Do you have what it takes to become a successful real estate investor?With most real estate markets around the nation recovering from the dramaticprice decreases that occurred from 1989 to 1993, many individuals are consideringmaking direct investments in real estate again.
As the stock markets spiralever higher, reasonably-priced equities are getting harder to find. Withreal estate, individual properties can over time yield substantial returns.In addition, real estate investments offer tax savings that can boost returns.
Real estate is much different from any other type of investment. To helpyou decide whether it is for you, the Almanac put together these questionsfor the potential investor to contemplate. If you can honestly answer yesto each question, then real estate investing may be for you.
Q: Are you patient enough to own a long-term, illiquid investment?
Owning investment real estate is not like owning a stock or bond. Realestate must be purchased as a long-term investment for two reasons. First,real estate prices do not move quickly in most markets. Very rarely willan investor be able to purchase a property in January and sell it in Junefor a profit. Second, selling a property almost always involves a relativelylong period of time and substantial transaction costs. An investor who purchasesa property can not call their broker and sell it in one day. Often threemonths to a year is needed to sell an investment property. On the positiveside, the gains from profitable real estate transactions can be much higherthan for most other types of investments.
Q: Are you ready to be an “active” investor?
A stock investor in a nationally listed company purchases shares andpatiently waits for dividends and increases in stock prices. For real estateinvestors, they have essentially bought a business that involves rentingspace to tenants. Too many over-eager investors buy real estate and completelyunderestimate the work involved to support the investment. This work includesmarketing to tenants, property management, capital investment planning,complying with building, zoning and environmental codes and a host of otherfunctions. In most cases, investors can hire a property manager to handlethese tasks, but they can charge up to 10% of gross rents and still areessentially independent contractors who must be managed like employees.The need for additional labor required for real estate investments is counter-balanced,of course, by the fact that active participation gives the investor substantialcontrol over the success or failure of the investment.
Q: Will you be comfortable with large debts supported by your realestate investments?
Some investors shun debt like the plague. For them, real estate may notbe an appropriate investment vehicle. Because even the smallest real estateproperties are too large for all-cash purchases, most investors must obtainfinancing for some or most of their purchases. On the down side, the investoris responsible for these debts no matter how well or how badly the propertymay make or lose money. If a property purchased for $150,000 with $30,000down and a $120,000 mortgage goes down in value to $100,000, the investorcould not only lose the $30,000 investment but could also lose $20,000 more.Only if the investor was not forced to sell and could wait until valueseventually rebounded could the investment be preserved.
On the other hand, using the leverage of debt financing (i.e. investorsleverage their small down payment to purchase a large property using a mortgage),a relatively small investment can yield large returns. Take the exampleof an investor who purchases a $200,000 property with $40,000 down. If theproperty breaks even for three years and increases in value by only 10%over that time, the borrower can sell the property for $220,000 and earn$20,000 profit (selling costs are excluded in this transaction). In effect,the investor has earned a 50% profit in three years, or 16.67% annuallyfrom the equity appreciation alone. To this return must be added the annualincome (if any) and the value of depreciation tax benefits.
Q: Are you a good judge of real estate value?
Aside from the well known keys to real estate of location, location,location, numerous other factors help distinguish a good investment froma loser. Buying right is probably the most important part of insuring agood, long-term transaction. Real estate value is made up of two basic components:land and the buildings on that land. The value of the land will be dependentupon its location, zoning classification and will fluctuate according toeconomic factors outside the control of the investor. Building, within localzoning and building codes, can be managed and improved to increase the valueof the overall property. Real estate investors must develop a good instinctfor not just what a property is worth today but also what it could be worthwith appropriate investments to improve the buildings on the land. Equallyimportant, investors must determine the profitability of each investment,as net cash flow before financing costs dictates the market value of commercialreal estate investments.
Q: Can you handle the additional responsibilities of dealing withtenants?
If owning real estate is essentially equivalent to owning a business,then tenants are your customers. In addition to having to conduct a marketingeffort to attract renters, real estate owners become contractually obligatedto provide space to their tenants. This responsibility occasionally manifestsitself in the form of 2 a.m. emergency plumbing calls, evictions and otherproblems that occur with tenants. Although most problems are manageable,they can take time to solve.
If you feel comfortable answering yes to each of these questions, thenyou are ready to take the next steps. Ask yourself these three questions:
1. What is my real estate investment strategy?
In the 1970’s, many real estate investments were primarily tax shelters.Then the tax laws were changed. In the 1980’s, the basic real estate strategywas to buy any property, hold it for a short period, then sell it for aprofit. While real estate values have recovered since the bust cycle afterthe 1980’s, price appreciation is not great enough at this point to serveas the sole reason for buying a property. Today, most investors purchasereal estate for the cash flow and net profit that the property will generateon an annual basis. As with most other investments, this strategy is usuallythe soundest. An additional element of real estate strategy is to establisha time horizon for each investment, planning for when the property willbe sold.
What type of property suits your situation and investment goals?
Most small real estate investors can not afford to purchase shoppingcenters, industrial buildings or other large properties. For many, opportunitiesare limited to two to four family properties or small apartment buildings.These properties provide space to residential tenants, who are much differentthan commercial tenants. Residential tenants require substantially moremanagement assistance than commercial tenants. On the other hand, residentialtenants are much easier to find to rent to. Other investment opportunitiessuch as raw land, condo conversions and other properties should also beconsidered.
3. Is your financial house in order?
Nearly all real estate investors will require mortgage financing fortheir purchases, and in fact financing profitable properties can substantiallyenhance the net return on a real estate investment. In order to qualifyfor investor financing, most lenders require very good credit, enough assetsto make a down payment and reserve funds available in case problems arise.Some lenders now also require that investors demonstrate property managementabilities either through experience or taking a course. Eager investorsneed to examine their finances and their skills carefully before proceedingto purchase their first income property.
Clearly, real estate investing is not for everyone. For those who jumpinto it with realistic expectations and careful planning, real estate canbe a challenging and profitable adventure.
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