Avoid seeking short-term profit in real estate

Real estate investment is a unique area which requires in-depth understanding before trying to build a property portfolio or investing a lot of capital. This is important to understand because real estate transaction costs are very high and the property market is less liquid than most other investment markets.

In addition, most property investors normally use borrowed capital to build property portfolio. Real estate investment broadly involves the acquisition, ownership, management, rental or sale of property/ real estate for profit.

Redevelopment and improvement of real estate 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 very limited liquidity in comparison to other investments alternatives. It is also highly capital intensive (although capital may be gained through mortgage leverage) and is highly cash flow dependent.

The capital intensity increases the investment risk as it is generally difficult to get higher returns when the capital involved is higher. Normally the higher the return the lower will be the expected or achievable return. This is so because once the return is very high it attracts more capital which reduces the opportunity since more capital will be competing for the opportunity.

In addition, the use of borrowed capital introduces financial risk since the owner can fail to make interest and capital repayment which can result in the property being seized by the bank or lender. If these factors are not well understood and managed by the property investor, real estate becomes a risky investment and can quickly ruin an otherwise promising real estate investment venture.

The primary cause of investment failure in 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, seek expensive refinancing or file for insolvency.

Flipping is another reason for failure as the nature of the investment is often associated with short term profit with less effort.
The period when the investor acquires the property and when they seek a tenant is the main challenge that first time or small portfolio investors face.

An ideal situation is when an investor buys a property that’s already fully rented and it’s already producing a cash flow.
Such properties are, however, very rare since not many investors are willing to let go a positive cash flow property. This means an investor normally has to build their own positive cash flow portfolio from nothing.

Real estate assets are typically very expensive in comparison to other widely available investment instruments shares which can be bought for amounts from as low as US$100.

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 collateralised 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 is maximised.

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 25 percent 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, joint venture etc.)

If the property requires substantial repair, traditional lenders like banks will often not lend on a property and the investor may be required to borrow from a private lender utilising a short-term bridge loan like a hard money loan from a hard money lender.

Hard money loans are usually short-term loans where the lender charges a much higher interest rate because of the higher risk nature of the loan.

Hard money loans are typically at a much lower loan to value ratio than conventional mortgages. Many real estate investment organisations, such as real estate investment trusts (REITs), insurance firms, pension funds and asset management firms, have large enough capital reserves and investment strategies to allow 100 percent equity in the properties that they purchase.

This minimises 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 creates 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.

Some individuals and companies are engaged in the business of purchasing properties that are in foreclosure. A property is considered in foreclosure when the homeowner has not made a loan/mortgage payment for at least 90 days.

These properties can be purchased before the foreclosure auction (pre-foreclosure) or at the foreclosure auction which is a public sale. If no one purchases the property at the foreclosure auction then the property will be returned to the lender that owns the mortgage on the property.

This means the bank will end up owning the property and can end up building its own investment property this way. The sitting tenants have to continue paying rent but now to the bank or lender. Once a property is sold at the foreclosure auction and the foreclosure process is completed, the lender may keep the proceeds to satisfy their loan or mortgage and any legal costs that they incurred.

The foreclosing bank has the right to continue to honour the tenants lease (if there is a tenant in the property), but usually 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.

Disclaimer
GMRI Real Estate is a property holding division of GMRI Capital which owns, manages, develops and leases out its own property. We do not act as agents for the public or third parties.

This article is provided as is for informational purposes only as a public service, not intended for trading purposes or advice. Prior to execution of any property/real estate trade, you are advised to consult your authorised financial advisor/real estate agent to verify the accuracy of all information.

Neither GMRI Real Estate nor any independent provider is liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein.