Three property risks beyond your control

Investment risks may give us jitters but they apply to all asset classes. As they say a butterfly fluttering its wings in China may set off a tornado elsewhere, sinking many a carefully-laid profit plan. Some risks are controllable to a lesser or larger degree but some are usually beyond the control of investors.

For example, when buying a property you can mitigate developer issues, legal problems and agreement trouble to a large extent through due diligence. But not all risks can be foreseen and even if it can be, prevented. This is true not just in property investments but in all asset classes. It is therefore important for investors to know some of the perils one may not have control over.

Government policy
Government, at various levels, can be a real wild card as their policies have a big impact on property investments. For example, a road project that would have greatly enhanced connectivity and boosted growth in a locality may be shelved or stalled when there is a change of power. A new project may be taken up and authorities may acquire land and want to demolish other property in an area. Owners may only get rates below the market rate and are forced to sell if they had intended it to hold it for the long term; worse, even these payments end up being stuck for years on end due to delays or litigations.

Policy changes may also play truant with investments. Adding extra layers of clearances in approval process or any ambiguities in a new procedure may lead to projects getting stuck with the local authorities. New objections may be raised on approvals already given, setting back the clock on completion and hand-over. Buyers and builders do not much recourse in these cases.

Macro changes
Events that impact the larger economy – nationally and globally – are another category of risk over which investors have no control. The global financial crisis sapped liquidity and changed central bank policies and economic growth trajectory globally for many years. The slowdown in China has affected commodity-centric economies around the world. In an inter-connected world, where money flows freely to pockets of opportunities and leaves quickly, sentiments shift suddenly.

There are also wars and acts of terrorism that de-stabilize growth plans. Civil wars and political unrest also create ripples that may take a while to settle. Currency fluctuations, global tax low changes such as FATCA and changes for BEPS also impact the performance of various assets.

While some events such as policy shifts may unfold slowly, most events are sudden but lead to large structural shifts that are long lasting. The collapse of the twin tower in the US in 20011 is one example of a black swan event that was hard to foresee and whose impact lingers for many years.

Natural calamity
Similar to man-made disasters, nature may also wreck havoc on carefully laid investment plans. The tsunami that hit Chennai dented buyer’s appetite for coastal properties for a few years. Cyclones such as Katrina that hit New Orleans, USA may shift property buyer interest from one area to another as their priorities change after the calamity.

While floods or likelihood of water shortage can be somewhat assessed, many others are not so easy to predict. For instance, many regions may be categorised as seismic zones with a risk of earthquake occurring; but no quakes may have happened for even a century. And just when we become complacent, nature may show who is in control. Insurance policies can help with a few situations to reduce loss but the financial damage in most catastrophes is to be borne by the buyers.

So, property buyers must be aware of the worst case situations by understanding the many risks that are beyond one’s sphere of control.

Risks in Property Investments

Most people wish they had bought a home sooner or invested in a piece of land. Lately however the charm of property investments is waning due to three main reasons – low returns, illiquidity and completion risks. But the time tested rule in investing is that profits are made by being greedy when others are fearful. Property investors can make handsome gains amidst the current negative sentiments, if they know how to mitigate the risks.

Lowering delivery risks
Poor delivery track record and developer problems are risks that keep buyers from entering the market. In certain geographies such as the National Capital Region, delivery deadlines have been missed by over three years in many projects. Change in project specification, cost escalations and quality issues are other problems buyers had to deal with. These make buying a home, especially one that is under-construction, a risky proposition for many.

That said, the risks can be mitigated with due diligence and rating of developers. You must look at the developer’s credentials for on-time delivery, quality standards and process, customer satisfaction and financial strength to determine the likelihood of on-time delivery to the specifications given. Experts can also help you with the evaluation and rating process so that it is objective and based on data.

Liquidity issues
Property investments, due to large ticket size, uniqueness which makes comparison difficult as well as high transaction costs, are typically illiquid. But when there is good demand in the locality, solid developer credentials that makes the project a sought-after one and reasonable price expectation, illiquidity is no more a worry.

