What is a real estate investment? A way of earning passive income
How to invest in real estate? 5 ways to do so
What are the risks involved in real estate investment?
How to calculate the risks involved in real estate investment?
1. What is real estate investment?
Real estate investment means the acquisition of any property for generating income rather than holding for residential purposes.
The property implies land, building, infrastructure, and other tangible property. It is generally immovable but transferrable.
It can also be referred to as a financial strategy in which a property is managed, acquired, leased, or disposed of for making a profit.
Real estate has been considered a sound investment and it is also a store of value.
You can enjoy passive income, excellent returns, tax advantages, diversification, and the opportunity to build wealth by investing in real estate.
2. How to invest in real estate? 5 ways to do so
If you want to diversify your existing investment portfolio and wish to add some extra cash to your existing investment returns, investing in real estate is the better alternative.
You can do so in the following 5 ways:
a) Buy Real Estate Investment Trusts (REITs):
If you want to invest in real estate without physical real estate, REITs would be the best alternative.
Commercial real estate such as office buildings, retail spaces, apartments, and hotels are under the ownership of REITs.
By investing in REITs you may have regular income in the form of dividends. If you opt otherwise, you may reinvest those dividends for further growth.
Whether is it good to invest in REITs?
If REITs are traded on stock exchanges, you can opt for them.
On contrary, if REITs are not traded on stock exchanges, you have to be careful while investing. You need to consider their liquidity and marketability before investing.
b) Use an online real estate investing platform:
These are platforms where real estate developers and you, as an investor, can meet. You can finance the real estate developers' projects either through debt or equity. You are required to pay a fee to the platform.
Your expectation will be to receive the periodic distribution in exchange for taking a significant amount of risk.
Here also, you have to consider the liquidity and marketability.
c) Invest in rental properties:
Another alternative to investing in real estate is to lease the whole property and sublease the part of it while keeping the remaining part for your own use.
If you are a businessman or student or in any profession you can opt for this alternative considering its relevance to you.
d) Renovating investment properties:
If you have money, you can buy an underpriced property and renovate it to sell it for a profit.
You should be good enough at estimating the expected renovation expenses.
And, if you have used borrowed money to buy the property, the delayed sale of the property may add extra cost.
e) Renting out a room:
If you have a spare room, you can rent it out and receive a periodic rental income.
3. What are the risks involved in real estate investment?
Although the investment in real estate sounds lucrative, you need to consider the risk associated with the ownership of real estate investment.
The seven risks associated with real estate investment are as follows:
a) Market Risk: Before the Great Recession of 2008, there was a perception that the real estate market is unidirectional i.e. it always moves up.
The investors believed that if you acquired a property you could always sell it for a profit later on.
In general, the value of real estate moves in an upward direction over time but the only thing that is certain about the real estate market is that it is uncertain.
Supply and demand, the economy, demographics, interest rates, government policies, real estate trends, prices, rental rates, and unforeseen events play an important role in the marketability of real estate.
If the above factors are adverse, your real estate investment may depreciate.
What strategies you can apply to counter market risk?
Real estate is a type of investment that requires continuous monitoring from your side. It is not a set-it forget-it type investment. You should carefully analyze your entry and exit strategies and make the appropriate adjustment to them.
You should carefully study the trend, conduct market research, do due diligence, and monitor your real estate investment.
This will definitely help you mitigate the risk of going on the wrong side of the trend.
b) Location Risk: The location of your real estate investment is the most critical factor out of all factors.
If you want to generate the highest return on your investment, you should choose the best location.
The demand for rental properties, types of properties that are in the highest demand, tenant pool, rent rates, and the potential for appreciation all depend on the location of your profit.
The bad location might ruin your profitability and the value of your real estate investment.
What strategies you can apply to counter location risk?
You should do market research to find the best location.
c) Cash Flow Risk: The cash flow risk means the risk of losing your money. This occurs when the cash inflows are less than cash outflows.
