REAL ESTATE AS AN INVESTMENT

Risk and reward

Illiquidity

Management requirements

Real estate investments participate in the general risks and rewards of all investments. However, real estate investments are often complex. They are also distinguished by their lack of liquidity and by the amount of management they require. In addition, each investor has specific aims and circumstances that affect the viability of any particular real estate investment for that individual. Licensees who lack expertise in the area of real estate investment analysis should refer potential investors to a competent advisor. Nevertheless, a licensee should be familiar with the basics of real estate as an investment.

Risk and reward         

Capital put into real estate is always subject to the full range of risk factors: market changes, income shortfalls, negative leverage, tax law changes, and poor overall return.

Market demand for a specific type of property can decline. For example, a business district’s retailers may vacate stores in an area in order to obtain better space in a new shopping center. Market downturns leave the income property investor with an unmarketable property or one which can only be re-leased at a loss of some portion of the original investment. Thus the expected reward from income or appreciation may never be obtained.

Another risk of the investment property is the cost of development or operation. If start-up costs or ongoing operating costs exceed rental income, the owner must dip into additional capital resources to maintain the investment until its income increases. If income does not rise, or if costs do not decline, the investor can simply run out of money.

Leverage is a constant risk in real estate investment. If the property fails to generate sufficient revenue, the costs of borrowed money can bankrupt the owner, just as development and operating costs can. Investors often overlook the fact that leverage only works when the yield on the investment exceeds the costs of borrowed funds.

Tax law is an ongoing risk in long-term real estate investment. If the investor’s tax circumstances change, or if the tax laws do, the investor may end up paying more capital gains and income taxes than planned, undermining the return on the investment. An investor needs to consider carefully the value of such potential tax benefits as deductions for mortgage interest, tax losses, deferred gains, exemptions, and tax credits for certain types of real estate investment.

Another consideration is opportunity cost. Opportunity cost is the return that an investor could earn on capital invested with minimal risk. If the real estate investment, with all its attendant risk, cannot yield a greater return than an

investment elsewhere involving less risk, then the opportunity cost is too high for the real estate investment. Despite all the risks, real estate remains a popular investment, because, historically, the rewards have outweighed the risks. Real estate has proven to be relatively resistant to adverse inflationary trends that have hurt money, debt, and stock investments. In addition, real estate has proven to be a viable investment in view of the economy’s continued expansion over the last fifty years.

Illiquidity                      

Compared with other classes of investment, real estate is relatively illiquid. Even in the case of liquidating a single-family residence, one can expect a marketing period of at least several months in most markets. In addition, it takes time for the buyer to obtain financing and to complete all the other phases of closing the transaction. Commercial and investment properties can take much longer, depending on market conditions, leases, construction, permitting, and a host of other factors. The investor who is in a hurry to dispose of such an investment can expect to receive a lower sales price than may be ideal. Compare this with the ease of drawing money out of a bank account or selling a stock.

Management requirements              

Real estate tends to require a high degree of investor involvement in management of the investment. Even raw land requires some degree of maintenance to preserve its value: drainage, fencing, payment of taxes, and periodic inspection, to name a few tasks. Improved properties often require extensive management, including repairs, maintenance, onsite leasing, tenant relations, security, and fiscal management.