WHY INVEST IN REAL ESTATE?
There are numerous benefits of investing in real estate. From predictability in cash flows to excellent returns, tax advantages, and diversification, real estate is one of the most profitable ways of building wealth. There are many ways through which an investor can make money from real estate. Rental incomes, appreciations, and profits generated by business activity on the property are the most significant sources of generating profits. The benefits of investing in real estate include the generation of passive income, stable cash flows, and leverage. There are also ways to invest in real estate without owning, operating, or having to finance properties using real estate investment trusts (REITs). Investments in real estate based on loans are also beneficial as the cash flow and net income after expenses increase over time as loan payments are reduced.
People usually invest in stocks, bonds, and other assets, but investments in real estate have many additional benefits which have always made them a lucrative option. Investors in real estate make income by rentals, business activities based on the property, and appreciation over time. Land usually appreciates over time and is positively affected by developments in urban infrastructure. Rentals also increase every year allowing for a significant cash flow to be generated. Investors in real estate can also take advantage of tax breaks as loans mature over longer periods and the owner can deduct reasonable costs from his earnings such as owning, operating, and managing a property. Moreover, as one pays off his loan towards a real estate investment, it helps grow the individual in equity which can further be used to purchase more real estate. There are also many options for investing in real estate that offer diversification of the investment portfolio. Almost all assets are affected by inflation, but real estate is considered the most powerful hedge against inflation. Real estate maintains the buying power of the capital as growth in the GDP also drives more business activity and demand for real estate. Therefore, investing in real estate is among the best investment options.
Investing in real estate is a complex process that can prove to be extremely rewarding if done properly. Most of the people who invest in real estate do not take care of the steps involved in a comprehensive investment strategy. As a large sum of capital is involved even in the lowest of investment options, keeping in mind the who, what, and where of deals is particularly important. Not only does this protect the person from getting involved in scams and frauds, but it also acts as a safety valve against getting involved in loss-making properties. Therefore, the first step towards making investments in real estate can be called the origination process. Who to get deals from? How to get those deals? Where are the deals going to be, and what kind of deals are those? All these questions, along with many others, are required to be answered for successfully investing in profitable real estate. Continue reading to understand the origination process of investing in real estate.
Gathering information regarding an investment opportunity is the most important step of the investment process. It is known as the origination phase of a real estate investment. Three main areas of “who”, “what”, and “where” need to be defined regarding the investment. Deciding who to get the investment option from, what type of property to invest in, and where that property is can become the make-or-break points for a long term profitable real estate investment.
THE “WHO” OF REAL ESTATE INVESTING
Understanding the “who” part is perhaps the most important step of investing in real estate. Great real estate investment deals are most often not lying out in the open, and different entities can be approached to access them such as brokers, agents, property owners, and developers. However, they do not necessarily have to be real estate related people. They can also be from personal contacts or other professional networks. Real estate agents have a professional license to help people with buying, selling and renting real estate. Most agents work in collaboration with real estate firms, while others can also choose to work independently. Independent real estate agents are also known as brokers; however, they need to get additional licensing for acting as standalone agents. Real estate brokers can also hire other real estate agents to work under them.
It is most often the case that people look towards real estate agents and brokers as the first line of action before investing in real estate. However, another good option can be to look towards real estate developers. Real estate developers work in the most challenging field of real estate – land development. They purchase vast tracts of land to build residential, commercial, and industrial complexes. They can be approached for investment options because many developers require funding for existing and future projects. Investing with developers can also be rewarding over a longer period of time as developments on land can appreciate its value greatly. After gaining an understanding of who to go to for investing in real estate, it is important to understand the “what” of investing in real estate.
