Posted: Tuesday 23rd October 2018
The world of property investment is a lucrative and tempting one to many. Businesses and independent investors are increasingly turning an eye to this large pool of opportunities with the aim of maximizing profit and securing a wealthy and comfortable future. Although generating profit is one of the attractive sides to property investment it is not the only reason why people enter the field. The process of investing goes hand in hand with a number of interesting and intellectually challenging practices and policies, which stimulate an interesting learning process while making money.
Property investing is among the top choices for investors in the UK. Research carried out by Experience Invest shows that 31% of respondents would choose to invest in property over other forms of investments such as gold shares, stocks, and shares, start-up businesses or others.
So property investment is a good idea, great. But how do we examine if an investment that we are interested in will actually be profitable for us or for our business?
For the experienced investor, the financial associations with property investment will probably be a no-brainer as experience would either have educated the investor to calculate whether a future project is worth it or a professional property consultant would have already been hired for the task. However, for beginners, it may be worth the time to get a basic understanding a few important areas that help investors define the level of profitability of an investment.
In a previous blog post article, we already looked into Return on Investment, one of the major factors indicating an investment’s lucrativeness. It is now time to dwell into a new area of property investment – risk appetite.
In basic terms, risk appetite is used by organisations or companies for risk management in investing practices. Risk appetite is simply explained as the type and amount of risk an organisation is willing to take. Of course, for the professional, this explanation is nowhere close to substantial and in order to fully understand risk appetite a detailed research into risk management is required. However, to broadly explain the term and show how it can be used we will provide a more general outlook.
The definition of risk management is “the amount and type of risk that an organisation is prepared to pursue, retain, or take”, according to the ISO 31000 standard, which provides a “structured framework of international best practices for managing risks and opportunities”.
In order to be useful for organisations, risk appetite cannot be looked at in isolation. The most difficult task associated with risk appetite is executing it to a business in such a way that makes it applicable to all parts of the business. Risk appetite should be synchronized with the short- and long-term strategic outlook of a business and the organisational decisions taken on a daily basis.
In order to work, risk appetite also required the right metrics to provide insights and measures that will help organisations make a decision regarding a potential investment.
Not quite. There is a clear distinction between risk appetite and risk tolerance. The Chartered Institute of Internal Auditors provides valuable information on the differences. However, it confirms that both risk appetite and risk tolerance are used to put limits on the amount of risk an organisation is prepared to take. The main difference between the two terms is the level of detail provided in the final statement.
Risk tolerance tells the story of how much risk an organisation could take in reality from a financial point of view.
For example, a risk appetite statement by a business would state that the entity is not willing to undertake risks that could negatively influence its revenue performance. Therefore the risk appetite for the project would be low. However, if the same statement were to be translated into risk tolerance, the business would need to explain in more detail the logic behind avoiding the risk. An example would be stating that the organisation will not pursue risks leading to a 20% reduction of revenue from its existing 300 client base.
Risk tolerance can, in reality, be used by management to ensure that the business’ operations and future projects lead to results, which remain within the risk appetite of the organisation.
Before looking into setting risk appetite it’s important to mention that no business of independent investor can perform successfully without ever taking risks. Risks are a part of our daily lives and the only way to cope is to make a rational evaluation of whether they are worth it, considering our long-term objectives.
By setting a risk appetite, the organisation can have exact parameters to look to when in doubt regarding risks. The dominant reasons behind setting a risk appetite for your organisation include laying out specific strategic plans and acting upon them, managing projects successfully, or simply being asked to set one by external audits or specific practice requirements.
Furthermore, setting a risk appetite in a statement with free access to individuals or parties involved in your business can help everyone work in the same direction, under the same parameters, unifying the business operations and ensuring everyone is on the same page to avoid mistakes or poorly made decision.
Let’s look into the process itself!
It is also important to note that key decision-making individuals in the organisation should all be included in this process as risk appetite conversations usually result in interesting ideas and conclusions that could improve everyday business operations.
Although it is advisable to create a single statement in some cases this may not be possible due to the diversity of people involved and the different opinions that may arise as well as different appetites for different risks.
A useful idea for creating your risk appetite statement is to segment down the different risk areas and carry out an analysis for each one individually. The areas to be considered include what the acceptable and unacceptable risks are, the level of risk your organisation is willing to take in general, the facts behind that decision, possible ways of monitoring or examining the decision to keep it synchronized with other goals, or how new risks that arise can be added or how a previous risk can be changed within the statement.
The risk appetite statement should be communicated to the rest of the business in order to keep everyone aligned with the conclusions.
As we’ve already mentioned, organisations usually define their risk appetite in a risk appetite statement document, the objective of which is to assist the business in organisational risk management. In other to be relevant and useful, the risk appetite statement should be aligned with the perspectives and concerns of all parties involved and take into consideration the existing strategic direction and current corporate practices.
Looking at the example below, we can see how an entity has prepared a simple risk appetite statement, which covers the main risk areas associated with the organisation. In this case, the last column has cleverly outlined potential scenarios, which may require an alternative action. This is a useful part of the statement as it allows flexibility and shows that a thorough thought process lies behind the decision making, making it more adaptable to change.
Whether you are an independent property investor or an organisation that invests in property, the risk appetite is an important factor to consider when making your next decision regarding a potential project.
Using the information from above it might be a good idea to have a detailed talk with the people involved in the property investing process and lay out the risk appetite of your desired investment. For example, think about the purpose and type of property investment. Will you be acquiring a single apartment, a house, a building, or a block of buildings? Depending on the different types of property, think about what the major risks could be that could lead to a lower return on your investment.
Think about the cost of the investment, would the project involve additional costs associated with renovation, construction work, or others that may be a risk to your desired return? If you are buying to let could the type of tenants you choose be a risk? For example, students tend to change living locations dynamically and renting out to students may leave your property empty for months? Furthermore, think about any external factors that may influence the value of your property in the future. Are there any new roads or institutions being built around the property, which may negatively influence the site while the construction is taking place?
The risk appetite can be set by you individually but there is also an easier and quicker way to finding out the level of risk that you are able to take by using the services of a professional property consultant like Seed Property Consultants. Here, you can work with experts who will help you establish whether an investment would be worth it, taking into consideration your budget, specifically desired returns on the investment, and any other goals that you may have.
We have years of experience working with a large range of clients to fulfill their property investment dreams and help shed light into the risk of investing. There is no need to worry! Although investing may be scary at times because of its complex nature, we’re here to make the process smooth and beneficial for you! Get in touch to receive more information and professional advice on property investment.