Weighing Up The Risk On Your Foreign Property Purchase
“Isn’t investing just another form of gambling?” asked my teenage son.
Not the reaction my husband was expecting when he announced the current status of his cryptocurrency play.
I couldn’t laugh. The 8-year-old had just called me out on my own double standards. Following lectures earlier that week on the evils of drugs, here I was, Friday night, sipping a gin cocktail.
Trust me, there was no point laying out the differences between gin and crystal meth with this kid. Much easier to join the “investing versus gambling” debate…
Of course, we know that when we invest in real estate, we own a physical piece of property—in the best case, one that brings us cash flow… whether that’s from farm produce or rental income.
The value of our real estate may go up or down (it would take some extraordinary circumstances for it to go to zero), but we have the comfort of owning a hard asset. In this way, an investment in real estate feels less speculative than playing the stock market.
That said, any form of investment comes with risk. Today, we’re going to look at the kinds of risk you need to think about as you approach a foreign property investment—as identified by our international real estate guru Lief Simon in a recent Global Property Advisor article.
Read on for Lief’s insights…
Editor, Overseas Property Alert
Assessing Your Risks As A Global Property Investor
By Lief Simon
Whether you are a seasoned investor or just beginning to build your portfolio, international real estate is the best way to diversify your holdings while increasing your average returns. Investing in real estate in other countries gives you both economic and currency diversification. You can further hedge your bets by investing in various types of properties at various costs of entry.
But there’s no investment without risk. When investing in foreign property, you face five types of risk:
- Market Risk
- Transactional Risk
- Environmental Risk
- Different Investment Category Risk
- Investment Risk
While all these risks should be considered when evaluating any potential property purchase, some will take precedence over the others depending on the specifics of the investment.
1. Market Risk
One of the most important factors that you must consider when investing in property overseas is the location of the investment. In other words, you need to evaluate the risks associated with investing in a particular country or region. The risks of investing in a foreign market include political risk, economic risk, and currency exchange rate risk.
Political risk is a danger that will affect your investment due to political instability in a country. Risks include: the passage of legislation that is unfavorable to foreign investments; the transfer of political power from one political party to another; or a sudden overthrow of the current government (a coup d’état). Political instability may also arise from foreign or international policies including military conflict or economic sanctions. Then there’s the economic risk, which is almost always affected by the level of political stability in a country.
The health of a country’s economy will have an impact on your global property investments, especially if the returns on your investment are heavily dependent on the local market.
If you invested in a non-U.S.-dollar market, then you are also exposed to currency exchange risk. That is, if the currency in which you are holding your investment depreciates in value, so does your investment. This will come into play when you are ready to exit your investment.
It is important to point out that the longer the investment horizon, the more critical it is to assess the market risks.
2. Transactional Risk
As a global property investor, you will be faced with transactional risk. That is, you’ve found a property investment that you like and now you want to close the deal. However, the buying and closing process, including titling and the transferring of funds, will be different from purchasing property in North America… and different again in every country that you decide to invest in.
One thing that North Americans take for granted, for example, is that property has clean title. Depending on the country, titles and ownership can get complicated, and property ownership laws vary from one country to the next. While freehold title is the norm in the United States and Canada, you will encounter different variations of property ownership (or non-ownership) in other parts of the world that you must be aware of.
If you are not educated on the ownership laws of a country, you run the risk of purchasing a property to which you do not have full ownership rights.
Then there’s the actual sales contract. If you’re buying property overseas the contracts will most likely be in a foreign language. This off-the-bat difference can put you at a disadvantage when finalizing an international property deal. On top of that, you also must consider whether or not the sales contract is enforceable by the courts in the jurisdiction in which you are purchasing your property. For example, can the seller just back out of the deal after the contract is signed, without any legal recourse for the buyer?
The ease in which you can transfer money in or out of the country that you are investing in also plays a part. Typically, it is easier to move money to or from developed countries with established banking and foreign-exchange transfer systems. Generally, it is more complicated and, usually, more expensive—not to mention extremely risky—to transfer money into developing countries where banking and foreign exchange transfer systems are not fully established.
