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Do you have what it
takes to become a successful real estate investor?
With most real estate markets around the nation
recovering from the dramatic price decreases that
occurred from 1989 to 1993, many individuals are
considering making direct investments in real estate
again. As the stock markets spiral ever higher,
reasonably-priced equities are getting harder to find.
With real 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 help you decide whether it is for you,
the Almanac put together these questions for the
potential investor to contemplate. If you can honestly
answer yes to each question, then real estate
investing may be for you.
Are you patient enough to own a long-term,
illiquid investment?
Owning investment real estate is not like owning a
stock or bond. Real estate must be purchased as a
long-term investment for two reasons. First, real
estate prices do not move quickly in most markets.
Very rarely will an investor be able to purchase a
property in January and sell it in June for a profit.
Second, selling a property almost always involves a
relatively long period of time and substantial
transaction costs. An investor who purchases a
property can not call their broker and sell it in one
day. Often three months to a year is needed to sell an
investment property. On the positive side, the gains
from profitable real estate transactions can be much
higher than for most other types of investments.
Are you ready to be an "active"
investor?
A stock investor in a nationally listed company
purchases shares and patiently waits for dividends and
increases in stock prices. For real estate investors,
they have essentially bought a business that involves
renting space to tenants. Too many over-eager
investors buy real estate and completely underestimate
the work involved to support the investment. This work
includes marketing to tenants, property management,
capital investment planning, complying with building,
zoning and environmental codes and a host of other
functions. In most cases, investors can hire a
property manager to handle these tasks, but they can
charge up to 10% of gross rents and still are
essentially 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 substantial control
over the success or failure of the investment.
Will you be comfortable with large debts
supported by your real estate investments?
Some investors shun debt like the plague. For them,
real estate may not be an appropriate investment
vehicle. Because even the smallest real estate
properties are too large for all-cash purchases, most
investors must obtain financing for some or most of
their purchases. On the down side, the investor is
responsible for these debts no matter how well or how
badly the property may make or lose money. If a
property purchased for $150,000 with $30,000 down and
a $120,000 mortgage goes down in value to $100,000,
the investor could 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 values eventually rebounded could the investment
be preserved.
On the other hand, using the leverage of debt
financing (i.e. investors leverage their small down
payment to purchase a large property using a
mortgage), a relatively small investment can yield
large returns. Take the example of an investor who
purchases a $200,000 property with $40,000 down. If
the property 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% annually from the equity appreciation
alone. To this return must be added the annual income
(if any) and the value of depreciation tax benefits.
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 from a
loser. Buying right is probably the most important
part of insuring a good, 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 dependent upon its location, zoning
classification and will fluctuate according to
economic factors outside the control of the investor.
Building, within local zoning and building codes, can
be managed and improved to increase the value of the
overall property. Real estate investors must develop a
good instinct for not just what a property is worth
today but also what it could be worth with appropriate
investments to improve the buildings on the land.
Equally important, investors must determine the
profitability of each investment, as net cash flow
before financing costs dictates the market value of
commercial real estate investments.
Can you handle the additional responsibilities
of dealing with tenants?
If owning real estate is essentially equivalent to
owning a business, then tenants are your customers. In
addition to having to conduct a marketing effort to
attract renters, real estate owners become
contractually obligated to provide space to their
tenants. This responsibility occasionally manifests
itself in the form of 2 a.m. emergency plumbing calls,
evictions and other problems that occur with tenants.
Although most problems are manageable, they can take
time to solve.
By Michael Licamele
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