Real Estate Investing
Thursday May 15th, 2014
Real estate investing involves the purchase, ownership, management, rental and/or sale of real estate for profit. Real Estate has traditionally outperformed the Wall Street equity market. A street by street knowledge of the market make it perfect for small savvy investors. Large institutions lag behind trends. 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 entrepreneurs 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 and Real estate brokers
- Banks (such as bank real estate owned departments for REO's and short sales)
- Government entities (such as Fannie Mae, Freddie Mac and other government agencies)
- Public auction (foreclosure sales, estate sales, etc.)
- Private sales (off-market transactions for sale by owner For sale by owner)
- Real estate wholesalers and investors (flipping)
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's intent to purchase. The terms of the offer will also usually include a number of contingencies which allow the investor time to complete due diligence, inspect the property 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 forfeiture of the 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.)
If the property requires substantial repair, traditional lenders like banks will often not lend on a property and the investor may be required to borrow from a private lender utilizing a short term bridge loan like a Hard money loan from a Hard money lender. Hard money loans are usually short term loans where the lender charges a much higher interest rate because of the higher risk nature of the loan. Hard money loans are typically at a much lower Loan-to-value ratio than conventional mortgages.
Some real estate investment organizations, such as real estate investment trusts (REITs) and some pension funds and Hedge funds, have large enough capital reserves and investment strategies to allow 100% equity in the properties that 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.
With the signing of the JOBS Act in April of 2012 by President Obama there has been an easing on investment solicitations. A newer method of raising equity in smaller amounts is through real estate crowdfunding which pools accredited investors together in a special purpose vehicle for all or part of the equity capital needed for the acquisition.
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, and other items of that nature (debt service is not factored into the NOI). The ratio of NOI to the asset purchase price, expressed as a percentage, is called the capitalization rate, or CAP 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.
Management and evaluation of risk is a major part of any successful real estate investment strategy. Risks occur 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.
|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.|
Some individuals and companies are engaged in the business of purchasing properties that are in Foreclosure. A property is considered in foreclosure when the homeowner has not made a mortgage payment for at least 90 days. These properties can be purchased before the foreclosure auction (pre-foreclosure) or at the foreclosure auction which is a public sale. If no one purchases the property at the foreclosure auction then the property will be returned to the lender that owns the mortgage on the property.
Once a property is sold at the foreclosure auction and the foreclosure process is completed, the lender may keep the proceeds to satisfy their mortgage and any legal costs that they incurred. The foreclosing bank has the right to continue to honor the tenants lease (if there is a tenant in the property), but usually 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.
U.S. foreclosure activity dropped to a 74-month low in April 2013, with 144,790 properties with foreclosure filings. Although still about twice as high as the average 75,000 per month in 2005, it was 60 percent below the monthly peak of more than 367,000 in March 2010. - See more at: http://www.inman.com/2013/07/09/the-foreclosure-crisis-is-over/#sthash.eNrqJEjm.dpuf, 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.