Volatility risk in investment property | Pete Wargent

When considering getting involved in property investment, few investors consider the concept of risk and return.

While expert investors are able to obtain outstanding returns with a moderate level of risk, for most investors higher returns are usually only attainable by increasing risk exposure.

Beta in the world of equities

Beta or ‘β’ is the measure of the volatility of a security of portfolio.money_house

A Beta of 1 means that the security or portfolio is neither more nor less volatile or risky than the wider market.

A Beta of more than 1 indicates greater volatility so that, for example, a share that is twice as volatile as the stock market index is assigned a Beta of 2.

A Beta of less than 1 indicates less volatility, so a stock which is only half as volatile as the market is assigned a Beta of 0.5.

Beta is an important component of the Capital Asset Pricing Model, which attempts to use volatility and risk to estimate expected returns.

Investment returns: yield and growth

Purchasing a security offers a shareholder returns in two dimensions.shares

Firstly, income in the form of dividends, and secondly, the shareholder hopes that the share price appreciates to attain capital growth.

Property is also a two-dimensional asset for investors: rental income and hopefully capital growth.

Four important rules about Beta

Beta represents risk that cannot be diversified away; it is the systematic risk of being in the market for your portfolio.

There are four very important rules about Beta:

  1. Betas may change over time;gold house
  2. Betas may be different depending on the direction of the market (e.g. greater for down moves in the market as compared to upward movements);
  3. The Beta is not necessarily a complete measure of risk; and
  4. The estimated Beta will be biased if the asset does not frequently trade.

Applying this to property

Remote properties tend to generate higher rental yields than those located in the capital cities.

Generally, this is because capital growth in regional areas has been comparatively low and thus the rent greater as a percentage of purchase price.house contract sign

It’s argued by some that regional properties must be the star performers of the future because they generate higher rental yields (as a percentage, rather than as an absolute figure), and in some areas the capital growth can be outstanding too.

Sometimes this can indeed happen over periods of time.

But think back to what we said about higher returns for average investors (in this case high rental yields and growth too): high returns for average investors are usually only attained by some exposure to risk.

The risk here can be the Beta. There is an old saying in investment: “there’s no such thing as a free lunch.”

The volatility risk in low-demand property

It’s fashionable to talk of property as a low risk asset class as we’ve had periods of high inflation (1970s, 1980s), credit growth (1990s) and yet more capital growth since the turn of the century.

Few of us in Australia know of major losers in the real estate game who have held property for anything approaching a decent time horizon.

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Remember though, that most beginning investors buy one highly-leveraged, liquid asset, which can represent a risk.

The returns of the past do not prove that we’ll never have an extended period of negative returns.

Some investors talk about property only going up or property doubling in value over certain time periods, but history is no guarantee of the future.

We haven’t had a recession in Australia in two decades. What happens when we do? Consider the key rules of Beta as they might apply to property:

  • Betas can change and may be higher on the way down. Hmm, if that plays out then I don’t want to be holding property in a low-demand suburb, regional or city-based!
  • The estimated Beta will be biased if the security does not frequently trade. Wow, this certainly applies to property. Property is an illiquid asset, and while we’ve become used to credit growth in Australia, it’s entirely possible that credit may contract for a prolonged period. If you’re stuck with a depreciating, illiquid asset for which there is low demand, the outcome could be slow and incredibly painful.

Two ways to mitigate risk

Spectacular, fast returns can be found in niche property investments. Small mining towns are a great example. High risk; high return.

riskOver the longer term, there are two ways to mitigate investment risk. One method is to use active management skills to dive in and out of the market, using skillful timing to beat the average return of the imperfect, cyclical market.

In the world of fund management, the excess or abnormal return achieved through active management for the level of risk borne is known as the Alpha (also known as Jensen’s Alpha or the Alpha coefficient).

Can we do that in property?

Yes, but average investors time markets poorly and I question the ability of the overwhelming majority to beat the transaction costs and capital gains taxes to come out significantly ahead.

The other way to mitigate risk is to invest and hold in suburbs where there is a phenomenal, growing demand (either in a capital city or elsewhere). Growth can still be strong in a ‘bull market’.property investment risks

But even if the returns are more moderate on the way up, the compensation may be that you don’t get burned on the way down – as we’ve seen happen in some tourist property markets and particularly in some regional US and UK markets.

We’ll have a recession and a major real estate downturn one day, so we need to consider where we want to own property then.

Remember the story of the tortoise and the hare?

Slow and steady wins the race.

So it is in property.



Want more of this type of information?


Pete Wargent

About

Pete Wargent is a Chartered Accountant, Chartered Secretary and has a Financial Planning Diploma. He’s achieved financial freedom at the age of 33 - as detailed in his book ‘Get a Financial Grip – A Simple Plan for Financial Freedom’. Pete now manages his investment portfolio, travels and works as a consultant in the finance industry from time to time. Visit his blog


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