Investing in real estate is no easy feat. Despite the many glamorized television shows touting the seemingly “simple” process of buying and selling real estate properties for a quick buck, there is far more that happens when it comes to investing in real estate than these shows portray. For one thing, investing in real estate takes a tremendous amount of research and due diligence, especially for investors who are considering buying a property that they are not entirely familiar with.
To offer some guidance in your investing decisions, this article will lay out the key factors every investor should consider before they invest in real estate:
Determine How Much Risk You Are Willing to Take On
Any investment involves risk. Although it comes in many forms, there are five primary risk types that should be considered when determining how much you can take on. They are:
- Tenant Risk
- Financial Risk
- Market Risk
If you are risk-averse, you may want to consider investing in a property with an investment grade tenant, or in a market with significant demand employment drivers. While there is always risk when investing in real estate, knowing that a tenant or market is stable can help mitigate the inherent risk of the investment.
Determine Your Investing Objectives
Everyone’s investing objectives are different. Some choose to be very aggressive in their investing approach and buy and sell quickly. Others prefer a slower, more conservative approach that has the potential to provide a steady flow of income. The appreciation approach to real estate refers to buying a piece of property for a certain amount (say, $400,000), holding onto it for several years, and then selling it for a profit down the line (perhaps for $600,000). The property may appreciate due to a variety of factors, such as the demand for real estate in the neighborhood going up or a significant increase in net operating income.
The steady income (or cash flow) method involves collecting rental income from a stabilized property or a property with tenants that are financially stable or investment-grade each month to cover the mortgage payment, insurance, taxes, maintenance, etc. In doing so, the investor makes a steady profit on the building month-over-month. It is imperative to do careful research on every tenant and ensure that they are in strong financial standing so that you do not run the risk of bringing on a tenant who cannot meet their monthly rental requirements.
As a note, a stabilized property is when a property’s rental rates and occupancy have achieved levels similar to market or submarket. These types of properties are usually characterized by having very little turnover. Stabilized properties have the potential to provide a consistent flow of income. However, this is not a guarantee. Real estate properties come with their own set of risks. Properties can also depreciate, resulting in a lower sales price than the original purchase price. While a property might be considered stabilized, it is no guarantee of income.
A common appreciation-oriented investment is taking on a value-add project, which typically requires renovation or redevelopment to bring the property to a higher price point. The value-add strategy is considered to have medium to high risk, but there is potential for attractive risk-adjusted returns. Investors who are interested in taking the value-add approach should carefully consider the market where they wish to build. If several new buildings have gone up in the area and there are a lot of options for tenants to choose from, there may be a greater risk of several units in your building sitting vacant for extended periods of time.
Like all other investments, real estate is privy to the whims of supply and demand. It is important to understand that there is never a guarantee of sale, and that both nature and human purchasing behavior are unpredictable. Therefore, just as with all other investments, investors should exercise caution and wisdom in their decision-making process as they invest in real estate.
Determine the Investment Type: Direct or Indirect
Two investment approaches can be made when purchasing real estate: direct and indirect. Direct property means that you are purchasing and maintaining physical real estate, such as a multifamily building or retail space. Indirect property, on the other hand, means that you are not directly responsible for managing and maintaining the property. Investing in a real estate investment trust (REIT) or Delaware Statutory Trust (DST) is an example of owning indirect property, because investors own part of a company or trust which in turn owns and manages a portfolio of real estate. When investing in a REIT or DST, read the fine print to ensure you understand all of the fees inherent to this investment approach, as investing in a REIT typically involves paying several broker fees over the length of the investment.
Do Your Due Diligence
Conducting due diligence involves carefully researching four important factors: the property’s geographical location, the property type, the operator, and the property’s historical performance. Unfortunately, determining a property’s performance can be tricky, as this information isn’t usually publicly available and may be challenging to find. Prior to purchasing an investment property, it is recommended to speak with an investment professional to discuss your options. Conduct thorough research online as well and learn the pros and cons of the particular asset class you’re interested in investing in and study which asset classes are currently over performing and underperforming. It is also recommended to ask for the property’s operating statements. If the property has tenants in place, how long have they been renting in the building? What are the building’s expenses? What are mortgage rates like? How have other buildings in the neighborhood performed year-over-year? How much are they selling for? Have they increased in value?
Understand Leverage and Risks... and Be Patient
Leverage refers to borrowing money to fund a real estate purchase. Taking out a mortgage from a bank is an example of using leverage. Although this may come as a surprise, having some debt can potentially help the investor make even more money than they would if they owned the property in full.
Here’s an example to illustrate: Let’s say you have the option to own a $100,000 property outright (no debt), or take out a mortgage for $50,000 and only contribute $50,000 in equity to purchase the property (50% loan to value). If the property appreciates to $110,000 next year, the unlevered purchase will see a return on investment of 10%, while the leveraged purchase will have a return on investment of 20%! Leverage has the ability to magnify returns, but unfortunately the ability to magnify losses as well. If the property depreciated by $10,000, the unlevered return would be -10%, while the levered return would be -20%, all else being equal.*
Something else to consider: if you choose to take on debt, you may be able to reap the tax benefits of decreasing taxable income through mortgage interest deductions.
As with any investment, there is the potential to lose all of one’s investment. There is always the possibility that the sole tenant leaves or that a natural disaster strikes your investment property. It is important to make sure you have sufficient capital reserves or cash in the bank in case unexpected costs arise or you are unable to service debt through cash flow.
Being patient is integral to investing in real estate. Real estate is meant to be a long-term investment – it is not something that you buy and then sell for a generous profit several months later.
While investing in real estate can potentially be a lucrative investment option, it is important to conduct careful research when considering an investment and account for the various costs involved. Along with the key points mentioned here, speaking with an investment professional is one of the best ways to get started on the process when determining if you are ready to take the leap into real estate investing.
*Return on investment is calculated by taking the gain or loss in value divided by the initial equity amount invested.