Compared with other types of investments, real estate investing involves a relatively favorable risk/reward profile, but with relatively low liquidity (ease of entry and exit). Let's see some of the most important factors to be considered for investing in real estate.
I. Location of the Property
Why is it important? The age old punch line "Location, Location, Location" still rules and remains the most important factor for profitability in real estate investment. Proximity to amenities, peaceful conforming areas, neighborhood status, scenic views, etc. are major factors for residential property valuations; while proximity to markets, warehouses, transport hubs, freeways, tax-exempt areas, etc. play an important role for commercial property valuations.
What to look for? A mid-to-long term view, about how the locality is expected to evolve over the investment period. Today’s peaceful open land at the back of a residential building may be developed into a noisy manufacturing facility in future, making the residential valuations less profitable. It is advisable to conduct thorough check about ownership, type and intended usage of neighboring areas, establishments and free land in the locality.
II. Valuation of the Property
Why is it important? Real estate financing during purchase, listing price during sale, investment analysis, insurance premium and taxation - all depend on Real estate valuation.
What to look for? Commonly used Valuation Methodologies include:
- Sales comparison approach: Recent comparable sales of properties with similar characteristics –most common and suitable for both new & old properties
- Cost Approach: All cost summation minus depreciation – suitable for new construction
- Income approach: Based on expected cash inflows - suitable for rentals
III. Investment Purpose & Investment Horizon:
Why is it important? Given the low liquidity and high value investment in real estate, lacking clarity on purpose may lead to unexpected results including financial distress, especially if the investment is mortgaged.
What to look for? Identify which of the following broad categories suits your purpose and prepare yourself accordingly:
- Buy & Self-use: Savings on rentals, benefit of self-utilization and value appreciation
- Buy & Lease: Regular Income & long term value appreciation. Requires building a temperament of being a landlord - for handling possible disputes & legal issues, managing tenants, repair work, etc.
- Buy & Sell (Short Term): Quick, small to mediocre profit - usually buying under construction properties and selling slightly high once ready
- Buy & Sell (Long Term): Large intrinsic value appreciation over long period of time; solution for long term aims like retirement planning, child’s education, etc.
IV. Expected Cash Flows & Profit Opportunities:
Why is it important? The investment purpose & usage influences cash flows and hence profit opportunities.
What to look for? Develop draft projections for the following modes of profit & expenses:
- Expected cash flow from rental income - Inflation favors landlords for rental income
- Expected increase in intrinsic value due to long term price appreciation
- Benefits of depreciation (and available tax benefits)
- Cost benefit analysis of renovation before sale to get better price
- Cost benefit analysis of mortgaged loans vs value appreciation
V. Be Careful with Leverage - Know the Pitfalls:
Why is it important? Loans are convenient but may come at a big cost - you commit your future income, to get utility today for a cost of interest spread across many years. Real estate financing needs higher amounts and hence has higher exposures. Understanding it properly allows you to benefit from it to the maximum, while ignoring the risks can lead to major pitfalls.
What to look for? Depending upon your current & expected future earnings and paying capability, consider the following:
- Decide on type of mortgage loans (Fixed Rate, Adjustable Floating Rate, Interest Only or Zero Down Payment), whichever suits you best
- Be aware about the terms & conditions and other charges levied by financiers
- Hunt around and bargain for a better deal - lower interest rates, lower insurance premiums or processing charges waiver, as possible
VI. Investment in New Construction vs Existing Establishments:
Why is it important? New construction properties usually offer attractive pricing, the option of customization, clearly documented amenities and clear titles. The investor has to deal with only the construction company as a counterpart. Risks include delay in possession, increase in costs, no awareness about neighborhood, etc.
Those on resale have vice-versa factors and may need a more thorough check on ownership, documents and legal matters.
What to look for?
- Check past projects and the reputation of the construction company for new construction investments
- Review property deeds, recent survey and appraisal report for old constructions
- Be aware of monthly maintenance costs, outstanding dues & taxes from past owners. These costs can severely impact your regular cash flows
- Investing in on-lease property (possessed by others) – Is it rent controlled, rent stabilized or free market? Is the lease about to expire? Does it have renewal options in favor of the tenant? Are interior items owned by the tenant or owner? etc. are some of the details to be aware of.
- Quality-check items (furniture, fixtures and equipment), if included in sale
VII. Indirect Investments in Real Estate:
Managing physical properties over a long term horizon is not for everyone. There are also a few alternatives to indirectly invest in the real estate sector and aim to reap the benefit.
What are the Options?
- Real estate company stocks – Equity stocks of real estate companies can be bought and sold on exchanges (e.g. Forest City Enterprises FCE.A listed on the NYSE)
- Real estate sector-focused mutual funds/ETFs – Sector specific funds like “Fidelity Real Estate Investment Portfolio (FRESX)” offer the benefit of diversification and professional money management, at the cost of fund expense charges
- Mortgage bonds – Secured by physical property, they offer lower rates of return compared to corporate bonds
- Real Estate Investment Trust (REIT) – offer high yields, tax consideration and high liquidity as they trade on stock exchanges.
The Bottom Line
Real estate investments offer a good high value risk-return profile. Thoughtful consideration of the above mentioned factors in mind will enable investors to reap the benefits while mitigating the risks.