Today, real estate represents one of the most dynamic, exciting and mixed-use investments around. Although this business has pretty much been around since humans left the trees, people continue to innovate and improve. The market continues to change, adapt and expand. Consider that real estate is viewed both as a luxury and a necessity, a solid business as well as an even more solid investment. Real estate can be used to live in or work in and can be bought or rented. Compared to your typical stock of Microsoft that you check five times a day, real estate is a lot more comprehensive. But there is a lot that goes into the business and before one begins to invest, they must understand the basics. Firstly, each piece of real estate falls under a certain zoning administered by the local government. Ever think about why nobody lives between Kimbark Liquors and the Co-op? It's because Kimbark Plaza is zoned for retail real estate. This also means that each piece of real estate is classified into specific categories. These categories include, but are not limited to residential, industrial, retail, commercial, parks, schools and mixed use. The last one is particularly compelling in that some locations can be zoned for more than one purpose. In these cases, real estate owners can consider which type(s) of property would be most lucrative in their specific location and actively execute a more complex business strategy. In addition to different zones, real estate also has different stages of development. Whereas a stock might have an initial public offering (IPO), it quickly becomes a commonly traded security. Real estate, on the other hand, has several important stages that a business can enter.
The stages of development are known as Ground Floor, Loan, Interim, Tenancy, Absorption, Maturation, Aging and Demise. While each of these stages deserves its own description, that may require a more thorough undertaking. Nevertheless, these can be summed up by saying that the earlier one gets in on a project, the more risk they undertake and the greater possible reware they can receive. Each stage also has a range of associated real estate businesses, from the land surveyor, to the architect and engineer who design the building, to the banker who finances the project, to the developer that builds the property along with their associated contractors and subcontractors.
Once the building is completed, the owner must find tenants. This stage is particularly compelling because the real estate market is not as liquid nor as efficient as the stock markets. Prices are sometimes difficult to ascertain and the client is not always completely certain of what they are getting. At the company I worked with this summer, we provided professional consultation services to companies or individuals in this process. We also could represent, find and negotiate contracts for clients if they so desired. Professional real estate consultants have the enormous advantage of greater market knowledge than the typical investor.
After that phase, there is the long slow decline of the property toward economic obsolescence. If another buyer is found, there is a new round of financing, valuations (determining the value of the building and land) as well as tenant consultancy. Eventually though, the property will probably meet the wrecking ball and the process will begin anew. When thinking about investing in real estate, it is important to realize that it is one of the least concentrated investment vehicles. In other words, rather than control resting in the hands of a relatively few major investment firms or trusts, real estate is held by a wide variety of people throughout the country. It also turns out that real estate is the only major purchase made by average Americans in which they expect to see a return on investment (ROI).
The first rule of investing is always to consider the risks. Real estate investors must consider the financial risk of not getting back their principal (original lump sum invested), the interest risk that rates will diverge from expectations and the liquidity risk that the owner will not be able to find an adequate buyer or that money will be lost in the process of converting the property to cash. The final two are particularly important to the real estate investor. These factors are extremely important during the process of buying and selling a property, when all of the important financial decisions are made.
On the other hand, real estate investors have particular advantages in the realm of investing. The three most important benefits are tax shelter, cash flow and the payoff on the proceeds of the sale. For poor college students like us, the final two points are the most important. These can provide substantial income, and in the case of the sale, are the major incentive for real estate investment. Briefly, tax shelter occurs because cash flow plus amortization (repayment of the mortgage) - depreciation (loss of value of the property) = taxable income. In this situation, people are often in the position where cash flow is completely sheltered from taxes or even at a net tax loss. In addition, selling is particularly advantageous because property sales are subject to capital gains tax rather than the much higher income tax.
Another more limited way to invest in real estate is through publicly traded real estate investment trusts (REITs). These REITs were organized under a special tax law wherein they must return at least 90% of their profits to investors in the form of dividends. This is a great way to gain income and at the same time invest in the market. In fact Equity Office (EOP) and Equity Residential (EQR), which are headquartered right here in Chicago, have both beaten the S & P 500 over the last five years*.
With all that said, I must say that now is a great time to buy as interest rates slowly rise from historic lows. As time progresses, most properties' real value will be more expensive due to higher interest rates. It will be far more advantageous to rent than to buy. In that way, rent will go up and owners will take a greater profit.
With so many options and componants to the real estate business, it certainly is one of the most dynamic industries. Whether you are investing in, livings in, working in or just appreciating real estate, consider the underlying business and all its parts.
*Note that the author does not hold either company.