by Joseph Maas
Real estate is an important part of an investment portfolio’s asset allocation because it contributes to an overall reduction in risk and can provide significant portfolio growth.
The direct ownership of real estate is appealing because of its favorable risk-return tradeoffs and the relatively inefficient markets in which real estate trades. Real estate markets are unlike securities markets in a particularly unique way: while securities markets transact business in a central marketplace like the New York Stock Exchange with complete and accurate information available to both buyers and sellers, real estate is traded in generally illiquid markets that are regional or local in nature, and the value of the property is based on a variety of subjective factors. Skillfully conducted real estate analysis can identify investment value that can produce a generous return.
Your Investment Objectives
As a real estate investor, your primary focus must begin with your investment objectives. Not only must you determine your desired return on the property and the amount of investment and ongoing costs you might have during the duration of the period you hold the property, but you must also carefully consider the type of real estate you’re most comfortable owning.
- Income-producing property includes residential rentals and multi-family properties such as apartments.
- Commercial properties like office buildings and shopping centers.
- Speculative property can be raw land, and real estate that’s expected to grow in value because of its location, scarcity, etc.
Managing the Property…and Your Financial Investment
Carefully consider your role as the property manager and ask yourself these questions.
- If you choose to invest in income-producing property, how much rent should you charge?
- How much do you intend to spend on maintenance and repairs?
- Are all the property rights yours, or are they shared, such as with an easement?
- Do you see any near-term adverse environmental issues?
- Will real estate market changes favor your ownership?
- What are the macro and micro issues that could affect your investment?
Then, when examining the risk-return relationship of a real estate investment, you must find the following factors acceptable:
- How much money are you willing to allocate to the real estate portion of your portfolio?
- Will you be using debt financing?
- Do you require positive cash flow?
- How much down payment is required?
- How do the monthly mortgage payments and annual property taxes compare with the property’s potential appreciation?
When considering a real estate investment, you also need to calculate the effectiveness of your repair skills and your personal temperament for management, or plan to contract for the services at a cost. Your decision to purchase a trouble-free building with curb appeal versus your preference for a fixer-upper is a decision that sets your course.
The Four Features of Real Estate Investments
Here are four of the primary characteristics on which to base your real estate analysis.
- Physical Property
Through proper inspection of the site and its building(s), make sure you’re buying what you think you’re buying. Acquire a site survey, an accurate square-footage measurement, and an inspection of the building(s). Confirm that the purchase and sale agreement accurately identify the real estate with its legal description and that documentation lists all items of personal property you expect to receive (such as a refrigerator).
- Property Rights
When you buy real estate, you’re really buying a bundle of legal rights bound by documents such as deeds, titles, easements, liens, and encumbrances. Do a careful legal inspection with your attorney. Real estate and lease agreements should not be the work of legal amateurs.
- Holding Period
When evaluating your time horizon, remember that the real estate market goes through cycles just like other markets, and you need to identify which cycle the market is currently in. Prices go up and down slowly and quickly, so before judging whether prices will appreciate or depreciate, understand the property relative to the present cycle.
For some properties, the area of greatest interest and market value factors consists of a few blocks while for others, an area of hundreds of square miles is the relevant market area. Understand the boundaries that are important for your investment so you can wisely analyze supply and demand.
The Property’s Value
There are four key determinants of value that guide your evaluation of a real estate investment.
Demand measures people’s desire to buy or rent a property at a specific time, and stems from a market area’s economic base. Property values follow an upward path when employment is increasing, and values typically decline when employers lay-off workers. Population demographics and people’s emotional dispositions, called psychographics, are also key elements of demand.
How many similar properties (competitors) are available in your targeted area? Consider the competition. More properties on the market mean lower value; the fewer properties, the higher the value. Are there other properties that can fill the same need? If so, there is more supply.
- The Property
The property itself is an essential factor. Determine a property’s unique selling advantage. What makes it different? What is its competitive edge? Investors should consider these five factors:
- Restrictions on the use of the property
- The location
- The size and quality of the site
- Improvements that have been made…or need to be made
- The efficiency of management
- Property Transfer Process
This is the process of marketing the property, and the negotiation between the buyer and seller, which can significantly influence the cash flows a property will provide.
Summarizing the Process
Once you’ve gathered all the pertinent valuation determinants, you can now perform your valuation and investment analyses, interpret your results, and make a portfolio decision.
Here are the five broad steps to follow when purchasing real estate for investment:
- Set objectives, goals, and constraints
- Analyze important features of the property
- Gather determinants of value
- Perform analysis
- Implement your decision
Real estate investment can be a very lucrative activity when engaged with careful analysis and planning, diversifying your portfolio so you can achieve your investment goals and secure a comfortable financial future.
To learn more about Joe Maas, view his Paladin Registry research report.
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