Fundamentals of Real Estate Investment

Real estate investing involves the purchase, ownership, management, rental and/or sale of real estate for profit. Improvement of realty property as part of a real estate investments strategy is generally considered to be a sub-specialty of real estate investing called real estate development. Real estate is an asset form with limited liquidity relative to other investments, it is also 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. A similar practice known as flipping is another reason for failure as the nature of the investment is often associated with short term profit with less effort. Therefore the need to understand the fundamentals of real estate investments

Following are some frequently asked questions about real estate investment, as well as timely answers to them;

What is the difference between investment ROI (return on investment) and capital ROI?
Investment ROI (return on investment) is the return on an investment while it is being held. Capital ROI is the return on an investment when the investment is sold. Investment ROI may be considered cash flow, such as monies received as interest on a savings account or from a stock dividend. Capital ROI results from an investment’s appreciation in value; art or sculpture, for example, would not have a cash flow but may increase significantly in value over a period of time.
Real estate is an investment that may produce both investment and capital returns-a positive cash flow and appreciation in value. Generally, real estate is considered a moderate risk, but it has low liquidity. A sale could take considerable time unless one sells below market value. Real estate has a high management burden. Income, future value, tax benefits, and the ability to leverage purchases are what make real estate a top choice for many investors.

How are investment real estate returns evaluated?

Compared with other investment assessments, the measurement and evaluation of investment real estate returns are essentially unique if an analyst is intent on an accurate measurement of the income stream and the yield earned on it.
The character of investment real estate is fixed in terms of size and location. Its period of economic utility is very long-typically from 30 to perhaps several hundred years. Furthermore, it is unique in that its presence is capable of providing a service, such as manufacturing, consulting, or health care. Investment real estate by itself adds relatively little to the actual production of economic goods and services, but its presence is essential to defect-free outputs of goods and services. Investment real estate, therefore, can be viewed as having two fundamental aspects of economic utility:
• it houses productive processes
• it provides an investment return, or yield, to its owner
Investment real estate entails very long-term commitments of capital by the owner, who receives return on capital by signing shorter-term leasehold interests. Because money earned today is worth more than money earned in the distant future (as a direct result of inflation, taxation, and uncertainty), it is necessary to apply different evaluation techniques.
What are the financial evaluation techniques applied to investment decisions?
The standard financial evaluation techniques typically applied to investment or production decisions include:
• break-even analysis
• payback analysis
• NPV (net present value) analysis
• IRR (internal rate of return) analysis
Real estate investment analyses must be thorough, critical, and weighted slightly toward a conservative set of outcomes; otherwise, the investor could elevate the gain of an investment decision to an unacceptably high level.

What is a break-even analysis?
A break-even analysis maintains that if a project contributes any return greater than its variable costs, the project should be undertaken. This approach ignores capital investments and the time value of money. Because the capital required for investment real estate is large and the useful life of the asset is so long, the break-even point changes over time; therefore, this approach is relatively meaningless and deceptive to the owner in terms of actual investment yield.

What is a cost-benefit analysis?
Cost-benefit analysis is a well-known form of break-even analysis. It addresses the question, are the benefits of a project worth its costs? It is useful for projects that involve physical improvements to tenant space that do not affect the market or asset value of the property as a whole. This can even be used to support trade-offs between cost-related and qualitative factors. It accounts for the costs of purchase, installation, maintenance, repair, replacement, employees, and any salvage value upon retirement of an asset. This method should not be confused with life cycle cost analysis, in which costs are assessed over an investment’s useful life but not against its benefits.

What is a SIR (savings-to-investment ratio)?
The SIR (savings-to-investment ratio) is a form of the break-even analysis. For an investment to be viable, the ratio must be greater than 1.00. The SIR is useful for determining which investment among many produces the most return, but it can produce distorted results, especially on smaller projects or proposals. If the investment is very small and the savings substantial, the ratio may be so high that the investment will appear more attractive than other forms of analysis would indicate.

What is a payback analysis?
Payback analysis evaluates the length of time required to pay the investor back for the quantity of capital inputs. This time is called the payback period and must be shorter than the life of the investment. Once this point has been reached, the investment produces positive net cash flows (more cash is received than disbursed). This approach ignores the time value of money involved in long-term investment and the opportunity cost of foregone alternative investments (returns from other investment strategies that might be chosen). It is used for small investments that do not require in-depth study or analysis. It may also be used as a screening procedure prior to more extensive analysis or if the timing of cash returns from an investment is critical. For investments involving large cash flow streams, other methods are required.

What are NPV (net present value) and IRR (internal rate of return)?
NPV and IRR are the most common evaluators used for real estate investments. Both of these evaluators use discounted cash flow techniques to arrive at a value with which comparisons can be made.
Present value is the discounted value of a stream of future cash flows based on an expected rate of return. NPV is the difference between the present value of capital outlays and the present value of all future cash flow benefits.
IRR is the actual rate of return of a series of cash flows generated by an investment. This will account for periodic cash flows and appreciation of value. It takes into consideration the initial cost of the investment, cash flows while held, and the sale proceeds at the end of the holding period.
These discounted cash flow techniques stem from the concept of the time value of money. This concept requires a rate of return to be expected from capital invested over a period of time.

This article is excerpted from BOMI Institute’s NEW Property Investment Reference Guide