Cash inflows mean the amount that your real estate investment is generating. While cash outflows mean the related expenses, taxes, and mortgage payments.
The factors that add fuel to your cash flow risk are
-High vacancy
-Excessive maintenance cost
-High financing cost
-Undercharging of rent
-Bad rental strategy
What strategies you can apply to counter cash flow risk?
First, you need to do your homework before investing. This requires sufficient time and prudence.
The next thing you need to do is conduct due diligence to be sure that it is in a good location.
d) Occupancy Risk: You own an office building, a real estate investment, and if it is vacant then this is called occupancy risk.
It is the most common risk in real estate investment. The occupancy risk will affect your ability to generate rental income.
Property mortgage, insurance, property taxes, maintenance, and other similar expenses add severity to the occupancy risk.
What strategies you can apply to counter occupancy risk?
To lower the occupancy risk, you must buy the property in a good location.
Other tactics are
-Suitable price in line with market
-Marketing, promotion, and advertising
-Cleanliness and timely maintenance of the property
-Focus on the satisfaction of the tenants through better service, incentives, and rewards
-List your property with a real estate professional
-Develop a market reputation
e) Problem Tenants: Bad tenants can make you financially drained and they are more than a headache. The most common problem with tenants are
-Not paying on due dates
-Hosting extra roommates
-Trashing of the property
-Not reporting maintenance issues until it is too late
-Becoming irresponsible
What strategies you can apply to counter problem tenants?
You can eliminate or reduce this risk by the following measures:
-Adequate screening process of tenants through a credit check, criminal background check
-Information regarding late payments, property damage, and evictions can be obtained by making contact with the applicant's previous landlord
-Also inquire about the sources of income of the applicants
f) Maintenance Problem: When you cannot estimate your maintenance cost, it may also drain your money. The maintenance bill might surprise your heart.
What strategies you can apply to counter the maintenance problems?
You can eliminate or reduce this risk by the following measures:
-Inspect the property before buying
-Hire qualified and reputable property inspector, contractor, mold inspector, and pest control specialist to look for hidden problems
-Problems, if found, should be fixed on a timely basis
g) Liquidity Risk: When you sell your property below the market price or at a loss, this is liquidity risk.
Although real estate is a store of value, the liquidity risk is higher in real estate property.
What strategies you can apply to counter liquidity risk?
You can eliminate or reduce this risk by the following measures:
-Home equity loan
-Cash-out finance
-Commercial equity loan
-Equity line of credit
4. How to calculate the risks involved in real estate investment?
You can measure the risk involved in real estate by using the deviation of historical returns.
The standard deviation is the typical measure of the volatility of historical return series or a price series (e.g. the volatility of the share price of a company.
To calculate the risk of the real estate investment, the following factors are considered.
-Idiosyncratic nature and timing of revenues and expenses associated with the ownership of the property under consideration
-Investor's expected holding period
The discounted cash flow model is used as per the following steps:
Step 1: Basic Scenario
Here, you have to forecast the expected revenues and expenses of the property for the most likely market scenario. This should be assigned the highest probability of occurrence. This is referred to as the basic scenario.
Step 2: Pessimistic and Optimistic Scenario
Now you should develop a suitable pessimistic scenario and optimistic scenario considering the basic scenario.
Under a pessimistic scenario;
-The rent growth rate should be lower than that of the basic scenario
-The exit cap rate should be higher than that of the basic scenario
Under an optimistic scenario, both of the above conditions are opposite.
Step 3: Internal Rate of Return (IRR)
After step 2, you should estimate the IRR of the property under consideration.
Step 4: Probability multiplied by IRR
Then, you have to assign a probability to each scenario and multiply it with the IRR calculated under step 3. The sum total of probabilities should add up to 100%.
The product obtained shall be added up
Step 5: Standard Deviation
Finally, calculate the standard deviation of returns. This will give the risk associated with the real estate investment.
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