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January 4 - January 12, 2021
Environmental impact
EPC rating
Good risk management can help you survive a property crash and weather an economic storm,
The theory goes that by establishing a good risk management plan, which considers potential risks before they occur, a business can take steps to protect its profitability and safeguard its future.
A reserve fund for repairs
The question we’re left with is how to quantify this risk and how much of a reserve we need.
I simply set aside £2,000 for half of my properties as a reserve fund for repairs. So, if I had five properties in my investment portfolio, I would set aside 5 × £2,000 ÷ 2 = £5,000 to cover any large repair costs. If I had to dip into this reserve fund over the course of the year, I’d try to top it up again straight afterwards from rental profits.
For tenant default risk, you could look for an insurance solution. For example, you could take out a rent guarantee policy which pays the rent when a tenant defaults.
we’re going to assume that the risk of a single tenant defaulting in any given year is 10% or 0.1. This is the average tenant default rate for the private rented sector in the UK based on historical data.
Right, time for some examples.
we need to hold £6,000 in our reserve fund to cover tenant defaults.
Again, the sum of the probabilities over these four outcomes is equal to 1.
Default model – Outcomes and probabilities for two property case Outcome Property 1 Property 2 No. defaults, N Probability 1 ND ND 0 0.9 × 0.9 = 0.81 2 D ND 1 0.1 × 0.9 = 0.09 3 ND D 1 0.9 × 0.1 = 0.09 4 D D 2 0.1 × 0.1 = 0.01 Total 1.00
And the combined probability that we get one of these three outcomes is 0.81 + 0.09 + 0.09 = 0.99. That is, we are 99% certain that we’ll get one of these three outcomes. So, we can be 99% certain that by holding just £6,000, we won’t run out of cash over the year. The above shows us the benefit of diversification.
That is, our reserve fund didn’t need to increase as the size of our portfolio grew from one property to two properties.
Number of properties Cut-off point, N=? Reserve fund 1 1 £6,000 2 1 £6,000 3 2 £12,000 4 2 £12,000 5 2 £12,000 10 4 £24,000 15 5 £30,000 20 6 £36,000 30 7 £42,000 40 9 £54,000 50 10 £60,000
but if the UK was hit by a bad recession, the default rate may rise all across your portfolio at the same time. You could model such an event by using a higher default rate in the model above.
the principal revenue risk is a fall in market rents for one or more of your properties.
e.g. a certain apartment block falls into disrepute or part of a town or city becomes unfashionable. Changes in economic conditions can also impact on market rents more widely.
In scenario testing, we consider the impact of complete scenarios, each with their own narrative. That is, we look at the impact of a specific combination of variables.
In the Great Depression between 1930 and 1933,
the employment rate rose from 9% to 25% prices fell by around 20-25% in just four years interest rates were held low at between 0.5% and 1.4%
The property cycle itself is one of the most misused ideas in property investment.
I’m going to borrow from ideas put forward by the famous distressed-debt investor Howard Marks. In his excellent book, Mastering the Market Cycle, Marks shares his insights on the topic of market cycles. He covers topics like the economic cycle, the credit cycle, and the real estate cycle. He talks about how to position yourself at various points in the cycle and how the best we can really hope for is to tip the odds in our favour,
The cycle itself has four different phases.
The recovery phase
At the beginning of this phase, prices have just fallen in a recent market crash. Prices have in fact fallen to a level where yields are high and the monthly cash flows are strong. This is because prices have fallen much more than rents. For contrarian investors with cash resources to spare, this is a fantastic time to be buying.
The boom phase
House prices start to increase at a much faster pace.
unloved secondary locations will start to see their first price rises.
Yields have fallen, and higher property prices have made deal cash flows less attractive, except perhaps in secondary locations. Savvy investors are struggling to make property deals work. They can’t find value anywhere, so they stop striking deals. They might even sell a property or two to lock-in their gains,
The mania phase At a certain point, logic appears to leave the market and groupthink takes over.
The higher prices go, the more everyone believes they will continue to do so. The vast amount of money pouring into the market keeps prices going up and up.
The crash or slump phase
Confidence evaporates completely, taking the market with it. Property prices start to plummet. Individuals and investors who are over-leveraged go bankrupt. This triggers a wave of repossessions and forced property sales which add to the downward pressure on prices.
some of the deals start to look attractive. If only they could raise the capital to invest. The odd bank agrees to start lending again, albeit their financing terms are tougher. Investors are asked to put in 40% or more of the purchase price themselves, that is a 60% LTV mortgage.
ingredient that other financial cycles don’t share – long lead times.
Developers need to carry out economic feasibility studies. They need to find and purchase a new piece of land or development site. The building has to be designed, planning permissions have to be granted, and financing has to be secured.
Bad times cause the level of building activity to be low and the availability of capital for building to be constrained.
Property cycles can last anywhere between 15 and 25 years from peak to peak or from crash to crash.
the overall trend is generally upwards and in line with inflation.
Building projects started in the boom will be left unfinished, but the odd brave developer might take on one of these projects as a repossession.
Then comes the crash or market slump. No description is needed. Trust me, you’ll know when you’re in a crash.
I’m going to give you my five golden rules of portfolio building. Some of these will sound so obvious you may question their usefulness.
Golden rule # 1 – Only invest in properties that provide cash flow
the best time to be buying from a cash flow perspective is in the recovery phase and at the start of the boom.
Golden rule # 2 – Use the ripple effect to your advantage
Early in the cycle, properties in prime cities and prime locations will likely experience the first bout of capital growth. This growth will start to make properties slightly further out look comparatively cheaper, and so this price growth will start to ripple out.
Another way to use the ripple effect is to invest in areas which are set to receive big investment. This could, for example, mean city centre regeneration projects to revitalise an unloved part of town. It could also mean big infrastructure projects like HS2.
Golden rule # 3 – Manage your leverage carefully
