Compared with other types of investments, real estate investing involves a relatively favorable risk/reward profile, with relatively low liquidity (ease of entry and exit). Let's see some of the most important factors to consider when investing in real estate.
1. 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.
2. Valuation of the Property
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 and old properties
- Cost Approach: All cost summation minus depreciation – suitable for new construction
- Income approach: Based on expected cash inflows — suitable for rentals
3. Investment Purpose and 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 and 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 a long period; a solution for long-term aims like retirement planning, child’s education, etc.
4. Expected Cash Flows & Profit Opportunities
Why is it important? The investment purpose and usage influence 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
5. 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. Understanding how to handle loans of this nature 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 and expected future earnings and paying capability, consider the following:
- Decide on the type of mortgage loan that best fits your situation (Fixed Rate, Adjustable Floating Rate, Interest Only or Zero Down Payment)
- Be aware of the terms and conditions and other charges levied by financiers
- Hunt around and bargain for a better deal using a tool like a mortgage calculator to find lower interest rates. Also look for lower insurance premiums.
6. 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, an increase in costs, no awareness about the 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
7. 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
- 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.