Investing in Real Estate
Given that house pricing is driven by land scarcity and demographic distribution and concentration, the GTA and its surrounding Regions are forecast to enjoy a greater than average growth in both pricing and sales activity for the foreseeable future. The annual increase in house values over the next 10 years in this area is a conservative projected to be 4%, which is in keeping with historic norms.
Real estate investing involves the purchase, ownership, management, rental and/or sale of real estate for profit. If properly approached and managed as an ongoing business venture, it is without question one of the best investment vehicles for wealth accumulation and income generation.
It is imperative that investors understand that real estate is an asset form with limited liquidity relative to other investments, it is 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.
Real estate investment is not to be confused with speculation (purchase-for-resale), renovation-for-resale and development real estate strategies, which can increase investor cash flow but do little to increase net worth because the underlying income-generating asset(s) must be sold to realize cash flow and hopefully a profit.
Real estate assets are typically very expensive in comparison to other widely-available investment instruments (such as stocks 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.)
A typical residential investment property generates cash flows 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 when carryover losses which reduce tax liability are charged against income from other sources – in this case, from other homes in a real estate investor’s portfolio.
- 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.
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.
Verify ownership, purchase title insurance
Obtain a boundary survey from a licensed surveyor
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 analysis as part of the investment pro forma, do not rely on capital appreciation as the primary source of gain for the investment
Maintain sufficient liquid or cash reserves to cover costs and debt service for a period of time,
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