The term “property investment risk” will likely have some investors trembling and looking for the safest investment. In reality, there is risk in any type of investment, the greater the risk the greater the potential return. On the flipside of the coin, the lower the risk the lower the potential return. So, how do you manage property investment risk in your portfolio?
Linking stages of property development/Managing property investment risk
Remember, the greater the potential risk the greater the potential reward. So, if you are looking at a property development on paper which has yet to begin, there are many potential stages to consider.
Finding a site and obtaining planning permission
Starting with just the design of a property development on paper, this stage offers the greatest degree of risk. The initial risks include:
• Finding and purchasing a suitable site
• Obtaining planning permission
In reality, an investment in a property development at this stage could lead to a significant return or turn out to be a complete waste of money. Therefore, choosing who and what developments you follow is the key!
Funding a development
Once you have purchased a suitable site and obtained planning permission, the cost of which can vary enormously, the next stage is to fund the development. At this point the value of the development is an accumulation of the land/property purchased and the perceived value of planning permission (which will vary).
The key to obtaining development funding is straight forward, show the enhancement compared to the estimated end value of the development. In simple terms, the estimated value of the development on completion must be significantly greater than the cost of land, expenses and development funding. Some issues to take into consideration include:
• Development funding can be relatively short term
• The loan to value ratio tends to be around 75% of any security
• There must be significant headroom between the cost of the development and the estimated end value
• Funds will only be released in tranches when conditions have been met
The development funding stage tends to be popular with investors who are willing to take a degree of risk. Some of the risks which tend to arise include:
• Delays in completion which increase finance costs
• Cash flow can be a major problem
• Issues with third parties building the development
• Softening of the local property market which might impact the estimated completed value
• Unforeseen circumstances and additional funding requirements
The development stages can be very difficult to navigate because you need to keep financial costs to minimum while also budgeting for the unexpected. In the event that the project is unfinished this will significantly reduce the perceived value and may indeed induce a fire sale at a rock bottom price. In some cases this can lead to total loss of investment to date, once all liabilities have been covered.
Once a development has been completed then there is the opportunity to refinance on the higher value, pay off the outstanding development funding and pocket the balance as profit. In many ways this is the low-risk end of the equation but there are still issues to consider such as:
• Has the cost of finance changed?
• Is there still demand for this type of development?
• Are potential rental rates in line with earlier assumptions?
• What is the potential for capital growth?
The truth is that any investment carries a degree of risk; otherwise there would be no return. Investing in a completed development still offers a degree of risk in the longer term but nowhere near the risk of investing at the planning stage.
It is therefore possible to introduce an array of different property investments at different positions of the risk scale. The skill is to balance the overall risk of your property investments. So that you can maximise your returns and ensure that one failure would not bring your portfolio crashing down.