LUSAN

Have Real Estate Risks Increased or Decreased?

Every day investors ask me to look at potential real estate investments to help them evaluate the quality of the investment decision.

In this time of low interest rates and low capitalization (cap) rates, my answer is usually a negative one. Most investment decisions are not making sense or money.

Let’s explore this a little.

Consider this first:

There are many different investors at many different levels of investment. What works for one investor will not work for another. The match-up of goals between investor and real estate investment is critical.

In other words, if you have $50,000 in the bank you will look at an investment differently that if you have $10,000,000 to invest.

Consider also that the investor’s age and experience will have a significant impact on how they are going to invest. An experienced investor will understand how a property is going to operate in comparison to other like properties on the market. An inexperienced investor may take the word of a motivated real estate broker or mortgage broker and push forward into a property that might be very risky and not return the kind of cash they expect in either appreciation or cash-on-cash return.

Every market place is different, and is driven by the law of supply and demand, the availability of cash to invest, as well as land use laws and tax regulations. Right now long term capital tax rates are low — 15 percent for Federal and up to 10 percent in some states and as low as zero. These rates change annually and should be reviewed with your CPA.

There is one more variation on this theme in play at this time — a demographic twist. The baby boom has created a large group of investors that want to sell their investments at a premium now and invest the proceeds into real estate where the risk levels are not too great and where they do not have to pay much attention to the property. This has created a run on these investments and increased the pricing in response to the demand. Such momentum also has affected the national housing market and those that invest in single family houses.

This brings us back full circle to the issue of evaluating an investment.

As investors look to new investments such as office buildings, industrial buildings and retail buildings, they tend to look at them in the standard manner accepted by the last generation of investors. This view does not take into consideration tenant improvement costs and leasing commissions in the building’s expenses.

As long as cash returns and CAP rates were in the 10 to 12 percent range, buyers could make small mistakes and still have some room for error. The continued competition for real estate with CAP rates at 5 percent and cash returns at 3 percent, alleviates this margin for error and creates greater risk for the real estate investor. This means that investors in commercial buildings in particular, need to change their investment model to account for such shrinkage or suffer the consequence of significant cash flow losses.

A similar buffer that existed in residential properties has also evaporated. This has increased the risks investors face in making real estate investments, a risk many are ignoring as they rush into more real estate investments.

On August 27, 2005 Alan Greenspan, the Federal Reserve Chairman, was quoted at a Jackson Hole, Wyoming conference as saying:

“The housing boom will inevitably simmer down. As part of that process, house turnover will decline from currently historic levels, while home-price increases will slow and prices could even decrease,” Earlier that day, he warned investors not to assume that higher prices for assets such as stocks or houses were permanent, cautioning that gains could disappear if the economy or investor sentiment turned.

“I urge caution and thoughtfulness as investors look at potential opportunities. If on the hand you have lots of money and can handle a market downturn, it does make sense to pick up well-located properties and bet on the appreciation upside.”

The key to real estate investing at this time is taking risks you can afford, and not overstepping your financial means.

Written by Clifford A. Hockley