Real estate investing
Encyclopedia
Real estate investing involves the purchase, ownership, management, rental and/or sale of real estate
for profit. Improvement of realty property as part of a real estate investment
strategy is generally considered to be a sub-specialty of real estate investing called real estate development. Real estate is an asset
form with limited liquidity relative to other investments, it is also capital
intensive (although capital may be gained through mortgage
leverage
) and is highly cash flow
dependent. If these factors are not well understood and managed by the investor, real estate becomes a 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, often forcing them to resell the property at a loss or go into insolvency. A similar practice known as flipping
is another reason for failure as the nature of the investment is often associated with short term profit with less effort.
s in most countries are not as organized or efficient as markets for other, more liquid investment instruments. Individual properties are unique to themselves and not directly interchangeable, which presents a major challenge 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 be highly variable depending on knowledge of availability. Information asymmetries
are commonplace in real estate markets. This increases transactional
risk, but also provides many opportunities for investors to obtain properties at bargain prices. Real estate investor
s typically use a variety of appraisal
techniques to determine the value of properties prior to purchase.
Typical sources of investment properties include:
Once an investment property has been located, and preliminary due diligence
(investigation and verification of the condition and status of the property) completed, the investor will have to negotiate a sale price and sale terms with the seller, then execute a contract for sale. Most investors employ real estate agents and real estate attorneys
to assist with the acquisition process, as it can be quite complex and improperly executed transactions can be very costly. During the acquisition of a property, an investor will typically make a formal offer to buy including payment of "earnest money" to the seller at the start of negotiation to reserve the investor's rights to complete the transaction if price and terms can be satisfactorily negotiated. This earnest money may or may not be refundable, and is considered to be a signal of the seriousness of the investor to purchase. 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. Within the contingency period, the investor usually has the right to rescind the offer with no penalty and obtain a refund of earnest money deposits. Once contingencies have expired, rescinding the offer will usually require forfeit of earnest money deposits and may involve other penalties as well.
s or bonds
). Only rarely will real estate investors pay the entire amount of the purchase price of a property in cash. Usually, a large portion of the purchase price will be financed using some sort of financial instrument or debt
, such as a mortgage loan
collateralized by the property itself. The amount of the purchase price financed by debt is referred to as leverage
. The amount financed by the investor's own capital, through cash or other asset transfers, is referred to as equity
. The ratio of leverage to total appraised value (often referred to as "LTV", or loan to value
for a conventional mortgage) is one mathematical measure of the risk an investor is taking by using leverage to finance the purchase of a property. Investors usually seek to decrease their equity requirements and increase their leverage, so that their return on investment
(ROI) is maximized. Lenders and other financial institutions usually have minimum equity requirements for real estate investments they are being asked to finance, typically on the order of 20% of appraised value. Investors seeking low equity requirements may explore alternate financing arrangements as part of the purchase of a property (for instance, seller financing, seller subordination, private equity sources, etc.)
Some real estate investment organizations, such as real estate investment trust
s (REITs) and some pension funds, have large enough capital reserves and investment strategies to allow 100% equity in the properties they purchase. This minimizes the risk which comes from leverage, but also limits potential ROI.
By leveraging the purchase of an investment property, the required periodic payments to service the debt create an ongoing (and sometimes large) negative cash flow beginning from the time of purchase. This is sometimes referred to as the carry cost or "carry" of the investment. To be successful, real estate investors must manage their cash flows to create enough positive income
from the property to at least offset the carry costs.
s to an investor in four general ways:
Net operating income, or NOI, is the sum of all positive cash flows from rents and other sources of ordinary income generated by a property, minus the sum of ongoing expenses, such as maintenance, utilities, fees, taxes, and other items of that nature (debt service is not factored into the NOI). The ratio of NOI to the asset purchase price, expressed as a percentage, is called the capitalization rate
, or CAP rate, and is a common measure of the performance of an investment property.
Tax shelter offsets occur in one of three ways: depreciation
(which may sometimes be accelerated), tax credits, and carryover losses which reduce tax liability charged against income from other sources. Some tax shelter benefits can be transferable, depending on the laws governing tax liability in the jurisdiction where the property is located. These can be sold to others for a cash return or other benefit.
Equity build-up is the increase in the investor's equity ratio as the portion of debt service payments devoted to principal accrue over time. Equity build-up counts as a positive cash flow from the asset where the debt service payment is made out of income from the property, rather than from independent income sources.
Capital appreciation is the increase in market value of the asset over time, realized as a cash flow when the property is sold. Capital appreciation can be very unpredictable unless it is part of a development and improvement strategy. Purchase of a property for which the majority of the projected cash flows are expected from capital appreciation (prices going up) rather than other sources is considered speculation
rather than investment.
Some individuals and companies are engaged in the business of purchasing properties at foreclosure sales. According to the legal foreclosure stages when the process is completed, the lender may sell the property and keep the proceeds to satisfy its mortgage and any legal costs. The foreclosing bank has the right to continue to honor the client’s lease, but customary as a rule the bank wants the property vacant, in order to sell it more easily. Thus distressed assets (such as foreclosed property or equipment) are considered by some to be worthwhile investments because the bank or mortgage company is not motivated to sell the property for more than is pledged against it.
Real estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
for profit. Improvement of realty property as part of a real estate investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
strategy is generally considered to be a sub-specialty of real estate investing called real estate development. Real estate is an asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
form with limited liquidity relative to other investments, it is also capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
intensive (although capital may be gained through mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
) and is highly cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
dependent. If these factors are not well understood and managed by the investor, real estate becomes a risky
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
investment. The primary cause of investment failure for real estate is that the investor goes into negative cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
for a period of time that is not sustainable, often forcing them to resell the property at a loss or go into insolvency. A similar practice known as flipping
Flipping
Flipping is a term used primarily in the United States to describe purchasing a revenue-generating asset and quickly reselling it for profit...
is another reason for failure as the nature of the investment is often associated with short term profit with less effort.
Sources and acquisition of investment property
Real estate marketMarket
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
s in most countries are not as organized or efficient as markets for other, more liquid investment instruments. Individual properties are unique to themselves and not directly interchangeable, which presents a major challenge 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 be highly variable depending on knowledge of availability. Information asymmetries
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...
are commonplace in real estate markets. This increases transactional
Real estate transaction
A real estate transaction is the process whereby rights in a unit of property is transferred between two or more parties, e.g. in case of conveyance one party being the seller and the other being the buyer...
risk, but also provides many opportunities for investors to obtain properties at bargain prices. Real estate investor
Real estate investor
A real estate investor or a real estate entrepreneur to a lesser extent is someone who actively or passively invests in real estate. An active investor may buy a property, make repairs and/or improvements to the property, and sell it later for a profit. A passive investor might hire a firm to...
s typically use a variety of appraisal
Real estate appraisal
Real estate appraisal, property valuation or land valuation is the process of valuing real property. The value usually sought is the property's Market Value. Appraisals are needed because compared to, say, corporate stock, real estate transactions occur very infrequently...
techniques to determine the value of properties prior to purchase.
Typical sources of investment properties include:
- Market listings (through a Multiple Listing ServiceMultiple Listing ServiceA multiple listing service is a suite of services that enables real estate brokers to establish contractual offers of compensation , facilitates cooperation with other broker participants, accumulates and disseminates information to enable appraisals, and is a facility for the orderly...
or Commercial Information ExchangeCommercial Information ExchangeA Commercial Information Exchange is an Internet-based commercial property listing service that is operated by a local association to serve the local market. A CIE is the commercial real estate equivalent of the residential Multiple Listing Service...
) - Real estate agents
- Wholesalers (such as bank real estate ownedReal estate ownedReal estate owned or REO is a class of property owned by a lender typically a bank, government agency, or government loan insurer, after an unsuccessful sale at a foreclosure auction. A foreclosing beneficiary will typically set the opening bid at a foreclosure auction for at least the outstanding...
departments and public agencies) - Public auctionAuctionAn auction is a process of buying and selling goods or services by offering them up for bid, taking bids, and then selling the item to the highest bidder...
(foreclosureForeclosureForeclosure is the legal process by which a mortgage lender , or other lien holder, obtains a termination of a mortgage borrower 's equitable right of redemption, either by court order or by operation of law...
sales, estateEstate (law)An estate is the net worth of a person at any point in time. It is the sum of a person's assets - legal rights, interests and entitlements to property of any kind - less all liabilities at that time. The issue is of special legal significance on a question of bankruptcy and death of the person...
sales, etc.) - Private sales
Once an investment property has been located, and preliminary due diligence
Due diligence
"Due diligence" is a term used for a number of concepts involving either an investigation of a business or person prior to signing a contract, or an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations...
