Safe as houses an expression to satisfy a doubting person…
Oh…it’s as safe as houses, i.e., perfectly safe, apparently a figure of speech used in property as an investment.
Safe as houses phrase originated when the railway bubble began to burst, and people began to turn their attention to more reliable or stable forms of speculation, which was slow and steady…
Safe as houses, let’s firstly establish your investing strategy, criteria and action plan:
- How much money can you borrow to invest
- How much time required for research/due diligence
- How much money can you afford to lose
- How much debt can you manage
- What type of property deals
- How far from CBD
- What’s the maximum interest rates for borrowing
Residential real estate is almost the sacred cow of Australian investment. What if your sights are set on building a real estate empire, does it mean embracing risk with open arms?
Whatever real estate strategy you decide to do, just bear in mind networking is even more important in real estate than in other industries…so start pounding the pavement as soon as possible selecting the all-important team to manage your projects.
Risk, reward and reality. It’s easiest to think of property investments from least risky to most risky and analyze the pros and cons in each category:
(a) Least risky investing means acquiring and operating existing properties/buildings (buy and hold strategy)
Property investing is all about stability and getting high single-digit returns by operating existing assets (least risk when a building is already operational and generating rental income)
(b) More risky or value-add using opportunistic strategies for improving existing properties.
This is where investors aim to make substantial improvements and renovations to existing properties instead of acquiring and operating, (returns from 15–20% range, may go higher depending on how risky the strategy)
(c) Most risky which is real estate development and building completely new properties. Most risk equals highest returns?
You might think real estate development offers the highest returns because it’s also the riskiest, right?
Real estate development involves buy, sell, develop, managing properties, third party joint ventures (stakeholders) and of course all professionals including:
- Town planners
- Real estate agents
- Civil engineers
- Building contractors
- Construction managers
The real money in real estate development primarily goes to investors, which put their money at risk in the developments. To complete the construction of a new property, developers only put down a very small portion of total equity, perhaps 5% or less.
Many times the developer contributes land as the only form of equity in the project using debt and mezzanine financing to fund the entire construction cost.
You weigh up the risk versus reward before deciding. It is generally accepted the higher the reward the greater the risk. Property development slightly increases risk because of the many variables such as:
(a) Site costs
(b) Development costs
(c) council approvals and contribution costs
(d) Construction costs
(e) Resale values
Safe as houses…a thorough working knowledge of all these areas is required in order to succeed. Most of the returns go to the third party investors which come up with the rest of the funds.
How does no cash flow from properties sound like because buildings are under development, so there’s no cash flow generated until tenants move in and rental income starts flowing.
The fees property developers charge are not great compared to the amount of overheads, sometimes there isn’t much money left to pay salaries to employees.
That’s the reason why you wouldn’t get into real estate development if money is your main goal, only do it because you’re interested in building and construction side of real estate and you’ve cash resources with small surplus to cover contingencies and enough money to invest in development projects yourself.
What if you just love every aspect of real estate? People which find the greatest success in real estate focus on the end goal of owning income properties. There are actually real estate investors from all walks of life…
Investing in real estate yourself…you don’t need to raise hundreds of millions of dollars just to buy a house. The key is to find your core strengths where you can be initially be successful, so you’re able to generate enough cash flow to own properties yourself.
So let’s take a wild stab at your future goal here…you want to make a lot of money and ideally own three or more properties debt free and outright (perhaps multiple skyscrapers with your name on them one day, might even end up with your own island one day:)
You’d also like to avoid working in a job if at all possible, and perhaps you want to make the transition from investor to developer?
As an added bonus, you don’t want to earn badges from a top notch school of hard knocks to get started, right? You’re thinking its all worth learning how to crunch the numbers, and sounds like real estate investing is a good fit for you…
How to analyze real estate deals, making sure the numbers work?
Each property is unique and brings a different value to potential investors, so it’s trickier than it sounds to find the right property.
Investors generally look at three factors when analyzing a property:
(1) Investors look at what the property/building is currently doing, how much income it has been generating and what the property-level expenses are, which gives you the net operating income (NOI).
(2) Investors look at the property to make sure it can maintain its current income.
It’s one thing to have generated strong income in the past, sometimes factors like:
(b) Demographic shifts
(c) Changes to the local area can drive a property right into the ground…
(3) Investors project what the building could do in the future to increase income and/or cut expenses.
Depending on what kind of deal it is, investors will focus on either the current income or the projected income.
For example, a stabilized deal which isn’t expected to see much upside or current rents which is the key valuation driver.
