Real estate investing

From Wikipedia, the free encyclopedia

Real estate investing involves the purchase, ownership, management, and/or sale of real estate for profit. Improvement of real 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 expensive, non-liquid asset, and therefore real estate investment activity is capital intensive, risky, and cash flow dependent. The primary mode of business failure for real estate investors is an inability to remain cash solvent.

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[edit] 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:

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 many 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.

[edit] 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 equity (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.

[edit] Sources and Management of Cash Flows

A typical investment property generates cash flows to an investor in four general ways:

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.

[edit] 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
Short sale Limit leverage to 80% of appraised value maximum at time of purchase

[edit] Foreclosure investment

Main article: 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 easier.[1] 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.

[edit] Foreclosure statistics

The number of households in foreclosure increased 79 percent in 2007, with about one of every 100 U.S. households at some stage of the foreclosure process, according to the latest numbers from data aggregator RealtyTrac. [2]

[edit] References

  1. ^ Janet Portman, "Foreclosure causes heartache for renters", Inman News, Feb 07, 2008 Retrieved 24 Feb 2008
  2. ^ "Homes in foreclosure up 79% in '07", Inman News via RealtyTrac, Jan 29, 2008 Retrieved 16 March 2008

[edit] See also

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