Investing in real estate
INVESTING IN?REAL?ESTATE?involves relatively high risks. Such risks are heightened during difficult economic times. Not surprisingly therefore, such investments can also provide very high returns. Let us look at how this investment may work.
First, most real estate investments beyond home ownership are high risks. On a scale of risk aversion of one to ten, the real estate investor will be a person who is somewhere around two; the real estate investor is an aggressive investor.
The high level of risk for this investment stems mainly from the nature of the investment. It is not called real estate just for so. Real estate is land and buildings – very tangible assets, and furthermore, not easily moved from one place to another, like most other fixed assets.
Real estate usually costs substantial sums of money. Often, to raise the funds to make the purchase, the investor borrows. The large sum of money tied up in a real estate purchase, as well as the level of borrowing, contribute to the riskiness of this investment.
The real estate investor usually must therefore have a high tolerance of debt. If you are going to have sleepless nights and/or a queasy stomach during the day knowing that you owe, then maybe you should choose another investment.
Then after you have purchased real property, you stand the chance of property values declining. This could happen as a result of a change in the highway plan surrounding the property or say, by the establishment of a smelly pig or fowl farm adjacent to your property. Property value may also decline due to some discovered structural flaw in the building or its foundation.
Yet, usually, the greatest risk of real estate is as a result of the long time it may take to convert your investment back into cash during a financial crisis. It is a relatively illiquid investment.
Unlike real estate, you can withdraw your money from the bank usually in a day or two, and you can convert government saving bonds to cash in a day. With real estate, it can sometimes take years to sell your property at a price adequate enough to provide an acceptable return.
Yes, real estate can be a very successful investment when the real estate market moves in your favour. For sure, real estate has made solid millionaires of many people over the years. Many investors even see real estate as a sure investment – but the risks are there.
Just as the real estate investment is very good when the market is very good, the investment can be very bad when the market is down. Furthermore, when the real estate investment is made with borrowed funds and it goes wrong, you stand the chance of not just making a reduced or slightly negative return, you may actually lose all or nearly all of your original capital investment in the property. That is, when it is a bad deal it can be very hard for you financially, and emotionally.
Real estate borrowing is usually financed by long-term mortgages. During the period of the mortgage you also stand the risk of mortgage interest rates turning against your investment. You may have negotiated your mortgage at a six per cent interest rate. Four or five years later, this rate may have moved to eight per cent. The amount of the mortgage instalment will increase and be a bigger drain on your cash flow and the overall return on your investment may be eroded.
• Louise Fairsave is a personal financial management advisor, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances.