Investing in Real estate sounds easy to most people, they usually realize the hard way that much knowledge is needed. In order to be successful, you need to have as much knowledge as possible. You cannot control the market, but you sure can understand the moves you make within the market and need to be aware of the risks involved. The risk you are ready to take and most important you must know how to manage your risk exposure.
In order to achieve basic risk management, the key to an investment strategy is diversification. In finance, diversification is the reduction of risk by investing in a variety of different assets. If the assets do not move in perfect synchrony, a diversified portfolio will have less risk than a portfolio of similar assets.
Therefore, any risk-averse investor will diversify to at least some extent, with more risk-averse investors diversifying more than less risk-averse investors.
Unfortunately, the typical property owner ignores almost all notion of diversification when they are investing their savings (or even using finance) into the property market.
The typical first time buyer strives to save every penny available from the family budget so as to get into the property ladder. They may get support from others. They may not contribute to their pension trying to get onto the ladder, sometimes the typical property investor essentially throws everything they have into “property investment”. Lack of knowledge of basic principles of investing in Real estate as well as in any other asset class leads amateur investors into tricky decisions that could cause big losses.
Many people argue that your home is neither an investment nor an asset. Any NPV (Net profit value) investment analysis over a 25 year period for renting vs. owning would show that it is an investment. Therefore, the typical property owner has a very high proportion of their wealth invested in property.
Diversifying your portfolio.
Diversification means spreading your money between different kinds of investments (called ‘asset classes’), different kinds of investment products and different markets (location). This helps reduce the risk of your overall investments, (referred to as your ‘portfolio’), under-performing or losing money.
The key to diversifying – and successful investing in general – is to spread your money across different kinds of investments i.e. asset classes. The main asset classes are set out below – with the first four being the most common.
- Cash: Savings, current account balances, savings bonds, premium bonds, other bank products and any cash you have at home.
Risk: Low – but your money’s buying power is eroded over time if inflation is higher than the interest rates paid.
- Fixed interest securities – also called bonds: Essentially a loan to a company or government for a fixed period.
Risk: Relatively low with predictable returns if held to maturity. However, traded prices can be volatile. Your money’s buying power can still be eroded over time if inflation is higher than the interest rate paid on the bond.
- Shares – also known as ‘equities’: You can hold shares directly in a company or through an investment fund where you pool your money with other people, like with a unit trust, life funds etc.
Risk: Investing in a single company is usually very high risk. Investing in a fund provides more diversification but risk levels will depend on the type of shares in the fund.
- Property: Includes residential or commercial property, buy-to-lets, and investments in property companies, REITS or funds.
Risk: Price can vary and be more volatile than with bonds. Potential for gains but also losses. You may not be able to access your capital quickly if you have invested into property directly. Access to capital may also be restricted through property funds if closed to redemptions meaning, you will not have access until the redemption restriction has been lifted.
- Alternative investments: Includes gold, art, antiques, collectibles, fine wines and other investments that do not fall into the 4 main asset classes.
Risk: profile unpredictable – very much depends on prevailing (niche) market conditions and quality of asset.
Each kind of asset behaves differently. For example, when stock prices fall, the prices of fixed interest securities or property may go up. If you have a mix of investments in your portfolio it will minimize the risk that they’ll all lose value at the same time.
Diversifying within an asset class
There are many opportunities for diversification, even within a single kind of investment. For example, with property, you can spread your investments between:
- Different markets: i.e Your country, Europe and overseas markets.
- Different types and price ranges: Buy to let, Buy to sell, Funds, REITS etc.
- Different sectors: Land, Residential, Commercial, Hotel Investments etc.
When you’re investing in any asset class, there’s no such thing as a sure bet and residential or commercial property is no different. Whilst there’s potential for capital growth, there’s a flipside of a potential stagnation or decline in market value.
You can reduce these risks by implementing a simple strategy — diversifying your property portfolio.
You can do this in three ways.
First, buy properties in a range of locations; that is, different suburbs within a city, and/or different counties or even countries.
Buying all your investment properties in the same suburb or neighborhood means you’re intensifying your exposure to potential changes outside your control.
By diversifying across areas at least within a city, you can minimize the risk of substantial cash outlays and capital stagnation or loss. If one property takes a hammering, the pain won’t be as bad when your other properties are holding their own. (You need to follow up with your overall portfolio performance and not only with isolated investments)
The second diversification strategy involves buying across different price ranges. This will provide more flexibility when the time comes to sell and free up equity.
Let’s say you have $1 million to spend. You can purchase a single asset with the whole amount, or two assets worth, say, $650,000 and $350,000 each. Or even better spread your portfolio between a larger choices of properties, targeting different type of buyers in the future.
If you buy two or more assets, you need only sell one to free up cash, enabling you to keep the others and continue to amass a source of equity and income.
This strategy can also spread your tax burden. If you bought one property worth $1 million and sold it for a profit, you’d be liable for capital gains tax ( CGT , or any other applicable tax) on the whole profit at once.
If you bought two properties and sold them in separate financial years, you could spread your CGT liability over two years, etc.
Because houses are generally more expensive than units or townhouses, etc, diversifying your portfolio across different price ranges means buying across all property styles (if possible).
Having said this, diversifying doesn’t mean compromising on the quality of your investment assets. When it comes to residential property, quality is definitely more important than quantity.
You can’t control changes in the local environment, infrastructure or demographics. But by diversifying your portfolio and choosing good quality properties, you can minimize the risks associated with these factors and come through the worst of storms relatively unscathed.
Investing in different sectors of the market like commercial and residential provides a quite safer option when it comes to investing in real estate. In several cases, while residential property is outperforming, commercial is not doing that well and vice versa. A portfolio including both or more types will balance any possible losses.
In any case the choice of strategy is related with the risk that the investor is willing to take as well as the expectations that one has from his investment. If someone is willing to create a source of monthly income then obviously land investment is not the best choice. It would be a good option if someone is looking for a low risk investment in order to to create wealth in the medium to long term .
All the above different types of real estate and property investment options are subject to market opportunities and investors needs and wills. Diversifying your portfolio is one of the basic things that any wise investor should include in their strategy. The key to a successful investment is knowledge.
Buying real estate is about more than just finding a place to call home. Investing in real estate has become increasingly popular over the last fifty years and has become a common investment vehicle. Although the real estate market has plenty of opportunities for making big gains, buying and owning real estate is a lot more complicated than usually people think. Before investing a penny to any type of real estate or other investment I highly recommend to invest in knowledge .Invest your time to learn the market you want to get involved or involve a professional who has the experience and the knowledge to guide you safely into the amazing world of investments.
Written by Kosta Kioleoglou REValuer ,
Chief Strategist (CSO) for the East African Region
Director of Engineering – Property Appraisal & Valuations
Civil Engineer Msc – DBM
Taylor Scott International