THE “WHAT” OF REAL ESTATE INVESTING
The “what” of real estate investing can include parameters like what is the type of property that an individual is going to invest in? What is the deal size, and what is going to be the capital position of the investor? Properties in real estate are either residential or commercial. Residential real estate consists of single-family homes, townhouses, apartments, and any built structure with less than five units for consumption. It is mostly found in the form of developed societies that offer all the basic municipal amenities, security features, and management services. If considering a residential property, additional factors like is it going to be a rental income property, fix and flip property, a duplex, or a multifamily property also come into play. On the flip side, commercial real estate is used for non-residential activities and includes places like hotels, office spaces, retail shops, industrial buildings, warehouses, and public facilities.
Commercial real estate is best suited to those investors who plan for long term profits and are looking for a way to generate passive income. Furthermore, a significant aspect of real estate investment is the deal size. It looks at the value of an individual’s investment and is related to the amount of risk being taken as it can have repercussions for credit ratings and future lending from financial institutions. Lastly, the traditional method of investing in real estate is where an individual buys an asset to become its owner. However, someone might want to join later as a development partner or investor. Therefore, another consideration when someone is coming in to provide additional capital to an already ongoing project is the particular position they gain in that investment. This is called a capital position.
THE “WHERE” OF REAL ESTATE INVESTING
The last part of the decision-making process for a real estate investment project is to decide where to invest. Prospective areas can range from areas where an individual lives to different metros, markets that are close nearby, or markets that are new having growth potential. Location is key to valuing real estate. Properties in areas where land is becoming scarce have a higher value than areas with lesser development or population density. The accessibility, appearance, and amenities of a neighbourhood also determine the level of development that is planned for the future. Socioeconomic factors like education and crime rate can also affect the value of a given area. Making investments in nearby areas gives the advantage that an individual is readily aware of most of these factors and can decide relatively easy on the future of a property. In comparison, properties that are not located nearby, or are in a different locality, cannot be evaluated on the same level, and therefore, remain riskier investments. Considering all these factors can greatly reduce the chances of failure, and keeping in mind the where, what, and who of investment deals can narrow down the types of deals an individual can do.
REAL ESTATE INVESTMENT ANALYSIS
Analysing an investment proposal can be one of the most critical aspects of investing in real estate. Most people do not realise the importance of carrying out a proper analysis and are forced to bear significant losses along with a host of other problems related to the property. Investment opportunities are mostly presented in a way that makes them very appealing and reliable. However, a proper analysis can help an individual understand whether the returns from an investment are sufficient enough to compensate for the risks involved. It can also help an individual understand the key drivers of a project’s performance and pick the most valuable investment option with confidence. Analytical strategies like the back of the envelope analysis and deep-dive analysis are used in different stages of the process to determine and filter out investment options.
Investments in real estate can be compared to investments in the stock market. Although many people invest in different stocks based on speculation and assumptions, those who make real profits have often deeply analyzed the market along with the company they invest in. They look at past trends of company performance along with forecast models to determine whether investing in its shares would be profitable over a certain period of time. It minimizes their chances of making a loss and manages their risk to a higher extent than the general investor. Investments in real estate are similar to the stock market but can require the evaluation of a much broader set of parameters. Properties can be either residential or commercial. Each sector has a different set of metrics that determine the overall value of a property. Analysing the potential cost, expense, income, and profit from a particular investment can even allow an individual to risk greater amounts of capital. Moreover, since real estate requires large sums of capital investments over a longer period of time, and are less liquid than a stock market transaction, the need for properly analysing all parameters before making any investment is highlighted.
TYPES OF REAL ESTATE ANALYSIS
Many real estate investors fail to realise the importance of a proper analysis. Whether they lack the skills or the knowledge, market analysis is an undervalued asset in real estate investment. There are two main types of analysis that can be done for a real estate property namely, the back of the envelope analysis and the deep-dive analysis. The former is a fast and reliable method to sift out those properties that fall in the criteria of the investor, whereas the latter is used to further investigate into the different aspects of a property and its characteristics. Considering the entirety of the analysis process, the back of the envelope method can be understood as the top of the funnel. Properties that make it through can move on to the next stage. The method is an informal mathematical calculation that uses numerical estimations to develop a “ballpark figure”. Five basic metrics are required before beginning the process namely, the purchase price or initial investment, rental income per month, down payment, loan amount, and monthly repayment amortization. Once these metrics have been collected, different calculations are performed to calculate the annual rent, cash flow before financing, annual cost of financing, and cash flow after financing. Completing the analysis seems time-consuming, but after a few attempts, it becomes easier and can be used as a powerful tool by investors.
