Thursday, November 02, 2006


Real Estate Investing: The Value Of Compromise

Capital growth, income, liquidity, borrowing, yield, debt-management and risk in real estate investing, and their economic interactions.
Investing in real estate, in general lines, involves compromise and is often more a matter of what an investor is willing to give up than what he actually wants.

If I were to ask "What is your investment objective?" how would investors respond? Most likely the answers would range from "I want to retire at 55", to "I want to start my own business within the next five years", or perhaps to "I want to have enough money set aside for my children education". We all have many different ways of expressing what we are trying to accomplish when we set investment objectives. When all is said and done, however, there are really only three fundamental goals we really intend to achieve. All goal-setting boils down to growth, income and liquidity.

We want our real capital assets to grow in value, that is to be worth more at some point in the future than they are today. Then, while we are in the process of accumulating whatever amount of wealth we can, we need to generate income out of those assets to minimize costs of owning such as property taxes and maintenance and, possibly, to increase our own salaries or wages. And, finally, we want to be able to quickly convert those assets into cold cash, should the need ever arise to get through some unexpected crisis, or if a better investment opportunity suddenly comes in sight.

That's quite a lot that we want from our real estate investments. The truth is that only few of all investors will have situations so straightforward as to be able to accomplish all three goals in equal proportions. For the vast majority of us, it will be a matter of seeking compromise so as to incorporate in our investments only some elements of growth, income and liquidity, and not in perfect equilibrium. This is due not only to the nature and type of the real estate investment we decide to make at any given time, whether residential, commercial, multi-family rental or a combination of any of the above, or to the situation of the market at the time we make our investment, but also for a quintessential human trait common to all investors.

We spend money on things we need, and we save money for things we want. Which is great, until such time as we decide to reclassify what is that we need and what is that we want. Human nature being what it is, when we see something that we suddenly decide we ‘need' and the money is readily available, our best intentions can wilt and disappear instantaneously. If the cash is not in the savings account already, we can pay an unexpected visit to our friendly neighbourhood banker who will be more than thrilled to advance the money secured by our real capital assets, or to refinance our existing real estate loans. This is, in ultimate analysis, how consumerism works.

There is no doubt that the judicious use and management of debt can accelerate the accumulation of wealth. In Finance, this is called ‘leveraging': the use of borrowed money to meet investment objectives, particularly growth and income. However, financial leverage is a double-edged sword: using other people money to invest also increases the risk associated with the investment. It is bad enough to lose one's own money if a real estate investment sours. It is much worse, however, to lose the banker's money - one may quickly discover how unfriendly, all of a sudden, the friendly neighbourhood banker may become.

Historically, leverage strategies work best and are more popular during times of low interest rates and high appreciation of property values. If, for example, an investor borrows money at 5 percent to purchase an investment that appreciates at the rate of 10 percent a year, obviously the investor will come out ahead. Additionally, in certain circumstances the interest expense is tax deductible, thus making the net return even higher. Unfortunately, however, during times of downward fluctuations leveraging may be a risky proposition, as the cost of borrowing may exceed the investment yield even after deducting interest expense.

So, therefore, when is leverage appropriate? In Finance, the rule of thumb is that every dollar borrowed increases the risk of investing by 50 percent. This means that if an investor has $100,000 of his own money and decides to borrow an additional $100,000, he increases the risk by 50 percent. If he borrows $200,000, he doubles the risk. If he goes as far as borrowing $300,000, he increases the risk by 150 percent. Therefore, if the real capital asset chosen by our investor would normally yield, say, 10 percent, he should expect a return of somewhere in the area of around 10 + 5 = 15 percent to account for the extra risk, if he pays $200,000 for the real property he is acquiring, $100,000 of which are financed by a lender.

This ratio holds true for leveraged investments of higher or lower proportions too. For instance, if the investor matches each dollar of his own money with 50 cents from the bank, his expected return should be at least 25 percent higher than if he only used his own money, or 10 + 2.5 = 12.5 percent. Likewise, in the case of $200,000 financing the expected yield should be 20 percent. And then, of course, there is the real big one: the 100 percent leverage, also known as the zero-down option (the one they show on TV at midnight), with the investor using none of his own funds (because he doesn't have any, since he just landed straight out of the Mongolian desert - like the chap on TV). On a purchase price of $200,000, the yield should hover to on or about 10 + 5 + 5 = 20 percent. On a purchase price of $300,000 it should be in the range of 10 + 5 + 5 + 5 = 25 percent and so on.

Luigi Frascati

Real Estate Chronicle

Prices of real estate only rise as time passes by and that's why you'll need the assistance of hard money lenders if you want to finance for a particular piece of land at a certain area.
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