REASONS WHY TO INVEST IN REAL ESTATE
Investing in real estate is a very challenging business. Although the required knowledge is not so difficult to acquire, it would still take lots of actual experiences to be completely confident in making investment decisions. This short seminar intends to serve as an eye-opener for new and prospective investors in real estate. We will try to present a preview on the various real estate investment opportunities and techniques and the required subjects or topics that are needed to be learned.
WHAT COULD MOTIVATE AN INVESTOR TO MAKE A PARTICULAR INVESTMENT? IT COULD BE ONE OR A COMBINATION OF THE FOLLOWING:
- Maximum current income
- Future income
- Protection from inflation
- Decreased or postponed income taxes
- Capital gains
- Safety of principal
- Least supervision
- Pride of ownership
WHY REAL ESTATE?
- YOU HAVE DIRECT CONTROL AND MANAGEMENT OVER YOUR INVESTMENT.
Compared to other investment alternatives, real estate allows you to have direct control and say in the business operation. For example, when you buy a stock, you are not free to act on anything that will improve your return. You simply become a passive investor. While in real estate, taking rental apartment as an example, you are the decision maker as to rent, tenant selection, maintenance policy and others that could positively affect your income.
- REAL ESTATE INVESTMENT OFFERS OPPORTUNITIES FOR HIGHER RETURN
If you are knowledgeable investor in real estate, you are compensated for the various risks that are associated with investing in real estate. Successful management of these risks will result to higher return than that of other investment alternatives.
Also, in real estate investment, the opportunity for sudden and an abnormally high return is always present. This will be fully discussed in the later topics.
- REAL ESTATE INVESTMENTS APPRECIATES NATURALLY.
Because of inflation, your real estate investment appreciates by itself, even without any change or improvement being introduced in the property except of course regular maintenance and needed repairs.
Another reason for the normal appreciation of real estate is the continuing growth in the demand for real estate as the population increases.
Another one is the continued improvement and development within the location of the property.
- DEPENDING ON SOME SITUATIONS, YOU ONLY NEED SMALL CAPITAL.
Take the case of some bank-acquired assets that are now being offered for sale at 10% down payment. For a small percentage amount of only 10%, you can take over a property, improve it and rent it out. Your exposure to the investment is only 10% plus any improvement that is needed and any negative cash flow in the future that would be required to amortize the 90% balance.
Of course some questions may arise as to the profitability of this highly-leveraged investment, but the point here is the possibility of going into real estate investment with little capital.
Of course there are more profitable examples than the above that would be discuss as we go on.
- THE KNOWLEDGE REQUIREMENT IS VAST BUT NOT DIFFICULT TO ACQUIRE
As i said, the knowledge requirement for real estate investment is son enormous and varied that many prospective investors are deterred in proceeding to actual investment. However, this knowledge can be gradually and easily acquired through reading related books, attending real estate seminars, or partnering with knowledgeable real estate professionals or other investors with experience.
- REAL ESTATE INVESTMENTS ARE ACTUAL PHYSICAL ASSETS.
Cash, deposit certificates and shares of stocks are all “pieces of papers”. In a worse scenario, all of these can be worthless, destroyed or lose. Remember the Japanese money during the war? Real estate, on the other hand, is a real existing physical asset that can be of use in many adverse situations.
Before we move on, I must mention here some precautions or mistakes that you should be aware of before investing in real estate. Some are listed below:
- The tendency to invest all capital leaving no cash reserve (liquidity) – the cash placed in real estate investment cannot easily be converted back to cash and if it can be, incurring big expenses or losses is unavoidable.
- The tendency to speculate – never be enticed to invest in real estate if the only reason would be the tip or information that prices would increase abnormally. Speculating is not only during buying. In holding on to their properties, owners are actually anticipating increase in value.
- The tendency to borrow too much – as you will learn later, it is in real estate that it is easy to get loans because of its collateral value. However, this is also the frequent reason for failure.
- The tendency to be in a hurry to invest. Never think that you will run out of investment opportunity. But, on the other hand, don’t be too slow.
- The tendency to fall in love with your property. Sell as soon as it is time to sel. Do not hold on to your property without valid business reasons.
- The tendency to over-improve. This is also a frequent reason for failure for many starting build and sell.
- The tendency to do all and keep all income.
- The tendency to be 100% sure. After this seminar, give another six months to continue learning. After that you should be making your first venture. You don’t need to know all, you need to take a little gamble.
- The tendency to quit in the middle of the game. Not really wrong if you feel real estate is not really for you. However some quit because of over expectation in the business of real estate.
- The tendency to believe that they will make good in real estate just because somebody else made money in real estate. In real estate, it is big mistake to think that what happened yesterday in a given scenario will happen again in the future.
- The tendency to invest even if still unprepared. Lack of education and experience. Thinking and saying that learning is waste of time and money, and that to profit in investing in real estate is simply finding a good deal and learn alone the way.
AREAS OF INVESTMENT OPPORTUNITIES AND TECHNIQUES IN REAL ESTATE
BUY AND SELL
Just like any buy and sell operation, the key to your profit is by buying below market value. You must possess a strong resistance from buying if it is not within your price. You should not be in a hurry to buy. Your money must be placed somewhere where such as a time deposit earning interest income while you are waiting or looking for the right property to buy. Usually, to simplify operation and avoid going into the intricacies of managing improvements, vacant lands are preferred rather than land with improvement. But as explained later, lands will qualify under this scheme only if they are real bargains. The expertise required is more on property valuation and some legal knowledge. The investor must possess the skill in negotiating for the buying stage and marketing and salesmanship, for the selling stage.
As to investment period – what is the investor’s objective
- Buy and immediately sell (flipping)
- Buy, hold and sell later
- Buy and forget
As to type of property
- Land only without improvement
- Land with improvement
BUILD AND SELL
The build and sell business is a very attractive investment alternative because of the high return it could yield. The process here appears simply as finding vacant lands at reasonable prices; determine the appropriate improvements to be built and marketing the units, either before during or after construction. However, would it builders should be aware of some common mistakes or disastrous eventualities.
THE REHAB BUSINESS
Rehabilitating old houses and apartments is one area of real estate investment that offers greater opportunities for bigger profit. The process involves looking for properties for sale whose prices are reasonable enough to allow an acceptable profit after repair and restoration works. Remember that you are buying properties for resale for profit afterwards, not as an ultimate owner. The process may seem simple but again, it is not.
In the previous scheme, always consider leasing the property as a possible alternative to selling and while on the leasing stage, keep an open mind on selling the property especially if the selling price is very attractive. There will be situations when leasing your property will give a better return than outright selling. Although leasing demands additional knowledge and skills like property management, some could be delegated to hired professionals.
Before you go into leasing your property, verify first the comparable rent your property will command from here, you can compute your net cash flow after tax. Applying the Net Present Value method, you can now determine which of the two selling or leasing would be more profitable. From time to time, the same analysis can be performed based on the actual return the property is bringing in. In the event that the price that the property could be sold is higher than the net present value of future net cash flow, then sell!
What to convert
- Apartments to townhouses or condominium units or office spaces
- Gasoline stations to retail outlets
- Old homes to office spaces
- Warehouses to badminton courts or other sports facilities
Steps in conversions of old homes to offices
- Secure a zoning map of your prospect location or city
- Target a residential home located in an area already rezoned as commercial
- What to check before converting apartments office spaces
- Is the location zoned already as commercial?
- Be sure that there is a high occupancy rate in the area
- Adequacy of parking space
- Is it profitable to convert
Developing small vacant lands
Advantages – there is an advantage in developing small lands:
- Faster turnaround of the project
- Lass rules to follow
- Less capital intensive
Disadvantages – economy of scale:
AN INTRODUCTION TO INVESTMENT ANALYSIS
Whenever an investor is confronted with an investment proposal or opportunity, one of the questions that had to be answered is “ Is this prospective investment acceptable”. The answer to that question depends on the investment objectives of the investor and/or his personal circumstances including that of his money and his perception of the risks involved in the proposed investment. While many investors hastily jump to conclusion primarily on “gut feel” or hunch and still manage to profit from the investment, none is better than conducting a thorough investment analysis. In many cases, the real reason to those who relied on their hunch or gut feel is they do not know how to do an analysis of the proposed investment.
Many of the real estate investment failures were due to situations like the following:
- Some projects were started even in the absence of assurance of full financing relying on other means of raising funds such as pre-selling.
- Some loans were granted and accepted with short loan period imposing periodic payments early on the project, and not as development loan in real sense.
- Loans were secured and granted without even thorough looking into the projected cash flow of the project, and in some cases, the net cash flows were overstated. Lenders simply depended on the collateral value.
- Sensitivity of the project’s income to some factors was ignored or omitted
- Some projects were conceptualized on hunch or gut feel
- Some investors simply joined the bandwagon
Analysis of real estate investments is the process of determining the acceptability of a proposed real estate investment according to the expectation of a specific investor. It also involves the detailed comparison of the expected benefits against all the risk. In the process, some assumptions are to be made. Optimistic assumptions will make the investment looks very acceptable jeopardizing the investor while good business opportunities may be lost by making pessimistic assumptions. Comparatively, real estate investment analysis is more complex than of other investments so much that it requires a lot knowledge and experience.
A Rate Of Return analysis (also called overall rate of return method)
In this method, the rate of return is calculated as the ratio of net operating income to capital or purchase price. This method is acceptable only in having a rough idea of the investment return and not for a complete analysis of the proposed investment.
DEFECTS OF RATE OF RETURN METHOD
- It implies that the property is held to the end of its economic life, say 25 years
- It assumes that the property is purchased for cash
- It makes no allowance for the effect of net income taxes on investment decisions
- It unrealistically calculates net operating income over the building life
- It makes no allowance for the possibility of capital gains or losses
- It assumes that the overall of return on invested capital is more important than the rate of return on equity
NET PRESENT VALUE METHOD
The Net Present Value method involves the discounting of the cash flows to present value at a given interest or discounting rate. The resulting present value of the inflows or benefits is then compared with the present value of the outflows or cost. If the present value of the inflows is more than the present value of the outflows, the proposed investment is acceptable. Otherwise, it will be rejected because it means that the investment proposal failed to satisfy the expected rate return (hurdle rate) of the investor, which is the same rate used as the discounting rate.
The only problem is the determination of the discounting rate. What discounting rate is to be used? It is this discounting rate that determines the acceptability or otherwise of the investment proposal.
APPLICATION OF THE NET PRESENT VALUE
Net Present Value Method helps in calculating an accurate maximum price for a proposed investment with a specified expected rate of return or given the price, the minimum rent income of the subject income property can be calculated ad then compared to prevailing economic rent in the area to determine the acceptability of the investment proposal. In other words, the value of every kind of property held for investment purposes is the present worth of all future net benefits.
PROJECTED CASH FLOW
Cash flow is the summation of income and expenses on per period basis. In a particular period, say monthly, there is positive cash flow if income is more than expenses, and it is negative cash flow if expenses is more than income.
STEPS IN PREPARING CASH FLOW FOR RENTAL PROPERTIES
- Estimate net operating income ( gross income –expenses e.g. administrative, operating, maintenance, property tax, percentage tax, insurance)
- Deduct interest expenses and depreciation to get taxable income (this is done only for the determination of the taxable income)
- If taxable income is positive, calculate the tax and subtract the tax from net operating income to find the after tax income. If taxable income is negative (tax shelter) multiply the tax shelter by the tax rate to get the tax benefits and add the tax benefits to the net operating income.
- Deduct the mortgage payment to determine cash flow. (This is now an after-tax cash flow)
- Determine the present worth factor for each year for a specified interest or discounting rate.
- Multiply the periodic (annual) cash flow by the Present Value Factor to determine the present worth of the annual cash flow
INTERNAL RATE OF RETURN METHOD
The internal rate of return is the discounting rate applied to the cash flows to which the present worth of all the future benefits will be equal to the original amount of investment or that rate of interest that equates the present worth of the outflows with present worth of the inflows.
Want to know more about real estate investing? please read our related article on why invest on real estate in the Philippines here.