Factors to Consider before Investing in Real Estate
by Rachna Bijlani, CFP®
August 8, 2020
In most cases, your primary residence should not be considered an investment asset. This article addresses investing in real estate with the purpose of generating income or earning return in the form of capital gains. Tangible investment assets, such as real estate, can be an appealing way to achieve portfolio diversification, given the possibility that they are not perfectly correlated with other investment assets. Potential returns in the form of rental income, tax write-offs, and capital gains can make real estate an attractive investment. Real estate investing can broadly be broken down into two categories based on investment characteristics; it can either be an equity position or a debt position. Instruments of real estate debt include investing in mortgages, residential or commercial Mortgage Based Securities (MBS) and deeds of trust. This article focuses primarily on equity investments in real estate, which includes property ownership and investing in REITs.
Besides the customary annual trips to Disneyland and Vegas, and an annual trip overseas, my family and I take a 2 week vacation every summer to explore the different states and all the beautiful cities in America. Over the past five years, we’ve travelled to several cities in California, Oregon, Washington, Nevada, Utah, Idaho, Wyoming, Colorado, Texas, and Louisiana. Besides fun and adventure, the secondary objective of these vacations is to get a feel of the psychographics of these places, while looking for investment opportunities. Combining demographic and psychographic trends makes it easier to judge the viability of real estate investments. Let’s look at some of the factors you should be considering before investing in real estate.
1. Determine your Investment Objectives
First and foremost, as with any investment, it is imperative to set your investment objectives. You first need to determine what percentage of your total investment portfolio should be allocated to real estate. Next, consider your acceptable level of risk and return and narrow down on a quantifiable, acceptable yield. In simpler terms, figure out how much return you are expecting to earn on your investment over a period of time. A good way to narrow down on an acceptable yield is to examine the opportunity cost of investing elsewhere and to also look at your required rate of return for achieving your financial goals, such as retirement. For instance, if your financial advisor has told you that you need to target an annualized return of 7% on all your investments to achieve your financial goals, and your current portfolio of securities is yielding 7%, then that might be a good place to start. However, this is an over-simplified view of the situation. In reality, a lot of other factors will come into play when narrowing down on your decision. Factors such as tax treatment, estate planning, level of risk tolerance, your time horizon, liquidity constraints, and the amount of time and work you need to put into it, will all play a crucial role in determining the acceptable level of return on your investment. Even if you outsource property management, you'll still have to account for the additional time that you spend resolving property related issues and handling taxes. I would recommend consulting your financial advisor to narrow down the details.
2. Select the Right Vehicle
Once you’ve determined the mileage that you’re looking for (your required yield), it’s time to pick the right vehicle. As mentioned earlier, an equity position in real estate can be achieved by either owning a property or by investing in REITs (Real Estate Investment Trusts). Equity REITs are professionally managed companies that invest in various types of real estate, ranging from office properties, shopping centers, residential units, healthcare and long-term care facilities, storage units, lodging, or a combination of several property categories. Buying a share of REIT is like owning a piece of this real estate portfolio. Most REITs trade on major stock exchanges, like equities, and do not require a minimum investment. The appeal of REITs lies in their ability to allow small investors to participate in capital appreciation as well as income returns in the form of dividends, without the hassle of direct property ownership and management. Majority of REIT dividends are taxed as ordinary income, unless they’re qualified dividends, which are taxed as capital gains. Capital gains tax applies at the sale of shares of equity REITs. Since REIT dividends can be higher compared to other equities, it might make sense to hold REITs in a tax-deferred vehicle such as an IRA account if you’re in a higher tax bracket. Equity REITs can be analyzed using techniques that are commonly applied for stock valuations, and your investment advisor should be able to do this easily for you. Equity REITs provide individual investors an attractive and simple mechanism for investing in real estate.
However, if you’re up for a bigger challenge, you might want to look at owning an actual property. Investment properties can be classified as either income properties or speculative properties. As the name suggests, the primary goal of income properties, like residential and commercial real estate, is to generate periodic rental income with the prospect of price appreciation. Speculative properties, such as land, are held primarily with the objective of capital appreciation. While losses in income properties can be incurred due to factors like competition, poor management, and tenant issues, in my opinion, speculative properties carry a greater risk because of factors that might be out of your control. Income properties have the prospect of providing steady rental income, price appreciation, and possibly some shelter from taxes.
3. Analyze Return Potential
Now that you’ve determined your required yield and narrowed down on your investment vehicle, lets evaluate the earning potential of your rental property. Rental properties have the potential to generate rent and provide price appreciation. Fundamental analysis of a real estate investment should start off by analyzing supply and demand. You can gauge demand by examining the driving forces for buying or renting a property in your chosen market. Start by answering questions such as: What are the sources of employment and what is their outlook in that specific market? What is the tourism outlook? Are their popular schools or universities in the area and are they gaining enrollment? Are there any industry specific expansions planned in that area? What is the average household size, age groups, income, and family structures in the neighborhood? What is the population mentality and lifestyle like? Once you’ve gauged demand, focus on supply by sizing up the competition. Examine the property price and rent trends in the area. Check the number of present and past listings. Look at the average number of days it takes to sell or rent. Check if the sale prices are above or below the asking price.
The next step is to evaluate the property that you’re considering buying. Besides the condition and layout of the property, check the location, proximity to parks, schools, offices, tourist destinations, grocery stores and other amenities, restrictions on use of the property, and the availability of contractors and property management firms in the area and their tentative management fees. It is always advisable to get a professional real estate appraisal and a thorough home inspection done before buying the property.
Now comes the most crucial step of the entire operation, which is to conduct an investment analysis to determine if the purchase fits your investment objectives. The supply and demand analysis and the appraisal should give you a fair idea about the income potential as well as the resale value of the property. You always have the option of using leverage (borrowing money) to buy the property. Leverage can magnify returns as well as losses. If you’ve borrowed money to buy the property, the amount of your down payment, and not the property value, should be considered as your invested capital for the sake of calculations. Set a time horizon, such as five or ten years, and compute your anticipated after-tax cash flow over this time horizon. Besides mortgage, property taxes, insurance, property management fees, utilities, HOA fees, and regular maintenance, don't forget to account for leasing fees, tenant screening expenses, advertising expenses, periodic unexpected big ticket expenses such as roof leakages and HVAC replacements, periodic renovations, and periods of unoccupancy while calculating expected net income. Next, calculate the expected yield on your investment using your down payment as the initial cash flow, net after-tax income over the years as your subsequent cash flows, and your anticipated after-tax net sale proceeds at the end of your term as your final cash flow. If this calculated yield matches your desired yield, then this could be an acceptable investment. If these calculations overwhelm you, please seek the help of your financial advisor. Remember to always use credible realtors, mortgage lenders, and escrow companies to facilitate the purchase.
4. Assess Associated Risks
Like any investment, real estate investments carry risk. Before investing in real estate, you must be cognizant of the risks associated with your investment. Macroeconomic factors like GDP, unemployment rate, income growth, interest rate levels, and government regulations can impact real estate prices. These factors are out of your control, but it is good practice to monitor these economic factors to evaluate your level of risk. Property location, zoning restrictions, regional tenant eviction and rent control laws, poor property maintenance and management, tenant issues, market competition, constraints on rapid liquidation, and issues with property transfers are some of the other risks inherent to real estate investments. Take your time to analyze the investment and evaluate all associated risks. Only, and only if this level of risk matches your risk tolerance, should you proceed with the investment. It is always a good idea to consult your investment advisor, estate attorney, accountant and tax advisor before investing in real estate.
Finally, to quote Mark Twain, “Buy land, they’re not making it anymore “. Strike that- we’ve still got the moon!