Five warning signs that a property is a bad investment
I am a firm believer that when it comes to property investment there isn’t one single ‘right strategy’ that suits everyone. Choosing a successful strategy should come down to your personality and, to end with the most positive result, the following should be taken into consideration: your attitude to risk, time availability, skill, and financial circumstances at that time.
As time progresses and you hit different life stages, that strategy may well change and that’s ok! There is however some signs that I’ve come across in all my years of investing and learning from other professional and amateur investors that are a red flag that you could be heading down a path of disaster. I’ve listed the top five warning signs below.
- Relying on hotspots
The majority of property investors are investing for the sole purpose of financial gain and so if you can purchase a property in a suburb that is just on the verge of going through a property boom then you are likely to make a substantial profit in a short space of time. Markets can really grow at 20-30%+ per year when there is lots of competition for a scarce resource and so a herd mentality appears.The key is your ability to pick that hotspot and to pick it in advance of it happening. Get it right and yes you may make a fortune, but get it wrong and maybe you’ve bought a lemon that won’t rise for years to come.Many of these areas are far out from our capital cities and the reason they are booming is because a new industry is planned to be set up or even a new transport link, reducing the time it takes to travel to the next hub. However, can you guarantee that this will actually happen?Another danger of having a hotspot strategy is that you’re a victim of short term investing i.e. you concentrate on the return you get for the next 1-3 years and ignore your return over 10 years+. Property is very expensive to get in and out of with 5-6% costs of purchase, 2-3% cost of disposal plus the capital gains tax implications. So trying to get in and out of the peaks and troughs like you would in a stock market is very difficult and is often not as rewarding as buying in a good area that gets consistent growth and holding on forever.If you are going to go for this type of strategy, ask yourself these questions:
- What are the main reasons I am buying in this area?
- What are the growth drivers for this area and how likely are they to eventuate?
- What will be the cost to me if this area doesn’t perform?
- What return to I need to receive in order to outweigh that risk?
Most investors have full time jobs and don’t have the necessary time to put into dedicated research, especially compared to experts that spend their whole lives doing it full time. I suggest buying some reports from www.hotspotting.com.au or www.residex.com.au to confirm your choice before proceeding, its small price to pay for some expert confirmation.
- Rental Guarantees
The fear of many an investor is the thought that they might not get a tenant or that their tenant may not pay the rent on time. So when brand new properties for sale offer a guaranteed rent for up to three years they think all their prayers have been answered. But have they?The principle of a rental guarantee is a good idea as it limits your risk of entering repayment difficulties or having your property re-possessed, however, with most things in life, sometimes a guarantee isn’t all that it should be and this is how it can all go wrong.If you expect to get a 5% return on your property and the rent return is $500/wk, many investors would be prepared to pay $500k for a property. If a property seller artificially inflated that rent to $550/wk and offered to guarantee it for 2 years, some unsuspecting investors may well pay $550k for the property – overpaying $50k.The seller may then need to cash flow the extra $50/wk rent ($550k inflated rent less $500 normal rent) x 2 years = $5,200The seller makes an extra $44,800 ($550k - $500k - $5,200) and the buyer has a guaranteed rent but has overpaid by $44,800.
What can make it even worse is that the guarantee is from a $2 company that is then collapsed once all the properties have been sold.
Please note – I am not saying that all rental guarantees are a sign that you are getting ripped off, just that you need to be aware. If you pay a fair price for a property and get a rental guarantee then treat it as a bonus. Rental guarantees should never be the primary reason for investing, the underlying property and its location is the most important.
If you buy a property that ticks all the boxes in a great location you rarely need a rental guarantee as there should be plenty of demand from tenants and not many properties around for them to choose from.
- One industry towns
Location is one of the most important factors that will dictate how your property investments perform. As property is typically a long term investment due to the high purchase and selling costs, you need to consider how that location is likely to perform in both the short and long term and the risk factors that may cause it to change.If you choose a property that is reliant on one main industry (e.g. mining, tourism, government, manufacturing) then it is likely to carry more risk than an area that has multiple industries supporting it.If you buy into an area that has limited industries and you work or have an expertise in that industry you could use it to your advantage compared to other investors that don’t have that intimate knowledge. However there is still a risk that things won’t go as expected.My suggestion is that if you are a passive investor that doesn’t have an expertise in a specific industry that you’re investing near, you’re probably better off investing closer to a capital city where there are multiple industries and there’s less chance of you being subject to a sudden change in the economy.
If you do have knowledge of an area or industry where you can take advantage compared to the average investor then yes make the most of it but I would still suggest that you perhaps only allocate a proportion of your funds into that area and balance it with some less speculative locations.
With a changing world, none of us know what’s around the corner and so it’s definitely not a time to have all your eggs in one speculative basket.
- Sold predominantly to investors
No matter whether you are buying second hand or new properties, there are buildings or areas that typically have owner occupiers, investors or a mixture of the two in them. So what’s best?Owner occupiers
- generally look after the buildings and areas as they care about where they live
- are less likely to suddenly sell in a down turn as they still need a roof over their heads – this protects your properties value
- don’t always have the funds to look after the buildings as they are concentrating on paying off their mortgage – many buildings can fall into disrepair where there are old age pensioners who cannot afford to fix damages
- when tough times hit, investment properties are nearly always sold before selling their private residences and often they need to sell quickly. If you’re part of a large complex and someone undersells or under rents a property, then virtually all other properties get de-valued in that area as buyers, renters and valuers will often look at the last transaction as confirmation of what something is worth
- a lot of investors can be highly geared as well and may not reinvest into a block that is starting to come into disrepair as they don’t physically see it every day and don’t have any emotion about keeping it up to its best potential (this isn’t always the case though as some investors target these properties and are very keen to render, add balconies or additional levels)
Again, there’s no wrong or right here and it’s very much on a case by case basis depending on the property and location. I do invest whether there are a lot of other investors because the properties are by the beach in the inner city. However all the blocks are very small (
- Large gap between the price of an equivalent second hand propertyIf your property investing strategy targets brand new properties then sometimes it can be hard for you or even valuers to calculate what a property is worth. Just because 100 other properties have been sold in the building doesn’t mean properties are worth that amount, they could have all been completely unsophisticated amateur investors that just assumed they were buying well.One way to see if you’re paying too much is to see what a renovated second hand property is selling for in the neighbourhood and then see how much of a premium you are paying for brand new.
I looked at an example for a client in the past where a 2 bedroom unit in a very large block with high strata fees was costing around $700k. For the same money you could buy a three bedroom house with a reasonable sized garden just round the corner. Now whilst some may still like the brand new property for the depreciation benefits, the larger house was perhaps more suited to the local demographic of buyers and renters and offered more value.
I think they key for most investors is to go out and at least do something as sitting on the fence will get you know where. It’s impossible to have 100% knowledge on the market and the various strategies available so at some point you’ve got to jump in. We all make mistakes and it’s easy to analyse decisions with hindsight but the reality is if you do a reasonable amount of homework, you can work around any issues that come up.