For instance, large plots or high priced homes may take a while to sell, but mid-income homes from a good developer in a well connected locality may not pose such problems at the time of selling. These may have a wider base of buyers and may be sold relatively quickly. The homework you do before a purchase – on the neighbourhood, project features; relative pricing of the property; demand and price growth aided by job growth in the area – would ensure that the property is easily saleable at or above market prices.

Ensuring returns
All these factors also contribute to price appreciation and return on your investment. Take the case of social infrastructure development. Schools, hospitals and shopping areas coming up in a place and connectivity improving over time will create demand for the property and lift prices. Job growth is a key driver of property prices and it helps to keep a watch on which companies are moving into the neighbourhood.

Usually good developers do their homework and perform a thorough analysis of these aspects before launching their project. They ensure that there will be enough demand for their project and price appreciation also happens as the development progresses. They also look at the master city development plan of local authorities and tend to be in the know of where expansions are planned and start a project based on this intelligence. You can look at the developer’s track record of location and project feature choices from their earlier projects to assess their skills and success on these aspects.

For sure, property investment, similar to any other asset class, has its share of risks. But risks are an inherent part of the system and gains can be made by knowing them and finding ways to reducing it through knowledge and expertise. This can enable earning profits over the long-term.

Risk Return

The simple truth in investment is that there is no such thing as a low-risk high-return opportunity. It is a myth and we must be careful when someone comes up with a scheme which offers high returns with no risk. The golden rule is that returns in general are proportional to risk, if the market is efficient. If you invest in a risk-free instrument, such as Government bonds, your return will be around the rate of inflation. The return you get is really just the time value of money.

By opting for high quality AAA rated corporate bond, your returns are higher; but you are taking on the additional risk, albeit minimal, of default by the issuer. And if you choose lower rating bonds such as AA or A rated ones, the returns tend to increase, along with the risks. The key really is to understand the risks, know what is suitable for you as an investor and find the investment that gives the best return for your specific risk appetite.

In the case of equity investments, investors demand higher return than what they expect from debt instruments, as the risks are perceived to be higher. For instance, the price of a stock may be volatile due to local political factors, market fluctuations, global perturbations as well as sector and company specific issues. A successful investor weighs the risks and chooses to enter into a trade only if the estimated returns are acceptable.

This is not to say that the market is very rational at all times. Mis-pricing happens all the time as investors become risk averse – they demand high returns even for a small risk. As a return prices are beaten down. Anyone who picks up the bargain when the mood is negative can earn good returns when the mood turns optimistic. Equity analysts and experts who can identify which risks are real and priced in, which are not real but priced in, can help identify such opportunities.

The same logic applies to investments in real assets such as property. When you buy a completed home, there may be limited risks, as property prices do not tend to fall substantially in the Indian markets. One can earn a rental yield of 2-3 per cent annually. Add capital gains of 4-5 per cent every year, the investor can hope to earn returns inline with inflation.

By investing in an under-construction home, you take on additional risk – of delays, quality and other changes that may happen during the duration of the project. Hence you would expect higher returns. The risks in the investment can be assessed and mitigated by evaluating developers on various parameters such as delivery and quality track record.

Likewise, investing in the pre-launch stage and exiting when the developer launches the project to the wider market can deliver higher returns. The risks may also be high – plan approvals may not be received and the market may not perceive the project as interesting. These risks are in addition to location specific supply-demand dynamic changes, but all of these can be evaluated and priced. In fact, many high net-worth investors (HNIs) evaluate the developer and the project and profit from taking calculated bets.

So, investors have to assess each investment choice with the yard stick of risk and return. You must build your overall investment portfolio with debt, equity and alternate investments, to maximise risk-adjusted returns for a given level of risk. The asset allocation must be adjusted periodically as the market shifts. This is the best way to build long-term wealth.