INVESTMENT
STRATEGY
Investment
strategy is an investment plan at a high, general or overall level.
It includes overall investment targets and the necessary actions to
achieve those targets according to assumed investment environments.
The strategy is set over the investment period for example, 5 or 10
years but is most applicable at the initial stage of the investment
as it will determine the type of investment property bought. It also
applies to the initial investment period but modern thought is that
the middle and later stages of the investment period should be
flexible with the ability to change the strategy because of the
dynamic nature of property investment. That is, circumstances change
that could not have been foreseen at the start of the investment.
The
investment strategy is personal to the investor and depends largely
on:
- The expertise and experience of the investor
- Source of investment funds
- Whether or not the investor is a risk taker
- Whether or not the investment is in the long or short run
The
above factors are not mutually exclusive but overlap.
EXPERTISE
AND EXPERIENCE OF THE INVESTOR
Expertise
and experience usually go together. The investor may have experience
and expertise in:
- THE CLASS OF INVESTMENT PROPERTY. For example, the
investor may have been a publican for 10-20 years and therefore, have
experience in hotels. This provides them with a comparative advantage
over other investors for example, one who is buying a hotel for the
first time.
- LOCALITY. An investor who has lived in the investment town
or suburb for most of their lives will have a comparative advantage
over an outsider. They will know the history of the area including past
land uses and local attitudes to those land uses. For example, they may
know that the sale property was previously used as a motel but closed
down because of poor access and visibility.
- PROFESSIONAL EXPERTISE. The investor may be for example, a
town planner, banker, architect, valuer or builder. This will provide
the investor with a comparative advantage in that particular field that
they can put to good use in the investment. For example, the architect
may see that a building suffering from road traffic noise caused by a
busy intersection can be overcome with better architectural design.
An
investor with suitable expertise and experience will lower the risk
of investment compared with an investor without that expertise or
experience.
SOURCE
OF INVESTMENT FUNDS
The
source of investment funds affects investment strategy as follows:
- THE INVESTOR USES THEIR OWN FUNDS. The investor is not
accountable or subject to a lender’s control or scrutiny. This allows
the investor full reign on investment decisions and is particularly
important for the risk taker. For example, the investor using their own
funds is able to buy a site to develop a pioneer land use. A bank would
not have provided sufficient funds to develop such a use because of the
high risk.
- THE INVESTOR USES OTHER PEOPLES MONEY. For example,
superannuation funds. Such funds are investing on behalf of other
people who require that their funds be safely invested. Superannuation
funds look for large (because it reduces management costs) and safe
properties to invest in such as regional shopping centres and landmark
commercial buildings.
- THE INVESTOR BORROWS. The lender such as bank will
evaluate the investment risk and lend accordingly. If the risk is high,
the bank may still lend (based on other collateral provided by the
investor) but at a lower loan to value ratio (LVR) and/or at a higher
interest rate. The bank will also look at the next best land use as a
fallback position. Therefore, most banks lends on “safe” investments
such as a block of residential flats in a proven residential area.
The
investor with their own funds has much greater freedom of investment
strategy than a borrower.
WHETHER
OR NOT THE INVESTOR IS A RISK TAKER
Whether
or not the investor is a risk taker is also subject to the expertise
and experience of the investor and source of funds. Good property
investment is logical and rational decision making and therefore, an
investor who appears to be a risk taker to an outsider, may be in
fact be engaging in a “canny” or clever investment because of
some comparative advantage such as expertise the investor possesses.
That is, that investor does not see themselves as a risk taker.
EXAMPLE
– PIONEER LAND USE
An
investor with expertise in motels while inspecting motels in the US
noted that a number of successful motels were located in industrial
areas. This would have been a novel location in Australia where
conventional wisdom has it that motels must be located fronting a
busy road or just off the road. The investor built the first motel in
Australia in an expanding industrial area of Sydney and it was a
success because it was a popular destination for executives and sale
representatives visiting companies located in that area.
To
the outsider the building of the motel in an industrial area and not
fronting a busy road would have been high risk. However, to the
investor although it was riskier than conventional building a motel
on a busy road (as it had not been proven in Australia) it was not as
risky to them because of their expert knowledge and experience. The
fact they knew that the new location had been proved in the US
reduced the risk of the new location in Australia.
A
number of pioneer land uses are uses proved overseas. The investor
has the comparative advantage of seeing that use in operation and
that it is successful overseas.
Another
example is the successful development of Pier 41 in San Francisco.
This development spawned comparable pier developments throughout the
world including Sydney.
Whether
or not the investment is short or long run
The
investment strategy will depend to a large extent on whether or not
the investment is short or long run. Again, such a strategy cannot be
excluded entirely from the factors mentioned above. For, example, a
risk taker using their own funds will look to short run investments
because of a need to “roll the investment over” so as to be able
to generate new funds for further investments. Because the short run
investor is concerned with small investments for example, building a
block of 10-20 flats the investment period will be the time taken to
build and sell. The period would typically be 18-36 months.
