Real estate investing
Real estate investing involves the purchase, ownership, management, rental and/or sale of
real estatefor profit. Improvement of realty property as part of a real estate investment strategyis generally considered to be a sub-specialty of real estate investing called real estate development. Real estate is an assetform with limited liquidity relative to other investments, it is also capitalintensive (although capital may be gained through mortgage leverage) and is highly cash flowdependent. 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 flowfor a period of time that is not sustainable, often forcing them to resell the property at a loss or go into insolvency.
ources and Acquisition of Investment Property
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 appraisaltechniques to determine the value of properties prior to purchase.
Typical sources of investment properties include:
*Market listings (through, for instance, a
Multiple Listing Service)
Real estate agents
*Wholesalers (such as bank
real estate owneddepartments and public agencies)
auction( foreclosuresales, estatesales, etc.)
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 tocomplete 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.
ources 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 loancollateralized 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 valuefor 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 costor "carry" of the investment. To be successful, real estate investors must manage their cash flows to create enough positive incomefrom the property to at least offset the carry costs.
ources and Management of Cash Flows
A typical investment property generates
cash flows to an investor in four general ways:
net operating income(NOI)
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
speculationrather than investment.
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
mitigationstrategies used by real estate investors.
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 more easily. [ [http://www.inman.com/InmanNews.aspx?ID=66028 Janet Portman, "Foreclosure causes heartache for renters", "
Inman News", Feb 07, 2008] Retrieved 24 Feb 2008] 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.
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. [ [http://www.inman.com/InmanNews.aspx?ID=65928 "Homes in foreclosure up 79% in '07", Inman News via
RealtyTrac, Jan 29, 2008] Retrieved 16 March 2008]
Cash on cash return
Creative Real Estate Investing
Off plan property
Internal rate of return
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