Risk Management and Property Investing
As you should understand, any investment which gives a rate of return in excess of the risk-free rate (i.e. a savings account), is inherently risky, by definition. This obviously applies to property investing too.
Put simply, the higher the return, then the higher the risk. There is no such thing as a fail-safe, high-return investment. If there was, then this would soon default to the new, risk-free rate of return.
So, given property will provide returns far in excess of a savings account, we are, by definition, taking on risk.
Risk management should be an integral part of your Property Investment Blueprint. In order to effectively risk manage, we need to understand:
- What the risks are.
- The likelihood of those risks occurring.
- The impact of the risk (likely either financial or reputational and sometimes a combination of both).
- What risk mitigation we can put in place.
Note: Not all risks are created equal!
Some will have a high impact. Some will have a high probability. We need to ensure we are focused on those with both a high impact AND a high probability of occurring.
We also need to understand that some risks are correlated. That is, the chances of certain risks becoming reality at the same time. This can multiply your risk exposure.
There are risks that impact a particular property deal or project (e.g. cost overruns). There are risks that impact all property investment, so-called macro-effects (e.g. legislature or tax changes).
Remember, you are running a business and all good businesses consider their risk management strategy.
With this in mind, this article details how you should manage the risks you will face when when executing your Property Investment Blueprint, using an approach I used to use in my days as a Project Manager in the City.
The standard way of managing risk is to compile a RAID Log. RAID stands for:
- Risks, together with their impact and probability of occurring and the associated mitigation.
- Assumptions. What are you assuming about the property project or the macro environment in your Property Investment Blueprint?
- Issues. These are risks that have actually occurred and are now issues to be dealt with.
- Dependencies. What is your property project, portfolio or Investment Blueprint dependent on? For example, a conversion project will be dependent on the builder delivering on time and on budget.
Let’s consider each in turn.
What risks do you face as a property investor? Here are some common ones to set you thinking:
- What if the bank base rate increases to it’s closer long-term average of 5%?
- What if rental demand drops? This could mean accepting lower rents and / or longer voids.
- What if lending becomes restricted and LTV reduces?
- What if you get a bad tenant, resulting in considerable rent arrears and a property requiring refurbishment?
The risks pertinent to your Property Investment Blueprint will be relevant to your strategy. E.g. if you plan on adding an HMO into your portfolio, another risk might be how will your cash flow and profit look if the local VOA decides to re-band each bedroom as Band A council tax? This is occurring in many areas of the UK.
Next, you need to determine the impact of that risk becoming an issue. This means your hypothetical risk becoming an actual reality, together with the probability of that occurring over your investment or the time frame of the risk itself (if such risks only exist for the duration of a particular project. An example would be a builder walking off the project mid-development. Once the development is complete, clearly this risk no longer exists).
Consider both financial impact (what will it mean for your profit and cash flow) and reputational impact (if a risk was to cause an issue to a private investor helping to finance your project, for example).
Then determine the probability of this happening. That is, how likely is it? Base rate rises over the medium to long term seem relatively inevitable. Getting a bad tenant (assuming your tenant selection process is robust) is less likely.
For both impact and probability of occurrence, simply rank as High, Medium and Low. You will have your own definition of each for the financial impact. A loss of £5k might be catastrophic to some and of little consequence to others (even if somewhat frustrating).
Now you can construct your own Risk Management Matrix by multiplying the Impact Assessment by the Probability Assessment, using the following values:
Clearly, those risks that have a Risk Level of Red are a priority to mitigate. Those with a Risk Level of Amber need close attention. Those with a Risk Level of Green are of the lowest priority.
You will need clear mitigation strategies for those Risk Level’s that are determined to be Red. If you cannot adequately mitigate the risk, you should consider if the particular deal or strategy is for you, since such a risk becoming an issue could wipe you out financially or reputationally.
Note I am using the phrase “risk mitigation”. You cannot necessarily eliminate risks. Remember, in seeking a return over and above the risk free rate, you are accepting risk necessarily. Your job, as an investor, is to mitigate the impact of the risk to a point it is palatable.
Russian Roulette Risk
You will all have heard of this. Take a gun, with six chambers. Put a bullet in a chamber and spin it randomly. Put the gun to your head and pull the trigger.
Would you play this game if I offered you £10k? £100k? A million quid?
I am guessing the answer is no! But why not? You have a greater than 80% chance of winning, right?
Of course, if you get it wrong, you are dead. Which is precisely why you shouldn’t play this game for any amount of money, as the downside is rather terminal and you can’t recover from it.
Always pay attention to the Russian Roulette options in any property deal. If there is a scenario that could occur that could wipe you out financially and you cannot mitigate this sufficiently, then simply don’t do the deal. There will be others.
The next section in your RAID log. What assumptions is a given deal or strategy reliant on? An assumption is something that you assume will be in place to help the project succeed, but can’t be guaranteed. If the assumption proves to be false, there will be an impact on the project. Such assumptions should be consistently reviewed and adjusted over time.
For example, you might be assuming that:
- In a Buy to Sell project, you can sell the property or all units within 6 months of completion.
- In a Buy to Hold strategy, you can achieve a rental within 2 months of completion.
Note that some assumptions could be risks and should be accounted for as such. To take the first example above, there is a risk that it takes longer than 6 months to sell the property. What does that mean for your cash flow? How can you mitigate that?
Issues are simply risks that have occurred. At this point, you must be actively managing and dealing with the risk to minimise its impact on your property project or strategy, with the goal of removing or containing the risk. This is where your project management should focus and should be based on the mitigation strategies outlined in the Risk section above.
Dependencies are actions that need to be undertaken or completed in order for you to succeed. This may be internal or external events, suppliers or partners.
For example, you might be reliant on:
- The builder completing a refurbishment on time and on budget.
- Planning approval being obtained.
- Materials being onsite at a given time.
It is your role, as the CEO of your business and Property Investment Blueprint, to monitor and manage your dependencies.
Risk management is a fundamental part of any Project Managers arsenal. Since you are the Project Manager of your own Property Investment Blueprint, then you should be managing your own risks inherent in your approach. You should now be able to review your own blueprint and build your own RAID log, determining:
- What risks are inherent in your plan, what the impact would be if they materialised and what mitigation actions you can take.
- What assumptions you have made for the plan to work.
- What issues arise during the lifecycle of your plan.
- What dependencies you are reliant upon.
Note: This should be an integral part of your Property Investment Blueprint.
For an example of a Risk Management plan in real-life action, see this article on the potential impact on a landlords cashflow during the coronavirus pandemic.