On
the other hand a superannuation fund is concerned with investing in
the long run which will reduce administration and management costs.
The long run investor is looking for reasonable capital growth over a
10- 20 year period and therefore, is attracted to large and safe
property investments.
Strategy
will also be affected during the investment period. For example, tax
depreciation allowances for the building at 2.5%pa allows the total
claim over a 40 year period. The short run investor will not be able
to enjoy the tax advantages for that period but will still be able to
onsell the residue value of the allowances at the end of a shorter
investment period to the buyer. This will be part of the short run
investment strategy.
USE
OF INVESTMENT ANALYSIS DATA
We
have already covered the sources of data for investment analysis in
learning outcome 2. This included economic data such as Gross
Regional Product, demographic data such as population change, and
sales data allowing the valuer to determine market value and the
market’s expected return on investment.
The
quality of the data affects the risk of investment. The better the
integrity and quality of data, the more reliable are the expectations
and forecasts in the investment strategy. Some data is better quality
and more reliable than other data.
ABS
DATA
The
ABS data on economic growth and population is the most reliable data
available as it is based on a good sample and has been scientifically
checked for integrity and reliability. It is the most reliable data
that the investor can use for economic and population growth.
However,
ABS data is often out of date because of the lead time in compilation
and preparation. For example, population change data may be 2-3 years
old having been based on the previous census.
Because
the property investor is dependent on topical data, ABS data may have
to be augmented with more recent data. The best source for up to date
information is the local council particularly if they have an
investment support or development section. Such a section will have
up to date economic and demographic estimates that the valuer can
use. The section should also have a copy of ABS’s snapshot of the
region or local government area which is a compilation of all
relevant data.
Similarly,
state governments will provide economic and population data at state
levels from departments and sections promoting development and
investment in that state. That body may also have data at regional
level. Such data is reliable data for the valuer to use in investment
reports.
The
valuer should acknowledge the source of the data. This is not only
professional but also part of risk management in case there is a
dispute about the data used.
If
up to date information on economic and population is not available
then the valuer can use trend lines to project the existing data to
the present.
VALUER’S
DATA
Other
investment data includes sales and market information. The valuer may
be able to compile a sufficient and reliable sales report from their
own sales data but usually this is not of sufficient sample size for
reliable trends to be established. The valuer may have to augment
sale information from other sources (eg newsletters, trade
newspapers) published by real estate firms. However, such subsequent
data is less reliable.
The
most reliable data are the latest sales information available from
Council by way of notices of transfer. The notices of transfer
are legal documents and therefore, reliable evidence of sales. The
valuer should maintain and keep sales evidence up to date on a
regular basis.
Analysis
of such sales to find rates of return will weaken the reliability of
the evidence as it will be necessary to ascertain the expected income
and/or benefits of the investment property. For example, the valuer
will have to ascertain rentals and outgoing information from the
property manager or owner. This information is less reliable or more
general (because of privacy concerns) compared to the sale price
derived from the notice of transfer.
The
further removed the source of information is from the valuer, the
less reliable it becomes. The reliability of subsequent data is
dependent on the source. For example, investment data prepared and
published by a large national real estate company and prepared by
their full time research section will be more reliable than that
published by a small agency.
RECOMMENDATIONS
AND COMMENTS
INITIAL
OR BUYING PERIOD
Recommendations
and comments by the valuer can be considered according to the stages
of the investment.
The
valuer’s most important single role in the investment is to find a
suitable property that meets the investor’s strategy and determine
the market value of that property. In practice it is often difficult
to find investment properties that fully meets this criteria and
therefore the valuer will probably recommend about 4-5 suitable
properties, leaving it up to the investor to decide which one to buy.
Once the investor has “firmed” or narrowed the range of
properties to say, one or two, then the valuer can carry out further
research and provide up to date market values. The valuations will be
the deciding factor in which property the investor should buy.
DURING
THE INVESTMENT PERIOD
The
valuer will also be engaged to make the following recommendations
during the investment period:
- Market rental values. These to be used by the investor for
rent reviews for existing tenants and asking rents for new tenants
- Starting values and building cost to be used in tax
depreciation schedules
- Extraordinary recommendation such as the need to renovate,
replace or repair major capital items such as lifts and air
conditioning.
- Periodic determination of the rate of return on market
value to determine the performance of the investment. This will include
the recommendation to maintain the existing strategy, renovate or sell.
- Following from the above, the valuer may recommend a
change of land use.
END
OF INVESTMENT PERIOD
The
final recommendation will be at the end of the investment period when
the valuer will carry out a market value of the property to determine
a fair asking price if the investor decides to sell. The valuer may
also be asked to make recommendations on the most suitable method of
sale. That is, private treaty, auction or tender.
