Mitigating Risk

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Strategy in real estate investment is a matter of mitigating risk and maximizing return. There are plenty of ways your investment can go sideways if your portfolio lacks in proactive strategy.

  • property damage
  • environmental risks
  • management risks
  • market volatility
  • macroeconomic trends
  • political instability

Property damage risks include flood, fire, vandalism, mechanical and electrical failures, building envelope issues, etc. Having a sound property insurance policy will mitigate against most such costs. But many property risks can be avoided proactively. When conducting due diligence on a new acquisition, a thorough Building Condition Assessment (BCA) will reveal issues with roofing, building envelope, mechanical systems and other basic infrastructure. Any anticipated costs to address such issues should be factored into the purchase negotiations. When operating the building, damages can be avoided through diligent property management. By monitoring the building systems closely, small problems can be detected before they lead to bigger issues.

Environmental risks refer to changes in the surrounding area that can impact your property. An oil spill at a nearby gas station could contaminate your land. Climate volatility can lead to record flood levels and more frequent flooding. Increasing crime in a neighbourhood can lead to higher vacancy. A large development project, changes in local infrastructure, or updates to local zoning bylaws could transform your neighbourhood, for better or worse. And then there are of course outlier risks such as terrorism and nuclear meltdowns.

Some of these risks are insurable. Others can be outside of our control. Therefore it is critical to consider environmental risks before completing a purchase. An Environmental Site Assessment (ESA) will reveal risks to your land such as soil contamination and issues with the water table. With a bit of homework, you can understand trends in local demographics, employment, crime, etc. And if you’re well connected in your city and neighbourhood, you can gain a decent perspective on where the city is going in terms of zoning and infrastructure. This all comes down to knowing your region and choosing your properties carefully.

Management risks are one of the biggest variables in property performance. Finding and keeping quality tenants requires competent management. If you choose tenants poorly, your property value will be affected. If you are not taking care of your tenants, they may not be inclined to stay. If you are not taking care of your buildings, they will deteriorate. If you are not rigorous in managing spending, your expenses will rise and your property value will decrease with your Net Operating Income. These are all highly variable factors that depend entirely on diligent, consistent, and systematic management.

Market volatility is a factor that cannot be controlled directly. But we can design our portfolio to weather these storms. The most important market factors are rental rates and vacancy rates. When choosing our acquisition targets, we have to consider how much tolerance we may need in case rents go down and vacancy goes up.

This comes down to cashflow and leverage. First, we look for buildings with strong NOI. Then, we use mortgage financing carefully. Higher leverage means less capital is required up front to do the deal, which generally equates to a higher return per dollar invested (% ROI) . But higher leverage also means higher debt servicing, which means less cashflow.

Ultimately, the key principal is that the revenues generated by the property should carry the operational costs and debt-servicing. After the costs are covered, there should still remain an additional cashflow buffer to absorb increases in costs or decreases in revenue. Applied across your entire asset base, this buffer will make your portfolio resilient to volatility in the market. And if the market is doing well, the cashflow buffer translates into dividends, cash in your pocket at the end of the year.

Macroeconomic trends include booms and busts in China, conflict in the Middle East, failed banks in Europe and the US, aging baby boomers, game-changing technologies, a butterfly flaps its wings in Crimea and the next thing you know Brazilian reales go into hyperinflation.

It’s complicated. But there are several  fundamental indicators that can offer some perspective. On the most fundamental level, property values are a function of demand. Housing demand is determined fundamentally by population and employment. If there is labour demand in a region, wages go up. If wages go up, people tend to move to that region. If the regional population increases, especially if people are gainfully employed, housing demand goes up, vacancy rates drop, and property values rise. It gets quite a bit less predictable in markets like Vancouver and Toronto that can be inflated by factors like foreign investment. But it basically comes down to jobs. Prices may fluctuate, but if people can afford to buy or rent, property values will tend to follow the fundamental baseline over the long term.

Ultimately you have to place your bets to the best of your knowledge. Before you can even start shopping for acquisitions, you’ll need to decide where you want to buy. Real estate assets are not liquid, so a solid grasp of the regional economic fundamentals is essential in choosing the region(s) you want to target.

Political instability is not generally a major factor in Canada. Fortunately, these days we don’t have to be too concerned about nomadic bands of marauding mongols. But factors like government power shifts, changes in policy and taxation, and trade negotiations do affect local economies. In other parts of the world, entire markets can be overturned by political upheaval. Generally, you’ll sleep a lot better at night if you own property in countries with clear property ownership laws and where the authorities don’t expect to be paid in bribes.

There is always risk. But in real estate the risks are well-mapped and the means to minimize risk exposure are tried and true. We can drastically improve the odds of a successful project by doing some homework, selecting our investment regions carefully, choosing properties on the basis of strict cashflow criteria, using financial leverage conservatively, applying adequate insurance coverage, and managing our properties with diligence.

 

NEXT ARTICLE 〉 Cashflow & Leverage – Engineering your portfolio to weather the booms and busts.