account all acquisition, holding, and exit costs. You should benchmark net capital gain and yield against appropriate indices, such as the Australian REIT Index, as well as alternative investments such as managed property funds and shares in property companies. Consider the risk (and labour) vs. the reward. If your investments are not performing, be prepared to change your strategy and seek professional help.