Real Estate Investing: Benefits & Risks

Michael Fenn

Many people chose to invest their money in real estate hoping for a return on their invested capital. Real estate is a popular investing tool because it has many advantages. A few being; monthly cash fl0w, tax shelter and leverage to name a few. Every investment comes with risk and real estate has its own set of risks. Some things to take into account when investing in real estate are the different types of risk associated. These are; management risk, inflation risk and financial risk.

Monthly cash flow is very attractive to many people looking to invest in real estate. As our textbook states “cash flow is generally an important benefit to most real estate investors” (Diaz & Hanz pg 234). Not all properties have the ability to generate great cash flows. When looking to invest in real estate for monthly cash flows the best market to look into is multi family and warehouse properties. For these have better potential to give larger monthly cash flows. The definition of cash flow is “the excess of cash revenues over cash outlays in a give period of time (not including non-cash expenses)” www.wordnetweb.princeton.edu. A cash flow is what money is left over after paying the debt service, which is the mortgage and interest expense on the loan. Other expenses and factors that need to be taken into account are vacancy and credit loss and operating expenses. What most investors should include in their cash flow account is a reserve account. Many serious investors have such an account which helps pay for improvements and replacements. Real estate is a depreciating asset, which means that often appliances and parts of the house need to be kept up or replaced frequently. Accounting for replacements is very important because it represents the true value of money left in the investor’s pocket.

Investing in real estate also offers tax shelter, our assigned reading puts it best “ Tax shelter is a reduction usually mortgage interest and tax depreciation for real estate investments, in taxable investment income.” ( Daiz & Hanz pg. 237). This gives real estate investors another advantage when putting their money into investment properties. Real estate allows investors to get deductions in taxation and mortgage interest. When an investor gets mortgage interest deduction he dose not have to pay taxes on the interest that he pays on the debt service. Taxation depreciation is considered to be the only true deduction because the investor does not have to pay taxes on the yearly depreciation amount. A real estate investor is able to deprecate the improvements on the land, which in most cases is the building.

A very unique aspect of real estate investing is leverage. Which is “borrowing money to finance the purchase of assets.” http://biztaxlaw.about.com. This quote from an online blog simply explains how leveraging works. An investor is able to borrow a large amount of money relatively easily and be able to create a monthly cash flow. The investor must be able to calculate whether or not the investment will have a good spread in order to get the highest return. A spread is “the difference between the return on the underlying assets and the cost of borrowed funds” ( Diaz & Hanz pg.241).

Along with all the great benefits that are associated with investing in real estate there are great risks that need to be accounted for and assessed before spending any money on an investment. For many investors who have multi family properties, managers are utilized to collect rents checks and maintain the property. Since real estate is very people oriented the investor must chose a reliable manager in order to mitigate manager risk. For if he chooses the wrong manager the investor runs the risk of receiving “ subpar managerial performance in turn lowering the investor’s expected return” (Diaz & Hanz pg. 232). Fees are attached to hiring manager but for some investors these fees are warranted.

For the short term investor inflation risk is important to look out for. Inflation risk is “ the risk that the purchasing power of the investment incomes and values does not keep up with the cost of other goods and services” ( Diaz & Hanz) pg. 233). In other words a property that does not generate enough income to stay ahead of inflation will fall victim to inflation risk. If an investor finds them self in a property that is not staying ahead of inflation they must shed this asset as quickly as possible.

Another serious risk that investors must look out for is the financial risk. The financial risk is when an investor has a shortcoming in cash flow due to vacancies or sub market rents. Causing the investor to not be able to make his debt service payments. This is very dangerous for an investor for if he does not pay his debt service on time he can lose the asset and mar his credit score.

Sources:

Murray, Jean. "What Is Leverage - Leverage Definition." Small Business Law - Filing Business Taxes - Taxes and Legal Issues for U.S. Small Business. Biztaxlaw.about.com, 12 Sept. 2006. Web. 22 Mar. 2011. .

Www.wordnetweb.princeton.edu. 13 Mar. 2009. Web. 19 Mar. 2011. .

Diaz, Julian, and J. Andrew Hanz. Real Estate Analysis Environments and Activities. Dubuque: Kendall Hunt Pub, 2010. Print.