Real Estate Investment
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. A similar practice known as flipping is another reason for failure as the nature of the investment is often associated with short term profit with less effort.
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.
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 |
| Market Decline | Purchase properties based on a conservative approach that the market might decline and rental income may also decrease |
| Fire, flood, personal injury | Insurance policy on the property |
| Tax Planning | Plan purchases and sales around an exit strategy to save taxes. |
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