A risky business

May 05

It is risky starting out as a landlord

- my mum, 1992

It is an understandable sentiment, particularly given that, at the time, we had just seen a major housing crash, and many people had gone into negative equity.

It is also a very, very, true statement, and one I have never lost site of.

Please realise, however, that my mum was NOT telling me not to be a landlord. My entire family have always been very supportive of what ever I have wanted to do. The comment was, however, making sure that I knew that it was not a one way street of easy money for little effort.

There are a few things we can do about risks however, and the most important by far is to understand them, and this means research.

The biggest mistake that I have seen new landlords make in getting started is that the start by going to the estate agents! Again, do not misunderstand me, I have bought the vast majority of my portfolio through estate agents, and have ample evidence that this can be a really profitable way to proceed. However, they are not the place to start.

Property investment / being a landlord is a BUSINESS. Running a succesful business means figuring out what customers actually want, and then looking at how best to provide it to them (in a way that gives a surplus.)

The way you can start figuring out what your customers want is by realising that your TENANTS ARE YOUR CUSTOMERS. The people who know most about what tenants want are the people who spend most time talking to tenants about what they want - that is to say, the letting agents

If I am considering a new purchase, the first visit I make, every time, is to the local letting agent to see what is in demand. When you make this visit, you have to be careful that the agent understands that you are trying to work out what types of properties in which roads, with which features let year in, year out, NOT what they have just had a one-off potential tenant come in and ask for. The ideal rental property is the one where the letting agent will have a drawer full of potential tenants to show round, and when you come in with the keys, she will just start making calls to book appointments. That bypasses the expensive business of booking advertising for your property, and if you can make your property more profitable to the letting agent, that will make them keener to do a good job, and look after you, long-term, as a landlord.

Obviously, you do not just want to talk to a single letting agent, ideally you should talk to at least three BEFORE you start visiting the estate agents.

This means that, once you go into the estate agents office, you know exactly what you are looking for. Estate agents are not your agents as a buyer - they are the paid agents of the VENDOR. Their obligation is to get the best deal for the vendor, not the most profitable investment for you, so there is no point going in and asking questions like "what is your best investment property?"

Instead, you want to be asking questions like "do you have any X-bedroom houses / flats in roads A, B or C?" This is a good way to use estate agents, and make sure that they are working to your agenda, not their own.

So, if local research on current tenant demand is a starting point, what comes next? Local research on what the job market is doing.

At the end of the day, tenants who are earning more pay more rent. It really is that simple. Hence you need to look not just at what local rents are now, but whether there is any risk that lots of tenants might lose their jobs at the same time... which is another way of asking how tied to a single employer the area is.

Everyone in their 30s or older remembers what happened to mining towns, or steel-working towns in the 1980s. No amount of union activism or militancy could change the underlying economics that the same goods were available, overseas, for a fraction of the price, either because there were easier-to-extract reserves of natural resources, or because there were labour forces who were willing to work for a tiny fraction of UK wages, even a tiny fraction of UK minimum wages.

In the 1990s, we saw the same begin to happen with call centres.

In the 2000s, we are beginning to see the same happen to other professional support functions, like IT Departments, or Finance Departments. The good news about these, for the landlord at least, is that while a single company may be a major employer in an area, there are relatively few areas where the IT Department is the major employer. (However, the recent IBM announcement may end up affecting many people in Portsmouth.)

There are also towns where large finance companies dominate the local labour market - one only has to think about Norwich (Norwich Union) or Horsham (Royal and Sun Alliance). These companies may not currently being displacing large numbers of jobs to cheap labour countries, but you can be certain that their Boards are being pressured to cut costs by their owners. (And, after a recent car crash, I can confirm that Norwich Union manage the entire insurance claims process, very politely and efficiently, out of Mumbai.)

The more complex and sophisticated a local economy is, the less impact that a single employer or even industry can have on the labour market. This is why I, personally, am still bullish about the long-term future of London, and would rather invest in metropolitan areas than small towns where a single employer dominates. I have no local knowledge about house prices in Yeovil, but I suspect that they have underperformed the rest of the South West since Screwfix shut down their distribution centre there and set up a new one in the Midlands.

Once you have begun to think about the risks, you can start plotting potential investments on a graph - along one scale is the return - the yield. Along the other scale is some assesment of the likely risk. In traditional investment, this graph, known as an efficient frontier, tends to be a curve that shows all the low-risk investments (Government bonds and so on) having a much lower return than high-risk investments (dot com shares?) In a field like this, you can pretty much choose the level of risk you want to accept, and then take up an investment to match your appetite to risk.

In property investment, however, very few small investors consider the risk profile of an investment in any structured way. As a result of this, risks do not get "bid out", and rather than a curve you get a scatter of investments. It may be that that high-yield property is indeed a low-risk, or medium-risk investment, in which case it is a better buy than a low-yielder. On the other hand, it may be that there are a whole bunch of extra risks to it that mean that, while it has a good-looking yield number, it would not be as straightforward as the more run-of-the-mill, lower yielding mid-terrace house (or whatever is the most demanded property in your area.)

To summarise, you do not need to be overly scientific about risk analysis in property. If, however, you even spend half an hour sitting down with a piece of paper and asking how your potential purchases compare to each other in risk terms as well as yield terms, you will be doing a lot more than most new landlords.

This is just the feature article from the May 05 newsletter. Subscribe for market comment, forthcoming events, and more.

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