For most real estate investors, the goal is to choose profitable properties that will maintain and grow in value. But factors out of your control can negatively affect the value of real estate. Investing in this sector requires good fundamental knowledge — and a modicum of caution.
Although national real estate trends are important to monitor, the best market indicators generally are in your backyard. Do everything you can to learn about and understand local rental rates, occupancy levels, competitive space supply and demographic trends. Moreover, don't forget that expansions, cutbacks or relocations by major local employers can significantly affect property prices. This means you'll need to regularly monitor local news and blogs for such developments.
Social and historical factors also play a large role. Knowledge of a historical event that took place on a property or a neighborhood's reputation as a hotspot for the rich and famous, for example, may help drive real estate prices up. Highly rated local public schools can be a major factor in the value of neighboring homes. Value-lowering factors, on the other hand, include:
Again, mine the local news and records for both good — and not so good — property information.
Your investment decisions are only as good as your financial projections. This means it's crucial to look at real operating figures when purchasing an established rental property.
Be sure to evaluate existing leases to find out when they expire. Do they include escalation clauses? Can you renegotiate any soon-to-expire leases at higher rates? Or will you need to renegotiate them at lower rates to retain the tenant?
Keep in mind that historic rental and vacancy rates may not be realistic going forward. And some landlords leave money on the table by forgetting to enforce escalation clauses or recoup expenses paid on a tenant's behalf. Finally, don't assume that you can slash expenses — or boost revenue simply by raising the rent. Rent-control laws, not to mention oversupply and competition, may limit your ability to increase rent prices.
Performing due diligence on a prospective property is the most important thing you can do as an investor. Be sure to look for deteriorating bottom lines, as well as aggressive revenue recognition policies or deferred expenses.
A comparison of the property's cash flow against its earnings statement can be revealing. If the former owner shows net income increasing while cash flow is in the red, be wary. A change in accounting methods or accountants midstream should also raise a red flag. Both of the situations should prompt you to question the reasoning behind such moves.
If used properly, leverage can be a powerful tool for increasing your return on investment. Debt allows you to use other people's money to boost your return, so long as you can earn a higher rate of return than you're paying in interest.
For a long time, interest expense was fully tax deductible, making leverage extra appealing. But the Tax Cuts and Jobs Act introduced a significant new restriction on the interest expense deduction for businesses with more than $25 million of average annual gross receipts, generally limiting the deduction to 30% of adjusted taxable income. However, the law generally allows real estate businesses to elect out of the interest limitation rules.
Important: Electing out of the interest limitation rules has complicated tax consequences that you should discuss with your financial advisor first.
Even if you do your research, you may end up investing in real estate that doesn't perform to your expectations. Most investors didn't anticipate the pandemic's negative effect on the value of office space — or its positive influence on the value of some housing markets. However, if you invest with a long-term perspective and focus on solid fundamentals, you're more likely to make the right choices.
Get in touch today and find out how we can help you meet your objectives.