(investigation and verification of the condition and status of the property) completed, the investor will have to negotiate a sale price and sale terms with the seller, then execute a contract for sale. Most investors employ real estate agents and real estate attorneys
Lawyer
A lawyer, according to Black's Law Dictionary, is "a person learned in the law; as an attorney, counsel or solicitor; a person who is practicing law." Law is the system of rules of conduct established by the sovereign government of a society to correct wrongs, maintain the stability of political...
to assist with the acquisition process, as it can be quite complex and improperly executed transactions can be very costly. During the acquisition of a property, an investor will typically make a formal offer to buy including payment of "earnest money" to the seller at the start of negotiation to reserve the investor's rights to complete the transaction if price and terms can be satisfactorily negotiated. This earnest money may or may not be refundable, and is considered to be a signal of the seriousness of the investor to purchase. 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. Within the contingency period, the investor usually has the right to rescind the offer with no penalty and obtain a refund of earnest money deposits. Once contingencies have expired, rescinding the offer will usually require forfeit of earnest money deposits and may involve other penalties as well.
Sources of investment capital and leverage
Real estate assets are typically very expensive in comparison to other widely-available investment instruments (such as stockStock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s or bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
). Only rarely will real estate investors pay the entire amount of the purchase price of a property in cash. Usually, a large portion of the purchase price will be financed using some sort of financial instrument or debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
, such as a mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
collateralized by the property itself. The amount of the purchase price financed by debt is referred to as leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
. The amount financed by the investor's own capital, through cash or other asset transfers, is referred to as equity
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
. The ratio of leverage to total appraised value (often referred to as "LTV", or loan to value
Loan to value
The loan-to-value ratio expresses the amount of a first mortgage lien as a percentage of the total appraised value of real property. For instance, if a borrower borrows $130,000 to purchase a house worth $150,000, the LTV ratio is $130,000/$150,000 or 87%.Loan to value is one of the key risk...
for a conventional mortgage) is one mathematical measure of the risk an investor is taking by using leverage to finance the purchase of a property. Investors usually seek to decrease their equity requirements and increase their leverage, so that their return on investment
Return on investment
Return on investment is one way of considering profits in relation to capital invested. Return on assets , return on net assets , return on capital and return on invested capital are similar measures with variations on how “investment” is defined.Marketing not only influences net profits but also...
(ROI) is maximized. Lenders and other financial institutions usually have minimum equity requirements for real estate investments they are being asked to finance, typically on the order of 20% of appraised value. Investors seeking low equity requirements may explore alternate financing arrangements as part of the purchase of a property (for instance, seller financing, seller subordination, private equity sources, etc.)
Some real estate investment organizations, such as real estate investment trust
Real estate investment trust
A real estate investment trust or REIT is a tax designation for a corporate entity investing in real estate. The purpose of this designation is to reduce or eliminate corporate tax. In return, REITs are required to distribute 90% of their taxable income into the hands of investors...
s (REITs) and some pension funds, have large enough capital reserves and investment strategies to allow 100% equity in the properties they purchase. This minimizes the risk which comes from leverage, but also limits potential ROI.
By leveraging the purchase of an investment property, the required periodic payments to service the debt create an ongoing (and sometimes large) negative cash flow beginning from the time of purchase. This is sometimes referred to as the carry cost or "carry" of the investment. To be successful, real estate investors must manage their cash flows to create enough positive income
Income
Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...
from the property to at least offset the carry costs.
Sources and management of cash flows
A typical investment property generates cash flowCash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
s to an investor in four general ways:
- net operating income (NOI)
- tax shelterTax shelterTax shelters are any method of reducing taxable income resulting in a reduction of the payments to tax collecting entities, including state and federal governments...
offsets - equityOwnership equityIn accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
build-up - capital appreciation
Net operating income, or NOI, is the sum of all positive cash flows from rents and other sources of ordinary income generated by a property, minus the sum of ongoing expenses, such as maintenance, utilities, fees, taxes, and other items of that nature (debt service is not factored into the NOI). The ratio of NOI to the asset purchase price, expressed as a percentage, is called the capitalization rate
Capitalization rate
Capitalization rate is the ratio between the net operating income produced by an asset and its capital cost or alternatively its current market value...
, or CAP rate, and is a common measure of the performance of an investment property.
Tax shelter offsets occur in one of three ways: depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
(which may sometimes be accelerated), tax credits, and carryover losses which reduce tax liability charged against income from other sources. Some tax shelter benefits can be transferable, depending on the laws governing tax liability in the jurisdiction where the property is located. These can be sold to others for a cash return or other benefit.
Equity build-up is the increase in the investor's equity ratio as the portion of debt service payments devoted to principal accrue over time. Equity build-up counts as a positive cash flow from the asset where the debt service payment is made out of income from the property, rather than from independent income sources.
Capital appreciation is the increase in market value of the asset over time, realized as a cash flow when the property is sold. Capital appreciation can be very unpredictable unless it is part of a development and improvement strategy. Purchase of a property for which the majority of the projected cash flows are expected from capital appreciation (prices going up) rather than other sources is considered speculation
Speculation
In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...
rather than investment.
Risk management
Management and evaluation of risk is a major part of any successful real estate investment strategy. Risk occurs in many different ways at every stage of the investment process. Below is a tabulation of some common risks and typical risk mitigation strategies used by real estate investors.| Risk | Mitigation Strategy |
|---|---|
| Fraudulent sale | Verify ownership, purchase title insurance |
| Adverse possession Adverse possession Adverse possession is a process by which premises can change ownership. It is a common law concept concerning the title to real property . By adverse possession, title to another's real property can be acquired without compensation, by holding the property in a manner that conflicts with the true... |
Obtain a boundary survey from a licensed surveyor |
| Environmental contamination | Obtain environmental survey, test for contaminants (lead paint, asbestos, soil contaminants, etc.) |
| Building component or system failure | Complete full inspection prior to purchase, perform regular maintenance |
| Overpayment at purchase | Obtain third-party appraisals and perform discounted cash flow Discounted cash flow In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money... analysis as part of the investment pro forma Pro forma The term pro forma is a term applied to practices or documents that are done as a pure formality, perfunctory, or seek to satisfy the minimum requirements or to conform to a convention or doctrine... , do not rely on capital appreciation as the primary source of gain for the investment |
| Cash shortfall | Maintain sufficient liquid or cash reserves to cover costs and debt service for a period of time, |
| Economic downturn | Purchase properties with distinctive features in desirable locations to stand out from competition, control cost structure, have tenants sign long term leases |
| Tenant destruction of property | Screen potential tenants carefully, hire experienced property managers |
| Underestimation of risk | Carefully analyze financial performance using conservative assumptions, ensure that the property can generate enough cash flow to support itself |
| Market Decline | Purchase properties based on a conservative approach that the market might decline and rental income may also decrease |
| Fire, flood, personal injury | Insurance policy on the property |
| Tax Planning | Plan purchases and sales around an exit strategy to save taxes. |
Foreclosure investment
Main article: Foreclosure investmentForeclosure investment
Foreclosure investment refers to the process of investing capital in the public sale of a mortgaged property following foreclosure of the loan secured by that property....
Some individuals and companies are engaged in the business of purchasing properties at foreclosure sales. According to the legal foreclosure stages when the process is completed, the lender may sell the property and keep the proceeds to satisfy its mortgage and any legal costs. The foreclosing bank has the right to continue to honor the client’s lease, but customary as a rule the bank wants the property vacant, in order to sell it more easily. Thus distressed assets (such as foreclosed property or equipment) are considered by some to be worthwhile investments because the bank or mortgage company is not motivated to sell the property for more than is pledged against it.
Foreclosure statistics
The number of households in foreclosure increased 79 percent in 2007, with about one of every 100 U.S. households at some stage of the foreclosure process, according to the latest numbers from data aggregator RealtyTrac.See also
- Capitalization rateCapitalization rateCapitalization rate is the ratio between the net operating income produced by an asset and its capital cost or alternatively its current market value...
- Cash on cash return
- Creative Real Estate InvestingCreative Real Estate InvestingCreative real estate investing is a term used to describe non-traditional methods of buying and selling real estate. Typically, a buyer will secure financing from a lending institution and pay for the full amount of the purchase price with a combination of the borrowed funds and his own funds .One...
- Real-estate developer
- Off plan propertyOff plan propertyOff plan property is a term used to describe pre-construction property or pre-construction real estate .Real estate developers usually market pre-construction developments to early adopters who are usually property investors, so as to secure better finance terms from their lender.Property...
- Real estate appraisalReal estate appraisalReal estate appraisal, property valuation or land valuation is the process of valuing real property. The value usually sought is the property's Market Value. Appraisals are needed because compared to, say, corporate stock, real estate transactions occur very infrequently...
- Internal rate of returnInternal rate of returnThe internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...
- Investment Rating for Real EstateInvestment Rating for Real EstateAn investment rating of a real estate property measures the property’s risk-adjusted returns, relative to a completely risk-free asset. Mathematically, a property’s investment rating is the return a risk-free asset would have to yield to be termed as good an investment as the property whose rating...
- FlippingFlippingFlipping is a term used primarily in the United States to describe purchasing a revenue-generating asset and quickly reselling it for profit...
- Wholesaling