Fishing for Hot Investments in A Cool Market
Saturday, January 28, 2006; Page F01
As the frenzied local real estate market appears to be cooling down, we are being asked a lot whether real estate is still a good investment.
As real estate agents, we tell our clients that it can be, but the risk of making a poor investment is increasing because prices are high and there's no guarantee that returns will justify those prices. Now more than ever, an investor must understand the fundamentals and remember that evaluating an investment property is like peeling an onion: There are many layers, and if you do it wrong, you'll cry.
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Your first step in evaluating a potential real estate investment should be to determine whether it fits your portfolio and financial plan. People tend to be at one extreme or the other: Either they have no real estate exposure or they are overexposed. A well-diversified portfolio should include some real estate, but not all real estate.
The next issue to consider is what type of real estate investment makes the most sense for you. There are many choices -- raw land, office buildings, warehouses, gas stations, apartment buildings, condominiums, real estate investment trusts, private syndications, etc. Each comes with its own risks, rewards and management challenges. But because many investors start with residential real estate, we will focus on residential real estate investments that generate rental income.
Realistically evaluating the finances of the individual property you are considering is the key to figuring out what might be a hot investment, even in a cooling market.
Understanding Leverage
One feature of real estate as an investment is that it is so easily leveraged. That means you can use borrowed money to increase the return on your capital. Investors can put in a relatively small amount of cash, perhaps 5 percent to 20 percent of the purchase price, and borrow the rest.
In a market that appreciates rapidly, as happened locally over recent years, investors have been able to achieve extraordinary returns on their capital, sometimes doubling their investment in a year or two. For example, consider the impact of leverage on a homeowner who bought a house with 10 percent down, kept it for two years, and then sold it for 20 percent more than he paid, after expenses. His return on invested capital wasn't 20 percent; it was 200 percent. That is, if the investor put $10,000 down on a $100,000 property and sold it for $120,000, the $10,000 would have tripled to $30,000 after paying off the $90,000 mortgage.
However, returns like that aren't guaranteed, and leverage can magnify losses. Using that same simple example, if the property sold for just $80,000, the $20,000 bath the investor would take isn't a 20 percent loss on the $10,000 investment. The entire investment would be lost, and the investor would have to pay another $10,000.
In contrast, with most unleveraged investments, you won't go in the hole: If you buy $1,000 in stock, you won't lose more than $1,000.
So how do you evaluate the odds on your real estate investment? It takes some math.
Building a Financial Model
To illustrate, here's an analysis of a hypothetical real estate investment.
Let's assume you want to own a small, multifamily rental property and find the following listing: "Four-unit apartment building in NW D.C. Strong rental history. Great potential for condo conversion. Charming building in historic neighborhood."
