There are many variables to be considered before an investor invests in income properties.
Among other things include the market factors, occupancy rates, tax influences, the level of risk , the amount of debt financing and methods of measuring returns on investment in real estates.
Similarly a lender would also be concerned with the same variables as they would also effect the value of the marketability of the properties being used as the collateral for the loan. In addition, the lender is also concerned about the sufficient cash flows generated from the properties to cover the loan payment.
CHARACTERISTIC OF REAL ESTATE INVESTMENT
As mentioned in the earlier chapter , investments in real estate involve in the following consideration:
1. Cash Outlay- real estate investment requires much larger initial outlays of cash than do other forms of investment
2. Liquidity-real estate investment is not liquid because it generally involves a long term commitment of investment funds
3. Management- real estate investment must be managed either by the investor itself or by a professional real estate management firm.In both cases ,it involves added cost , usually ranging from 5%-10% at the gross income depending on the types of building, the age of the building , the type of tenancy and location of the building
4.Risk- For investment properties ie: the properties required mainly for capital appreciation with little or no cash flow during the holding period, the risk would be in the form of loss in capital investment.
But for the income producing properties-i.e properties purchased primarily for cash flow, the level of risk depends on:
- the quantity of the income stream
- the quality of the income stream (refers to the sureness of its receipt) and
- the durability of the income streams(refers to the length of time the investment will generate an income)
There is a direct relationship between the risk an investor undertake with the return he experts to get-i.e the higher the risk, the higher is the required rate of return.
TYPES OF RISK IN REAL ESTATE INVESTMENT
We mentioned risk as an element to be taken into consideration when investing in real estate. Let us look at the different types of risks involved.
1. Business Risk-Real estate investor are in the business of renting space. Its returns will be affected when economic condition changes that affect the demand for the rented space.
2. Financial Risk-The use of financial leverage magnifies the business risk. The financial risk increase as the amount of debt on real estate investment is increased.
3.Liquidity Risk-Real estate investment has a relatively high degree of liquidity risk,unlike investment in bonds or shares. It taken an average about 5 months to a year to liquidate a property.
4.Inflation risk-As mentioned earlier on, historically, capital appreciation in real estate can act as hedge against inflation, but during period of high vacancy rates where demand for space is week; income from real estate may lag behind the inflation rate.
5.Management Risk-The rate of return on real estate on the competency of the manager
that managers the building. Some properties may require a higher level of management expertise that others. Managing a shopping mall is an example.
6.Interest rate risk-Changes in investors rate affect the returns on any investment.
Since real estate tends to be highly levered, the rate of return earned by equity investors can be affected by the changes in the interest rates.
7.Legistative Risk-The value of real estate is affected by the changes in its environment which are hazardous to health and surrounding such as building materials, contamination by toxic waste etc.
All the above risk must be considered if we are interested in real estate investment.