By Jon Hardamon
Real estate investing involves the purchase, ownership, management, rental and/or sale of real estate for profit. Real estate is considered an asset with limited liquidity in comparison to other investments. It is also very capital intensive and is highly cash flow dependent. In order to be successful in real estate investing, these factors must be very well understood and managed by the investor, otherwise, real estate becomes a very risky investment. The primary cause of investment failure for real estate is that the investor goes into negative cash flow for a period of time that is not sustainable. This results in the investor having to resell the property at a loss.
Real estate markets aren’t as organized or efficient as markets for other, more liquid investment opportunities. Individual properties are unique and not directly interchangeable, which presents major obstacles 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 vary widely depending on knowledge of availability. The inconsistency of knowledge among the differing competitors in a real estate market increases transactional risk, but also provides many opportunities for investors to obtain properties at bargain prices. Real estate investors typically use a variety of appraisal techniques to determine the value of properties prior to purchase. Typical sources of investment properties can include real estate agents, private sales, public auctions, wholesalers (bank,
real estate owned departments and public agencies), and market listings.
According to Diaz and Hansz’s Real Estate Analysis: Environments and Activities, once an investment property has been located, preliminary due diligence must be completed. Afterwards, the investor will have to negotiate a sale price and sale terms with the seller, then a contract for sale can be drawn up. Most investors use real
estate agents, as well as real estate attorneys to assist with the acquisition process, due to the complexity and costliness of improperly executed transactions. According to Diaz and Hansz’s Real Estate Analysis: Environments and Activities, during the acquiring of the property, an investor will typically make a formal offer to buy including payment of “earnest money” to the seller at the start of negotiations to reserve the investor’s rights to complete the transaction if price and terms can be agreed upon. Earnest money may or may not be refundable, because it is considered to be a signal of the total commitment of the investor to purchase the property. Although, the terms of the offer will also usually include a number of contingencies which allow the investor time to complete due diligence and obtain financing among other requirements prior to final purchase. The investor usually has the right to rescind the offer with no penalty and obtain a refund of earnest money deposits within a specified contingency period.
Since real estate assets are typically very expensive, real estate investors will usually finance a large portion of the purchase price using some sort of financial instrument or debt, such as a mortgage loan collateralized by the property itself. The amount of the purchase price that is financed by debt is called leverage. The amount that is financed by the investor’s own capital is referred to as equity. The ratio of leverage to total appraised value (referred to as loan to value, or “LTV”) is the mathematical measure of the risk an investor is taking by using leverage to finance the purchase of property. Real estate investors usually seek to decrease their equity requirements and increase their leverage to maximize their return on investment (ROI).
Lenders and other financial institutions usually have minimum equity requirements for real estate investments that they are being asked to finance. Typically, these requirements are on the order of 20% of the appraised value. There are other means of finding alternate financing arrangements that investors can look if they are seeking low equity requirements, such as seller financing, seller subordination, and private equity sources among others. By leveraging the purchase of an investment property, the required periodic payments for the debt create an ongoing negative cash flow beginning from the time of purchase. To be successful, real estate investors must manage their cash flows to create enough positive income from the property to at least offset the these costs.
There are various strategies and methodologies for creating wealth through properties, but the principles of real estate investing remain the same. Investors should always buy property for capital appreciation. Real estate first and foremost is a capital business. Rent and cash flow are important to help you keep the property for the long term. What some people don’t realize is that the popular assumption of “house flipping will make me rich,” is untrue. Flipping properties is used to generate cash to fund an investor’s long term investments and should not be confused with the long term goal of creating wealth through capital appreciation. Investing in real estate is not a get rich quick scheme. Capital appreciation happens over a period of time. Patience, perseverance and persistence, as well as the understanding of the compounding power of real estate investing is needed.
There are many other factors that come into play when dealing with real estate, such as location, mortgage loan interest rates, acquiring properties from motivated sellers, making good use of the property cycle at advantageous points, knowing which property is the correct property to acquire as part of your purchasing strategy, the importance of having a supporting cast to help with maintenance and legal matters relating to the investor’s property, etc. Proper planning and having a sound real estate strategy can turn a risky investment opportunity into a very profitable one.
Diaz III, Julian, and J. Andrew Hansz. Real Estate Analysis Environments and Activities. Kendall Hunt Pub, 2010. Print.
Holmes, Tamara E. "Now Is a Great Time to Invest in a Rental." Realestate.msn.com. Web. 08 May 2011.
"Homes in Foreclosure up 79% in '07." Inmen News, 29 Jan. 2008. Web. 08 May 2011.
Portman, Janet. "Foreclosure Causes Heartache for Renters." Inmen News, 07 Feb. 2008. Web. 08 May 2011.
"Real Estate Investing - Basic Principles You Should Never Forget." Http://www.real-estate-investment.net/. Web. 08 May 2011.