What are the risks?

The fixed location of a property is one of the key factors affecting its value.

It's often argued that location is the first choice to be made when looking for a successful property investment. However, this decision should take into account future prospects as well as current attractiveness.

Over the life of a property the attractiveness of its location is likely to change through factors such as the development of the surrounding area, or the nature of local business activity. Since location cannot be changed, a large part of the value of the property is tied to the fortunes of the location.

Location is, therefore, crucial to managing risk, although it can be hard to evaluate up front for the entire life of the property investment. Where the whole of an investment is tied up in a single location, the risk of that investment is concentrated, and is, therefore, higher than would be the case for a diversified portfolio (that is, where investments are located in a number of different places). 

Expert knowledge of an area and large-scale investments in varying locations can mitigate against this risk, but such strategies are likely to be out of reach for the average retail investor.

Tenants represent the source of income for property owners and investors, so minimising voids, where no rental income is receivable is a key objective.

Residential leases are typically only a year in length, and property values are actually maximised when the property is empty, because rental yields do not reflect full value of the property unlike commercial. There is a premium (reversionary value)  to selling a property empty above one with a tenant.

In contrast, commercial property values are highly dependent on the income stream from tenants. However, tenants' credit worthiness and their likelihood of defaulting on a lease vary significantly, and both factors represent a risk that can affect the value of the property they occupy. Investors and owners, therefore, need to pay as much attention to the quality of their tenants as they do to securing a rental cash flow.

The length of a tenant's lease will also affect the value of the income flow associated with a property. The longer the lease, the more assured it is; therefore, the more valuable the income stream is. However, in practice, many commercial leases have periodic break clauses to allow either party to give notice, and it is usual to assume that these will be exercised by one party when assessing the future value of a lease.

Related questions

See also questions relating to the factors that drive the performance of commercial property

There are a number of risks associated with illiquidity that must be managed by owners and understood by investors. Property is essentially an illiquid asset that can't easily be converted into cash. For investors with long-term objectives, this shouldn't be a problem, as there should be sufficient time to arrange the sale of a property. Meantime, the rental income often provides enough revenue to pay the costs of ownership and provide a return on the investment.

However, the real world is more complicated, and there are a number of risks associated with illiquidity that must be managed by owners and understood by investors.

A major risk would be a need to raise cash through the quick sale of property because of a change in investors' needs or objectives. The likelihood of achieving the best price for a property through a rushed (or forced) sale is significantly less than it would be if there was time to find the right buyer at the right price.

For managers of open-ended funds, a sudden and large-scale demand for fund withdrawals can put such a pressure on investments. In these circumstances, short-term cash management is paramount (and is significantly more difficult than for managers of publicly quoted vehicles, where sale and purchase of shares takes place in the stock market rather than through the vehicle). 

Residential investments do not typically yield enough rental income to produce a real return after taking the cost of debt service into account. Generating adequate returns may require the sale of property, ideally with vacant possession, so that the very large owner-occupier market can be accessed as well as the independent market.

Residential and commercial property owners use debt (gearing) to acquire their investments, and these require cash flow to service the debt, and cash to repay the debt.

Property is a cyclical asset, meaning its value goes up and down, and the returns it produces increase and decrease over time, and these variations roughly follow a regular pattern. It has been estimated that property follows a 9 or 10-year pattern, though clearly this is determined by a wide variety of factors in the wider economy, as well as by specific supply and demand issues.

These cycles are, however, very difficult to predict over the short term; as with other asset classes, trying to correctly time when to enter or exit property is neither an exact science nor recommended for risk-averse investors. Property should, primarily, be thought of as a long-term investment, intended to generate a steady income and with some long-term capital growth.

Indirect investment vehicles that own and manage property are exposed to all the same risks as direct investment - that is, all the risks such as location and illiquidity that are associated with this asset class. But they mitigate these risks by:

• Transferring responsibility for managing that risk from you, as the owner of the property, to the professional manager of the vehicle. In theory, this should reduce the risk and help to improve returns
• Spreading the risk across a larger number of properties than could be purchased for the same investment, as an individual investor. These properties may also represent a broader range of property sectors or territories
• Increasing liquidity, as the shares or units should be quicker and cheaper to buy and sell than the underlying property, either on stock markets in the case of publicly traded shares, or to the fund manager, in the case of open-ended vehicles

However, indirect investment vehicles also encounter additional risks that investors should consider, including:

• The transfer of management responsibility does not guarantee good performance, particularly under difficult market conditions. Although in most cases liquidity will be improved, there may also be liquidity issues relating to the investment vehicle itself. For example, fund managers may impose restrictions on redemptions to protect the overall position of the fund, or there may be no market for shares in private companies
• Short-term volatility may be an additional risk to be considered, particularly for publicly traded shares where valuations are continuously revised and particularly affected by market sentiment. However, volatility is as much a function of the frequency of measurement as actual variations in value under normal market conditions  
• Investing through a vehicle may also introduce issues of tax efficiency, which investors must consider.

Related questions

See questions on management risk
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