Real estate is an attractive investment because it is fundamentally satisfying to own something you can touch, feel and see. This allure, however, often causes investors to overlook the basic investment analysis required to make a sound decision to buy or retain a real property.
Any investment analysis, regardless of the asset, involves assessing the initial purchase price and then discounting future cash flows by a required rate of return.
That calculation will reveal whether the asset is undervalued (warranting a purchase) or overvalued (warranting a sale or no purchase).
Real estate offers some unique considerations. Here are six areas that pose particular problems for property buyers.
The old saying about “location, location, location” still applies. That variable will determine the ending cash value from a future sale and the amount of cash flows between the purchase and eventual sale.
Real estate is not as liquid as many other investments. You cannot sell a property as quickly and easily as a publicly traded stock. The costs of the trade are also much higher. All other things being equal, you should demand a higher rate of return on real estate than stock.
Most real estate deals involve some sort of loan or leverage. A large part of the projected gains from property sales pitches often is derived not from the fundamentals of the project, but from the financing. Always keep in mind that while leverage helps by magnifying gains in an environment characterized by rising prices and increasing cash flows, it’s detrimental in falling-price environments. So, stress test the leverage component for rate changes when floating-rate or balloon-debt financing is used.
Real estate creates more liability for owners than other investments. Pitfalls include, but definitely are not limited to, irresponsible tenants, bad contractors or partners and unknown environmental hazards. Liability must be addressed with the understanding that the expenses necessarily will be higher than with other investments. You will need insurance for both the property itself, and your own liability. You should also determine the appropriate entity structure to hold real estate in order to protect your other assets.
Real estate receives favorable federal tax treatment, and interest is usually deductible. Depreciation is allowed to reduce taxable income, even though it is not a cash expense. Like-kind exchanges can continue to shelter gains well into the future. And, depending on the ownership structure, a step-up in basis can eliminate income taxes when the property is passed to heirs. However, tax laws do change: Support is growing for tax reform that might remove or restrict some of these favorable tax measures.
Be sure you consider all the costs in your analysis. Rental property will require repairs. And at times, that property will be vacant. There will be make-ready and advertising costs to acquire new tenants as well as management costs, even when you are doing these tasks yourself. Put the going rate into your calculation to reveal your true rate of return and keep the property profitable in case you are no longer able to fulfill that role. Bad management in the form of non-market rental rates and overpayments for repairs is something many do not take into account as a cost.
If you break down these areas when considering a real estate investment, you’ll be better positioned to maximize the property’s value and return potential. Remember, too, that a trusted wealth management advisor can help you sort through these and other investment real estate issues, before and after your purchase.
This article was originally published in the December/January 2016 issue of Worth.