Most property investors undertake some form of analysis before they make an investment decision. They "Crunch the numbers" to forecast profit and in some cases they use quite sophisticated models to predict investment returns out some 10 years or so.
This typically would involve estimating the future rental stream, expenses, interest rates, and a resale value of the property. The timing of those future income steams and payments are then adjusted by what known as a discount rate to take account of the time value of money - because money in hand can be invested so net cash flow received sooner rather than later is worth more.
These models are great fun for people who love numbers, and can be developed on the likes of an Excel spreadsheet. Multiple scenarios can be produced based on how optimistically or pessimistically one view the future. I love them - use them myself and have enthusiastically lectured in the subject at University. However, I do have a slight reservation about them - I don't think they actually help a person make better investment decisions!
I had the good fortune recently to chat casually with a someone who is quite possibly New Zealand's most successful property developer and investor, having amassed significant wealth and land holdings over the last 40 years or so.
I am fascinated about the things successful people do that make them more successful than others, so I naturally quizzed him about the way he approaches an investment.
"What rate do you use as a cost of capital factor?"
"We don't use one", he replied.
"How far out do you project your cash flow forecasts?"
"We don't", he replied.
The worst investment decisions he had ever made were the investments he declined because the projections did not meet the minimum investment criteria.
The problem with sophisticated prediction models is the more complex they are, the less reliable they become. While I like playing with financial models, I have come to the view that as far as picking winners is concerned they are about as accurate as picking investments by drawing them out of a hat.
Is anyone able to predict with any degree of accuracy what property will be worth in 10 years time, or what interest rates will do, or how much your local council is going to charge in rates? It does not matter bow many university degrees one has - it's still a guess and nothing more than that.
So how did the successful property developer and investor make investments decisions? Instead of focusing on what we don't know, he turned his attention to what we do know - the past and the present.
His approach was essentially one of identifying and minimising risk.
Let's take an extreme case of a property investment where if things turn ugly the worst case scenario is you could walk away with your capital in tact. In other words, it's a no-risk, can't lose situation. Only a fool would pass up the opportunity and a rational investor would take every no risk investment on offer, knowing they can't lose on the ones that turn bad and the good ones will make money - lots of money in the case of the property developer I was chatting with.
We know the things that can go wrong:
- Property prices may fall.
- Interest rates may rise.
- Your income stream may disappear if the tenant leaves and the property remains vacant.
- There may be unexpected repair costs or major capital costs, or upgrades required to meeting new building standards (eg earthquake standards).
- The property may be damaged wilfully or by a natural event.
- Costs like insurance or rates may rise.
- A developer may get hit with increased building costs during construction.
- Banks may withdraw their funding.
- Government policy changes may impose greater costs and tax, or restrict rental increases, and so on.
All of these factors are easily recognisable and most are manageable to some degree. The skill is knowing how the risk can be minimised but that does not require any university degrees or knowledge about investment modelling - just common sense and an anything-is-possible attitude.
Frank Newman writes a weekly article for Property Plus.