If a property seems worth investing in after the back of the envelope analysis, it can be further analyzed using a deep dive analysis. In this method, multiple factors like lease rates, vacancy rates, construction estimates, rehabilitation estimates, stabilization costs, permits, local fees, and contingencies are also evaluated to understand the investment opportunity in a better way. For example, vacancy rates are an important factor when buying rental real estate, be it residential or commercial, to establish a future forecast of rental income from the property. Moreover, if considering a fix and flip property, construction and rehab estimates have to be figured out accurately to avoid incurring any future overhead and unexpected costs along with determining an accurate time frame for the job. Similarly, those who invest in properties where markets rates have fallen need to accurately calculate a stabilisation rate. This rate determines when the market will reach back to its normal state. Developmental projects in real estate require several permits and local fees to be paid. Calculating the estimated cost of these permits and local fees is also an integral part of the investment process. Lastly, contingency costs are associated with the what-ifs of a project. A developer might be interested in checking if installing a new kitchen would increase the property value. The cost of adding this new kitchen will be considered as a contingency cost and can help investors in evaluating the overall potential of a property. Conducting a proper analysis of real estate investment options can greatly impact a person’s risk assessment and profit management strategies. Not only will it help in putting a value on the property, but it will also help the individual or company in understanding the key performance indicators impacting a project’s development.
DUE DILIGENCE IN REAL ESTATE INVESTMENTS
Imagine conducting a complete analysis of a real estate investment option without taking due diligence and verifying the details of the property, project, or developer. As data and information regarding multiple aspects of a real estate investment option are available through online and digital means, a large portion of the society does not verify the actual on-ground details. This can lead to unintended and harmful consequences for the investor, as in some cases, it has been seen that a property sold to the buyer is actually not in the seller’s name. Therefore, conducting due diligence and verifying details of an investment option is a necessary step towards successful investing in real estate. Once all the details have been verified, the investor must ensure that he or she has enough resources to close the deal.
WHY DUE DILIGENCE IS IMPORTANT
After conducting a thorough deep-dive analysis of an investment option, due diligence must be taken on part of the investor. People usually trust the information they have, but it is important to verify. What needs to be verified are key drivers to the investment and anything that could create a worst-case scenario for the investor, such as verifying if the purchase being made is actually what was advertised. Anything that has been assumed correct by just seeing it on the paper must be verified for its authenticity. Another particularly important issue is the verification of the actual seller who has the legal title to the property. It is not uncommon for investors to run into this scenario where the seller is a scam artist who pretends to have title to some marketed property that no one’s paying attention to, whereas the actual seller may be overseas and does not realise his property is being sold. This means that the investor will never get a proper title to his property. Moreover, when investing in rental or commercial real estate, lease contracts from tenants must be verified to make sure that the rents the seller is advertising are actually what is being collected. In the case of commercial properties and industrial tenants, the details of the business being conducted on the premises must also be verified, as in some cases, the business can have legal repercussions such as environmental taxes in case of harmful chemicals businesses. In the case of a residential property, be it rental or fix and flip, verifying the integrity of the foundations, roof, walls, and fittings is especially important as repairs for these can be very costly. There are multiple professional appraisal services that can assist in the process. This is what due diligence is all about.
