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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 seeing steady increases in market values and rent prices, many individuals are considering making direct investments in real estate. As the stock markets have not provided the types of returns as in the past, many people are looking to real estate for better returns. 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, below are questions for the potential investor to contemplate. If you can honestly answer yes to each question, then real estate investing might be for you. Q: 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. Q: 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. Q: 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. Q: 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. Q: 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. If you feel comfortable answering yes to each of these questions, then you are ready to take the next steps. Ask yourself these three questions: 1. What is my real estate investment strategy? In the 1970's, many real estate investments were primarily tax shelters. Then the tax laws were changed. In the 1980's, the basic real estate strategy was to buy any property, hold it for a short period, then sell it for a profit. While real estate values have recovered since the bust cycle after the 1980's, price appreciation is not great enough at this point to serve as the sole reason for buying a property. Today, most investors purchase real estate for the cash flow and net profit that the property will generate on an annual basis. As with most other investments, this strategy is usually the soundest. An additional element of real estate strategy is to establish a time horizon for each investment, planning for when the property will be sold. What type of property suits your situation and investment goals? Most small real estate investors can not afford to purchase shopping centers, industrial buildings or other large properties. For many, opportunities are limited to two to four family properties or small apartment buildings. These properties provide space to residential tenants, who are much different than commercial tenants. Residential tenants require substantially more management assistance than commercial tenants. On the other hand, residential tenants are much easier to find to rent to. Other investment opportunities such as raw land, condo conversions and other properties should also be considered. 3. Is your financial house in order? Nearly all real estate investors will require mortgage financing for their purchases, and in fact financing profitable properties can substantially enhance the net return on a real estate investment. In order to qualify for investor financing, most lenders require very good credit, enough assets to make a down payment and reserve funds available in case problems arise. Some lenders now also require that investors demonstrate property management abilities either through experience or taking a course. Eager investors need to examine their finances and their skills carefully before proceeding to purchase their first income property. Clearly, real estate investing is not for everyone. For those who jump into it with realistic expectations and careful planning, real estate can be a challenging and profitable adventure. Michael W. Licamele is President of Residential Finance Network and 1st Option Realty. |