Why do Real Estate Investors buy Real Estate? Answer: because they’re real estate investors! Okay, what I was really trying to say was: “Why do INVESTORS by real estate instead of other assets?”
Well, one thing about real estate versus other investment vehicles is that it is a tangible asset. Your clients can touch it. Many investments such as securities are generally considered intangible assets. Investors may find themselves at the mercy of market makers, large institutional investors, or electronic traders squeezing out small profits margins 20,000 times per second. This type of casino atmosphere provides large investment entities with a distinct advantage over smaller mom and pop investors.
Conversely, due to the fact that there are so many different unrelated buyers and sellers involved in the making of real estate markets, it is much more difficult for the large players to “rig” the real estate market than it is the stock markets with their intangible investments.
Four Reasons Why Investors Select Real Estate as an Investment Vehicle
There are generally four main reasons why an investor might select real estate as an investment vehicle:
1. Leverage: Increases an investor’s total return by using real estate loans during an upward-trending sellers’ market.
2. Appreciation: A real estate asset’s increase in value over its holding period.
3. Depreciation: Paperwork loss the IRS may let your clients deduct on their income taxes.
4. Amortization: Paying off the principal balance of a loan over its lifetime.
Many real estate investors have become millionaires and multi-millionaires over the years by buying single-family homes at the bottom of an upward-trending sellers’ market, holding onto the properties as the market moves upward, then selling or exchanging them at the top of the market. The reason they have been able to significantly increase their net worth is due to leverage.
When dealing with real estate, leverage can be used to provide incredible returns on investment--if your client buys single-family homes when the market is heading in an upward direction. The key is for your real estate investor clients to utilize real estate loans to enable them to purchase more single-family homes than if they were being purchased with all cash.
For example, your client pays $100,000 all cash to purchase a single-family investment property. If the property increases in value to $200,000, your client has experienced a $100,000 increase in value over the initial $100,000 investment. That is a 100% return on investment. Not bad. It is calculated $100,000 return divided into $100,000 invested = 100% return on investment.
The increase in value is called price appreciation—and your clients will really appreciate it.
However, if your client had placed only $20,000 as a down payment and financed the remaining $80,000 of the purchase price, the return would have been significantly higher. Calculated: $100,000 increase in value divided into $20,000 invested equals a 500% return on investment! And that’s called leverage.
When Leverage Works and When It Doesn’t
Leverage is generally advantageous when the real estate market is heading in an upward direction. Sellers are in a profitable position when there are more buyers coming into the market than sellers who wish to sell their properties. Many buyers during an upward-trending sellers’ market think the real estate market will never go down. However, over time real estate markets generally go up, overheat, and then go back down. With each high and each low, property values will generally attain a higher level than the last real estate market cycle. Leverage generally does not work at all when real estate markets are heading downward. There are more sellers wanting to sell than buyers who are willing to buy, causing real estate prices to decline.
Single-Family Home Investors and Loan-To-Value Ratios
Your clients may be looking at a 75% or lower loan-to-value ratio (LTV) for single-family investment properties. By leveraging single-family income property purchases, investors may be able to purchase a greater number of single-family income properties and (hopefully) derive a greater return via: (1) cash flows during the holding period, (2) tax advantages through depreciation, and (3) increases in equity through appreciation in value.
If your client can reinvest cash flows during their holding period, they may be able to increase their investment return to an even greater level. As long as your clients are moving their chess pieces (i.e., real estate investments) forward on the chess board, then they are heading in the right direction. Trying to quantitatively predict actual returns on investment is not an easy task.
Single-Family Investors Have the Best of Both Worlds
The real estate market for single-family homes is usually driven by owner-occupied homebuyers—and NOT nonowner-occupied real estate investors. Owner-occupied homebuyers tend to make emotional purchase decisions that have nothing to do with rates of return in the single-family rental market.
For this reason, single-family investors have the ability to rent properties and receive a good rate of return during an upward-trending sellers’ market, then switch the use of the single-family rental property to owner-occupied and sell it to a homeowner for top-of-the-market prices near the top of the next upward-trending sellers’ market.
Real Estate Builders Use Leverage Too
Real estate builders sometimes leverage themselves too much by over-paying for land at or near the top-of-the real estate market. When the market changes from an upward-trending sellers’ market to a downward trending buyers’ market, many builders find themselves with a big problem: how to obtain loans to develop off-site improvements and build-out the lots. The lender’s loan-to-value ratio increases while lot values decrease, so builders are generally not enthused about this situation.
In fact, when the market changes from an upward-trending sellers’ market to a downward-trending buyers’ market, many lenders start asking builders for more money (out of the builder’s own pockets) before they will extend off-site improvement loans and construction loans. It is generally not in a builder’s best interest to pay any money out-of-pocket to reduce the loan-to-value of a loan. Many builders call this “Good money after bad.”
If the builder has deep-enough pockets, he may build homes out-of-pocket without having to deal with nervous bankers whose knees start shaking when they hear the words “buyer’s market.” As long as the bankers are aware that the builder has the financial ability to write a check and pay them off, the builder will usually be in a strong negotiating position. If not, then the builder will be at the mercy of the bankers.
Generally, there are four reasons why investors select real estate as an investment vehicle: price appreciation, depreciation, amortization, and leverage. In addition, there are five variables a real estate investor should consider prior to any real estate property investment, they include price, terms, condition, location, and market timing.
This is an increase in value of the real estate asset over its holding period.
Depreciation is the paperwork loss the Internal Revenue Service (IRS) may allow a real estate investor to take on their income tax return. The IRS generally will allow a real estate investor to depreciate a real estate income property's improved (building) portion over 27.5 years for residential income properties and 39 years for leased investments.
Pay off the principal balance of the loan usually over 15 to 30 years. It is a systematic liquidation of a debt obligation on an installment basis. A fully amortized loan allows the property owner to pay off the loan through principal and interest payments usually over 15 or 30 years.
There is an old bankers saying, “When you need money you can’t get it and when you don’t need money you can get all you want.” Real estate loans are often used for risk management purposes by deep-pocketed builders. Instead of risking all of their own money (i.e., all their eggs in one basket) why not risk a small amount of their own money and borrower the rest from the bank?
Next week we’ll continue on with this subject and take a look at the five variables that affect real estate value.