REAL ESTATE INVESTMENT CLOSING
After reaching a point where a thorough analysis has been conducted and due diligence has been completed, the investor must now put money into the investment. This is the stage where the financing and closing details must be sorted out. Ensuring that all the funds are in place is crucial to making a time-based decision. Investment opportunities can slip up quickly as more than one investor is planning on making the same investment at a time. Moreover, besides the purchase price of the property, there are additional costs such as closing costs, professional fees if the property is a commercial type where architecture and engineering fees also apply, legal fees, and whatever needs to be added for the development of the property. In cases where an investment is linked to the development of the property, finances for construction and rehab must also be considered. It may be a good idea to have funding for contingencies as well, in case things are more costly than what was anticipated. At this stage, reviewing and executing a purchase agreement is also important. Closing the deal can be in the form of bank transfers, cash transfers, or exchanges through an escrow account. Once the funds have been transferred, the investor has secured his rights over the property. However, this does not mark the completion of the investment process as an investor considers exit after any profit or loss has been made.
After purchasing an asset, the next stage is to prepare it for resale. This is known as stabilisation of an asset and can contain important tasks like construction, restoration, listing the property, and making a sale. The scope of stabilisation will depend on the type of investment along with the funds available for development. Construction and restoration are the most challenging part of a real estate investment. Multiple aspects of how contractors and developers work must be known for the effective utilisation of time and resources at this stage. Once the property is ready for sale, the next task is to list it on online real estate marketplaces or with real estate agents or brokers. Finally, exiting an investment at the right time can make all the difference between net profit or loss.
Once a property has been purchased or financed, stabilisation begins by either construction or restoration. The process largely depends on the scope and type of investment. Determining how much construction or restoration is required can impact costs, timing, and how much contingency funds must be set aside by the investor. Construction and rehab can be tricky as various factors need to be checked before getting into a contract with any developer or builder. It is necessary to obtain multiple bids from different developers to get a sense of exactly how much it will cost. Doing this will also lead to greater exposure as not all developers are equally skilled and equipped to execute the investor’s plan. It is also necessary to check the developer’s past projects and reviews of their prior clients to better understand how they work. Once construction and rehab are finished, the asset needs to be prepared for sale. The goal is to get the property ready, list it on multiple property portals, and ultimately make a sale.
There are two different types of investments, namely, properties related to rental income or operating assets such as hotels and commercial malls. In the case of income-generating properties, stabilisation will come from getting the occupancy levels and rental rates to market levels. If the market is considered stable at an occupancy rate of 80 percent or a certain amount of rental income is expected from a similar property, then the property being advertised must also be at the same occupancy level for generating market interest. Getting a property leased out at a higher rate will also ensure a higher price because it can achieve a higher rent. Therefore, stabilisation includes getting the tenants on the property, getting the right market rent, and getting the occupancy to a level that is equal to the market. If the property is an operating asset, the investor must also consider key performance indicators used to gauge such properties. For example, turnover and operating costs must also coincide with similar properties in the market. Lastly, the property also has to be listed on reliable real estate portals or with established agents or brokers. This is a crucial step as many properties have the potential to generate profits for their investors, but weak marketing strategies fail to generate the level of buyer interest that is required to sell them.
THE EXIT STAGE OF A REAL ESTATE INVESTMENT
The final stage of the investment process is called the exit phase. This is the part where returns on the investment are realised in terms of profit or loss. The net proceeds are calculated by subtracting the closing fees or costs associated with making the sale from the actual sale price. But what was the performance level? It is important to check how the investment performed in terms of predicted and actual values. An analysis can be based on several different models, and an investor can keep track of the success rate of an analysis method by comparing the internal rate of return and net income value for different properties analysed using different methods after the exit stage. This will ensure that only those methods which provide the highest profits are used in future ventures. Retrospectively, investments made in diverse markets can also provide insights into market performance and forecasting of future sales. The last consideration during the exit stage is the distribution of profits between investment partners in the case of partnerships. This marks the completion of the investment process in real estate. Following this four-step strategy covered in our blog can ensure a safe and reliable investment method for investing in real estate.