Real estate investing involves the purchase, ownership, management,
rental and/or sale of real estate for profit. Improvement of realty
property as part of a real estate investment strategy is generally
considered to be a sub-specialty of real estate investing called real
estate development. Real estate is an asset form with limited liquidity
relative to other investments, it is also capital intensive (although
capital may be gained through mortgage leverage) and is highly cash flow
dependent. If these factors are not well understood and managed by the
investor, real estate becomes a risky investment. The primary cause of
investment failure for real estate is that the investor goes into
negative cash flow for a period of time that is not sustainable, often
forcing them to resell the property at a loss or go into insolvency.
Sources and acquisition of investment property
Real estate markets in most countries are not as
organized or efficient as markets for other, more liquid
investment instruments. Individual properties are unique
to themselves and not directly interchangeable, which
presents a major challenge to an investor seeking to
evaluate prices and investment opportunities. For this
reason, locating properties in which to invest can
involve substantial work and competition among investors
to purchase individual properties may be highly variable
depending on knowledge of availability. Information
asymmetries are commonplace in real estate markets. This
increases transactional risk, but also provides many
opportunities for investors to obtain properties at
bargain prices. Real estate investors typically use a
variety of appraisal techniques to determine the value
of properties prior to purchase.
Typical sources of
investment properties include:
Market listings (through a Multiple Listing
Service or Commercial Information Exchange)
Real estate agents
Wholesalers (such as bank real estate owned
departments and public agencies)
Public auction (foreclosure sales, estate sales,
etc.)
Private sales
Once an investment property has been located, and
preliminary due diligence (investigation and
verification of the condition and status of the
property) completed, the investor will have to negotiate
a sale price and sale terms with the seller, then
execute a contract for sale. Most investors employ real
estate agents and real estate attorneys to assist with
the acquisition process, as it can be quite complex and
improperly executed transactions can be very costly.
During the acquisition of a property, an investor will
typically make a formal offer to buy including payment
of "earnest money" to the seller at the start of
negotiation to reserve the investor's rights to complete
the transaction if price and terms can be satisfactorily
negotiated. This earnest money may or may not be
refundable, and is considered to be a signal of the
seriousness of the investor to purchase. The terms of
the offer will also usually include a number of
contingencies which allow the investor time to complete
due diligence and obtain financing among other
requirements prior to final purchase. Within the
contingency period, the investor usually has the right
to rescind the offer with no penalty and obtain a refund
of earnest money deposits. Once contingencies have
expired, rescinding the offer will usually require
forfeit of earnest money deposits and may involve other
penalties as well.
Sources of investment capital and leverage
Real estate assets are typically very expensive in
comparison to other widely-available investment
instruments (such as stocks or bonds). Only rarely will
real estate investors pay the entire amount of the
purchase price of a property in cash. Usually, a large
portion of the purchase price will be financed using
some sort of financial instrument or debt, such as a
mortgage loan collateralized by the property itself. The
amount of the purchase price financed by debt is
referred to as leverage. The amount financed by the
investor's own capital, through cash or other asset
transfers, is referred to as equity. The ratio of
leverage to total appraised value (often referred to as
"LTV", or loan to value for a conventional mortgage) is
one mathematical measure of the risk an investor is
taking by using leverage to finance the purchase of a
property. Investors usually seek to decrease their
equity requirements and increase their leverage, so that
their return on investment (ROI) is maximized. Lenders
and other financial institutions usually have minimum
equity requirements for real estate investments they are
being asked to finance, typically on the order of 20% of
appraised value. Investors seeking low equity
requirements may explore alternate financing
arrangements as part of the purchase of a property (for
instance, seller financing, seller subordination,
private equity sources, etc.)
Some real estate
investment organizations, such as real estate investment
trusts (REITs) and some pension funds, have large enough
capital reserves and investment strategies to allow 100%
equity in the properties they purchase. This minimizes
the risk which comes from leverage, but also limits
potential ROI.
By leveraging the purchase of an investment property,
the required periodic payments to service the debt
create an ongoing (and sometimes large) negative cash
flow beginning from the time of purchase. This is
sometimes referred to as the carry cost or "carry" of
the investment. To be successful, real estate investors
must manage their cash flows to create enough positive
income from the property to at least offset the carry
costs.
Sources and management of cash flows
A typical investment property generates
cash flows to an investor in four
general ways:
net operating income (NOI)
tax shelter offsets
equity build-up
capital appreciation
Net operating income, or NOI,
is the sum of all positive cash flows
from rents and other sources of ordinary
income generated by a property, minus
the sum of ongoing expenses, such as
maintenance, utilities, fees, taxes,
debt service payments, and other items
of that nature. The ratio of NOI to the
asset purchase price, expressed as a
percentage, is called the capitalization
rate, and is a common measure of the
performance of an investment property.
Tax shelter offsets occur in
one of three ways: depreciation (which
may sometimes be accelerated), tax
credits, and carryover losses which
reduce tax liability charged against
income from other sources. Some tax
shelter benefits can be transferable,
depending on the laws governing tax
liability in the jurisdiction where the
property is located. These can be sold
to others for a cash return or other
benefit.
Equity build-up is the
increase in the investor's equity ratio
as the portion of debt service payments
devoted to principal accrue over time.
Equity build-up counts as a positive
cash flow from the asset where the debt
service payment is made out of income
from the property, rather than from
independent income sources.
Capital appreciation is the
increase in market value of the asset
over time, realized as a cash flow when
the property is sold. Capital
appreciation can be very unpredictable
unless it is part of a development and
improvement strategy. Purchase of a
property for which the majority of the
projected cash flows are expected from
capital appreciation (prices going up)
rather than other sources is considered
speculation rather than investment.
Risk management
Management and evaluation of risk is
a major part of any successful real
estate investment strategy. Risk occurs
in many different ways at every stage of
the investment process. Below is a
tabulation of some common risks and
typical risk mitigation strategies used
by real estate investors.
Risk
Mitigation
Strategy
Fraudulent sale
Verify ownership, purchase
title insurance
Adverse possession
Obtain a boundary survey
from a licensed surveyor
Environmental contamination
Obtain environmental survey,
test for contaminants (lead
paint, asbestos, soil
contaminants, etc.)
Building component or system
failure
Complete full inspection
prior to purchase, perform
regular maintenance
Overpayment at purchase
Obtain third-party
appraisals and perform
discounted cash flow analysis as
part of the investment pro
forma, do not rely on capital
appreciation as the primary
source of gain for the
investment
Cash shortfall
Maintain sufficient liquid
or cash reserves to cover costs
and debt service for a period of
time,
Economic downturn
Purchase properties with
distinctive features in
desirable locations to stand out
from competition, control cost
structure, have tenants sign
long term leases
Tenant destruction of
property
Screen potential tenants
carefully, hire experienced
property managers
Underestimation of risk
Carefully analyze financial
performance using conservative
assumptions, ensure that the
property can generate enough
cash flow to support itself
Foreclosure investment
Some individuals and companies are engaged in the
business of purchasing properties at foreclosure sales.
According to the legal foreclosure stages when the
process is completed, the lender may sell the property
and keep the proceeds to satisfy its mortgage and any
legal costs. The foreclosing bank has the right to
continue to honor the client’s lease, but customary as a
rule the bank wants the property vacant, in order to
sell it more easily.Thus distressed assets (such as
foreclosed property or equipment) are considered by some
to be worthwhile investments because the bank or
mortgage company is not motivated to sell the property
for more than is pledged against it.
Finances
