RISK AND INVESTORS DUE DILIGENCE
 

Investors should take the higheset level of care to become fully conversant with all the pros and cons associated with any investment. As such, we have prepared some key points that all Investors should consider before they invest in the NZ and/or US property markets.

NOTICE TO ALL PROSPECTIVE INVESTORS

Nothing on this website constitutes legal, tax, or financial advice. Prospective Investors should seek their own professional advice on the consequences of investing. No representation is made that any further information will be given, other than is required by law.
Furthermore, the information contained on this website is not comprehensive and is selective. This website does not contain all the information that a prospective Investor may require to evaluate a decision to invest and the risks associated with that investment. In making a decision to invest, prospective Investors must rely on their own examination of the information contained on this website, as well as all other information as they may consider relevant.

Property investment risks in general

There are a variety of different risks that can affect the future capital value of and/or the income from property(s). Before deciding to invest, prospective Investors should consider carefully the risks set out below in conjunction with the other sections of this website. These risks do not take into account the personal circumstances, financial position, investment requirements or experience of any Investor in particular. Furthermore, the following examples are not exhaustive:

Loss of capital value:
Investors should consider a number of different scenarios that would reduce the capital value of their investment and potentially create cash-flow difficulties for them.

A fire sale: Investors should expect to lose money if they find themselves needing to sell property(s) quickly. If they are reliant on the income from their property(s) to meet mortgage payments and/or other costs, then they should take particular note of some of the risks detailed below under the heading ‘Risks to Net Income’. Furthermore, Investors are advised to adopt the widely-held view that property investment is a long-term investment and not a short-term ‘get rich quick’ scheme.

Change in local economic conditions: For example, if a major business in the area closes, resulting in many of the locals being unemployed, then property would almost certainly fall in value.

Change in rental income: For example, if a neighbourhood slowly deteriorates over time, resulting in lower rentals being paid, the capital value may also decrease – see Location Assurance in the Definitions section above, as an option for Investors to mitigate this risk.

Over-supply of properties for sale: For example, unexpected changes to tax laws or interest rates can cause many properties to be listed for sale at the same time. A flood of property onto the market under these circumstances would almost certainly drive all prices down.

No preventative maintenance: If the property is not sensibly and regularly maintained, for example, not repainting the exterior resulting in split and rotten cladding and damage to the structure, then ultimately the loss in capital value will far exceed the money saved in deferred maintenance.

Excessive Leverage: Investors should note that whilst high LTV (loan to value) borrowing can produce attractive ROI’s, it can also result in the loss of all their cash (equity). For example, if an Investor borrows 90% of the value of the property and the capital value of their investment falls by 10%, and they sell the property at this time, then the Investor will lose all their cash/equity.

Risks to Net Income (cash flow)
Investors should look seriously at any circumstances that can reduce the Net Income they are expecting to receive from their investment, especially if the circumstances might force them to sell quickly. For example:

Interest Rates: Rising interest rates can put pressure on cash flow, particularly if the property is too heavily geared and the rental income no longer pays principal and interest payments to the bank. In these situations, Investors may need to top up the monthly income or quickly sell the property to meet expenses, and could easily lose a substantial portion of their investment capital.

Vacancies: Industry standards suggest an average allowance of 8% for vacancies (1 month each year), but Investors should note these figures are only market averages, therefore in the same way one tenant can stay for 5 years, a property can also be empty for 3 months or more waiting for the right tenant. A prudent Investor should prepare for either event. There are also indirect costs associated with vacancy, such as maintaining power/water/gas, re-letting fees payable to property managers, advertising for a new tenant, etc.

Property Managers: If applicable, Investors should do background checks on any proposed property managers, as they can affect the value of an investment by the way they select tenants, manage maintenance, vacancies, etc. Certainly Investors should note that bad property management can directly affect Net Income, and in turn the value of their investment.

Bad tenants or debts: despite good screening processes, it is still possible to get a bad tenant or one that cannot pay because their circumstances have changed. This situation can result in the loss of income for a few months, and Investors should have a contingency plan for this event (for example, owning multiple properties - like a Premium Investor Portfolio - dilutes the effect of one bad debt).

Maintenance: Costs for small repairs and larger expenses such as a roof or air-conditioning need to be allowed for, and Investors are advised to create a sinking fund to meet such expenses as and when they occur.

Expense increases: Rates or insurance costs could increase. As these increases cannot always be passed on to the tenant, Investors should prepare for this possibility.
Rents go down: some neighbourhoods deteriorate over time, resulting in rent decreases making it difficult to meet expenses, particularly if the property is too heavily geared. To provide some protection against this possibility, Investors’ attention is directed to details under Location Assurance in the Definitions section above.

Natural disasters: Whilst insurance can repair damage from natural disasters, there can still be quite an interruption to cash flow while repairs are undertaken, and a reduction in capital value in the area. Investors should always plan for this possibility and also consider the possible benefits of income protection insurance. 

Risks Unique to the US market

It is important that Investors understand the source of demand that currently underpins much of the value in the US property market at this time, and how changes in that demand could directly affect the value of their investment.

Property Demand: Unlike New Zealand, US property sales at this time are nearly totally driven by demand from Investors, rather than the normal mix of Investors and home owners. This is firstly because the US is still dealing with around 2 million foreclosures (mortgagee sales) each year, and secondly the banks are keeping a tight rein on credit for new mortgages and offering virtually no credit to mortgage defaulters. This in turn is fuelling demand for rental property, as 2 million families a year are forced out of their homes but still need a roof over their heads.
Whilst this is good for property investment in the short term as rental demand is strong, Investors should be very clear that this is an unusual situation, and over time the backlog of mortgagee sales will be cleared and the banks are expected to resume normal lending.
As this situation corrects itself, Investors should consider the possibility that the capital value of their property may rise on a sales basis because it becomes more attractive (or possible) to own again, but their Net Income(s) may fall as renting becomes a less popular option.

Exchange rate: In assessing the exchange rate risks of an overseas investment, the following two situations should be carefully considered:

i) If the New Zealand dollar strengthens against the US dollar, then the Investor will realise a loss when and if they bring the original capital investment back to New Zealand.

ii) Investors who wish to borrow and buy US property should borrow from US loan facilities, so that a shift in exchange rate does not impact on debt servicing costs. Conversely, if an Investor borrows from a New Zealand bank to buy US property, they should carefully assess risk and the cost of servicing debt for each point movement in the exchange rate.