There are many countries that have anti-money laundering laws in place that restrict movement of money internationally unless specific procedures are followed.
This will come into play should you exit your investment and you want to send the proceeds back to your home country in your home country’s currency. Understanding the specific anti-money laundering laws and procedures in any country that you invest in will ensure that you can get your money out with no problems.
3. Environmental Risk
Environmental risk is another component that you have to take into account when investing overseas. This is especially true when it comes to rental property or agricultural investments that are dependent on environmental factors for their profitability. Environmental risk would include natural disasters, climate, and beach erosion.
You should have a good idea as to what type of natural disasters are prevalent in the country or region in which you are investing. For example, when investing in agriculture you should be concerned with whether droughts or wildfires exist within the area of the farm. If you were investing in a beachfront rental property, then you should be concerned with hurricanes and typhoons.
The overall climate will also play a factor in specific investments, particularly for agriculture. While mango trees thrive in sub-tropical climates with warmer temperatures, grapevines flourish in Mediterranean type climates with cooler temperatures. If a crop’s optimal climate condition drastically changes, then that will affect overall production and harvest, thus affecting your potential yields.
If you are investing in beachfront property, it is critical that you are aware of any coastal erosion issues in the area. Beach erosion is a serious threat to any oceanfront property, it would decimate the resale value. Worst case scenario, your property could literally fall into the ocean.
4. Risk Levels Of Different Investment Categories
We usually highlight four investment categories: rental property, land, agriculture, and indirect. We drilled down from there to suggest specific investments within these categories (short-term rental, raw land, timber, and hard money loans, for example), while detailing the level of risk associated with each.
Typically, rental property and agriculture are the lower risk property investments, while land and indirect investments like a hard money loan are higher risk.
In a nutshell, this is how they would rank from the lowest to highest in terms of risk:
Rental Property < Agriculture < Land < Indirect.
That said, a typically low-risk investment can be high risk, while a usually high-risk investment can be low risk, depending on the situation. A rental property investment can be considered high risk if it’s in the pre-construction stage, for example. On the other hand, a hard money loan on a construction project that is 90% complete and is collateralized by a condo unit can be considered low risk.
5. Investment Risk
All things considered, as a global real estate investor you will still need to evaluate each real estate investment as if you were investing directly into any type of business. In other words, you will need to take into consideration factors including: the business model (or vision), investment horizon, market, experience of development team, exit strategy, and progress of the project to get a reliable gauge of the risk involved in the investment.
When reviewing the business model of a real estate investment the general idea is to understand how the investment is going to generate income or yield.
The way you earn from your investment should be straightforward. In fact, the more complicated the business model the more risk involved. For instance, with an agricultural investment you should see your returns from the sales of your harvest.
With a lot investment in a new development, you are getting the bulk of your returns from capital appreciation. You’re earning rental income from a condo-hotel (short-term rental) investment.
Furthermore, you need to have an idea of the investment horizon. That is, how long will it take to recoup your initial investment? Generally speaking, the longer it takes to recoup your initial investment, the riskier the investment. However, the exception to this would be an agricultural investment such as timber.
You will also have to evaluate the market that your investment is targeting. For example, if you are going to invest in a turn-key agricultural plantation that grows a specific crop, you want to know if there’s a growing demand for that crop. If you are going to make an investment in a short-term rental condo unit in a specific region, then you want to know how strong the short-term rental market is in that area. Plus, you want to know if there is a resale market if you want to exit your investment.
To that end, another factor that you need to consider is how easy it is to exit your investment. In other words, how easy is it for you to convert your investment back into cash. Is the developer willing to buy you out if you want to get out of your investment?
You should also consider assessing the level of experience that the development team has that is behind the project. If the developer does not have any experience or an established track record, then there’s a higher level of risk associated with the investment.
Additionally, you should also have an idea of the project’s progress. Typically, a project that’s in its early stages of the development or in its pre-construction phase has a higher investment risk.
On the other hand, if a project is in its late stages of development or construction is nearing completion, the investment risk is much lower.