In
the alternative the investor may decide to keep the property
particularly if there are good quality tenants in occupation subject
to long leases. The valuer can advise on the best alternative. This
may mean a valuation of value to the owner rather than a
market valuation.
See
SWOT
MONITORING
AND REVIEW OF INVESTMENT
Feedback
is necessary during the investment period during which there should
be ongoing and regular reports on the state of investment
particularly; rate of return against current market value. The valuer
will be called upon to provide a review of investment report and if
rents or new leases are due; a market rental value report. This
report is used to monitor the status of the investment. If the
property is showing a return on investment below a reasonable level
then remediable action should be taken.
Review
of the investment will involve an up to date valuation to decide the
property’s performance from a return on investment perspective.
This valuation will also provide an indicator of viability. For
example, if land value is increasing against the improved value then
the building is showing the effects of depreciation. This is to be
expected as a building becomes older so does the drop in depreciable
value. If there is a sudden and large rate of increase then this
could be an indication of the need for remedial action.
A
fall in rate of return will not necessarily mean that the property is
not performing as well as it did at the initial period. The
establishment of the subject property together with further
surrounding development supporting that land use will result in a
building less risky than it was at the start and therefore, a lower
rate of return is appropriate.
On
the other hand a higher rate of return may come about because of a
large drop in market value. This would indicate that the investment
is losing value and risk has risen. This scenario is more important
during the review of investment as it may indicate that when the
existing tenancies fall due the investor may have to settle for lower
rents.
The
investment review will allow the investor to assess and address
problems that have risen. They may carry out remedial action which
may be renovation, change of use or even cutting losses by selling.
The ultimate remedial action is decided by the investor and the
valuer can only advise on what they think is the best option.
Dynamic
qualities of property investment
With
the large number of factors covered above in SWOT it is apparent that
a property investment, particularly in the long run, will change over
time. That is, property investment has a strong dynamic quality. The
changing dynamic factors can be considered under the heading of
external and internal factors.
EXTERNAL
OR MACRO FACTORS OR FIXED COSTS
The
main concern for the investor is changing external or fixed factors
as these cannot be controlled. Changing costs and conditions such as
rates and taxes and government laws have to be, because of their
nature, accepted by the investor.
EXAMPLE
A
new government law requiring more expensive fire control measures is
a cost that the investor has to endure. Such unavoidable property
investment costs are part and parcel of property investment and one
of the reasons why the required rate of return is substantially more
than the “risk free” rate.
If
the new external costs are “across the board”, applying to all
other investment properties of this class of land, the extra costs
can be passed onto the tenants or if not, the land value will fall.
If an increase in external costs becomes too onerous then the
valuer’s review of investment will help the investor decide whether
or not to try to remedy the situation or sell.
Another
important external dynamic factor affecting the investment is the
state of the market including market competition. Competition in the
locality may mean that market rents are falling so that the
expectation is that future market rents may be less than currently
being achieved. This may not mean that the value of the investment is
less as the market value may have risen with the locality becoming a
safer investment.
With
periodic review of the investment an up to date market valuation will
show the investor the current status of the investment so that the
investor can prepare for change and if necessary take remedial
action. For an existing investment property, a falling rental market
is not as critical as existing tenants generally, prefer not to move,
particularly if they have incorporated a number of tenant
improvements, established site goodwill (eg naming rights). When the
leases of such tenants fall due, the investor may still be able to
negotiate a good rent.
INTERNAL
OR MICRO FACTORS OR VARIABLE COSTS
The
valuer plays a role during the review of investment period in
deciding the best option taking into account variable costs. Micro,
internal or variable costs are those costs that can be changed by the
investor.
EXAMPLE
If
the cost of running the air conditioning has shown substantial
increases in recent years the investor can decide to:
- Make the unit more efficient by installing new components
- Install a new unit
- “as is” – do nothing.
The
valuer can help the investor to decide the best course of action by
determining the NPV of each option. The option with the lowest NPV is
the preferable option.
The
valuer plays an important role in assessing and identifying the
dynamic qualities of the property and will be part of their
monitoring and review of the investment report.
See
privacy
SUMMARY
Development
of strategic analysis is the “mission” of the investor and sets
the basis for the whole investment program. Strategy is at a high and
general level and it is most important at the initial or buying
period of the investment plan.
During
the investment period the dynamic qualities of property investment
means that the strategy will change over time. That is why the valuer
should monitor the perfiormance of the investment and report back to
the nvestor so that any problems can be remedied.
The
headings of the report be SWOT headings as these provide a thorough
analysis from 4 perspectives.
All
information used and received by the valuer is confidential and
private. If the valuer even inadvertently releases confidential
information they will be in breach of the Privacy Act and probably,
the common law as well,
See
establishing investment requirements
See
developing investment strategy
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