There are four main real estate deal types:
(1) Stabilized deals (buy and hold) are “blue-chip stocks” of real estate investing. These properties are generally recently built and currently have a stabilized high yield, e.g. 7% or 8% per year.
When investors look at these properties/buildings, they’re generally maintaining income which is currently produced. There isn’t a lot of risk with a buy and hold (stabilized deal) and also not much reward.
(2) Renovation is the next type. A property which is a good candidate for a renovation would fit the description of an older building in a stable growth sub-market (one which can support higher rent prices) could get significantly higher income or value from renovating houses, units or entire building.
There is more risk involved with renovation type deals than a buy and hold stabilized deal, because property investors are banking on future upside of renovating the property (perhaps reselling to homeowner or another investor).
Value-add deals do limit risks? Typically the property/building is in decent condition and is a tangible asset ( i.e, asset = liability + stockholders equity) which is easier to show, discuss and understand.
An asset is a resource which is expected to provide future economic benefits (i.e. generate future cash inflows or reduce future cash outflows)…an asset is recognized when:
(a) Asset is acquired in a past transaction or exchange
(b) Value of asset’s future benefits can be measured with a reasonable degree of precision
In markets where there is increasing momentum and upside, value-add deals are easier to do because it requires vision and creativity, which is fun. Downside of increased momentum is competition from other bidders dramatically increases pricing for certain assets.
However, added value is created by gaps in information and understanding. This is where real deals can be made by being innovative,
creative and diligent with the details.
Success comes from properties which others may have overlooked or passed due to their lack of motivation and understanding.
Nothing in real estate is easy, yet if you have the desire to roll up your sleeves and get a little dirty, there are diamonds in the dirt.
Real estate is challenging and rewarding and you just got to know how to dig for the value-added, diamond in the rough deals.
(3) Real estate distressed properties, these usually need a lot of work (units or building itself is in bad shape) or under performing.
Often, these building have huge vacancy rates, so the projected income is a big factor in valuation. Real estate distressed properties carry even more risk than a renovation deal because the building needs work and it is already under performing.
4) New development deals. These are just what they sound like. Development happens when an investor wants to take raw land, then evaluates what can be built on it and what kind of future returns can be generated.
Development deals have the highest risk, and also carry the highest return. In reality, you don’t necessarily make the most money with development deals, because of inherent risks and uncertainty, don’t assume highest risk equals highest profits in your bank account.
Property valuation and due diligence: You are primarily wanting cash flow and reliable cash-on-cash returns because in real estate, property itself produces the income for your return on investment.
While the numbers are generally used to support valuation, comparable sale analysis is king when valuing properties because property is only worth what someone is willing to pay for it.
In residential “yield” is often used instead of “cap rate”. Capitalization rates are used as the primary metric in property valuation.
Cap rates are a very simple way of calculating the return on a building. Essentially, capitalization rates tell you what percentage of the funds you paid for the building comes back to you annually.
It’s just an easy metric to use; for example, if you have a 6% cap rate property and it’s at a 6% debt interest rate, you can easily see it is neutral leverage and isn’t returning any money.
Cap rates do have flaws and the biggest is everyone assumes cap rates in a specific sub-market to apply to every property within that sub-market. Simply this assumption isn’t true.
Every single property has its own nuances which makes it more or less appealing to potential investors.
If you get too clinical on only measuring cap rates, you could either be overvaluing or undervaluing your building. You really need to analyze each property/building and the market thoroughly to get a sense of how much value it is truly worth.
Another weakness, while cap rates are great to use in a city like Melbourne where buildings are constantly being bought and sold,
there’s considerably less data in other regions without as many sales taking place, so the numbers may not be reliable.
Basically due diligence means you are making sure the deal stacks up and doesn’t have more holes than a slice of swiss cheese.
Sellers want to sell their property at the highest price and investors have an interest in closing the deal.
Safe as houses, buyers need to protect themselves; due diligence is generally broken down into two components:
(1) You analyze the property at a micro level and then in the macro.
In the micro, you look at the building itself. You check the market to make sure projected rent prices at the property/building actually make sense, and people are paying those prices at similar properties in the area.
Next, you look at macro trends. You then dig deeper to make sure the tenants are in good financial shape. This is especially true if you are buying a single tenant building or more tenants in general.
You look at what other investors are paying for comparable buildings to make sure you aren’t over-paying. It’s also important to look at macroeconomic trends in the region you are investing to make sure the submarket can sustain positive economic growth over time.
Safe as Houses