Property investments offer several benefits, but also entail several risks of different magnitude depending, on the particular property that is acquired and its location. That is why smart property investors need to first understand and assess as accurately as possible the potential benefits of a real estate investment and its risks, before proceeding to the acquisition of any property.
The major benefits of investing in property include the following:
- Usually the largest profits from property investments come from capital gains, that is, from increases in the value of the property over the holding period. Property markets move in a cyclical fashion due to inefficiencies in adjustments of demand supply and prices. In the long- term though, it is widely believed that there is a secular upward trend of rising property values. However, caution is needed when selecting locations and properties for investment purposes because this secular trend of rising property values does not apply to every property at any location.
- Income received monthly from renting the property is another significant benefit of property investments. Notice that real estate, is definitely superior than stock investments that rarely pay any income (dividend) to the stockholders, and even when such income is paid is very low compare to the net income returns that can be achieved by in investing in property. Under normal property market conditions income returns from property can range roughly from 5% to 10% depending on property type and location.
- Potential tax deductibility of some expenses associated with property investments, such as depreciation on the property and interest payments on loans that were used for the acquisition of the property
- Positive leverage is another potential benefit of investing in property. Investors can enjoy the benefits of positive leverage when the use of borrowed funds increases the return on the investor’s own funds used for the completion of the transaction. However, this is not always the case, because it will depend on the cost of borrowed funds and the income return and after tax capital gains that the investment will eventually produce for its owner. The best way to analyze the potential and magnitude of positive leverage when borrowed funds are to be used for the acquisition of a property is through the use of the discounted cash flow model, which can take into account the timing and size of the expected after tax-cash flows, which incorporate and the perioding mortgage payments. If the income return and after tax capital gains are not high enough then the use of borrowed funds can actually have a negative effect on the ultimate return on the investor’s own funds. See my post Borrowing Can Help Property Investors Achieve High Returns for more on this
The major risks associated with property investments include:
- Capital losses due to decline in property values or due to circumstances that may lead the owner to liquidate the property at a value lower than the cost at which it was acquired
- Negative cash flow when the income produced by the property is not sufficient to cover operating expenses and mortgage payments, in which case the investor will need to use money from his/her personal accounts
- Significant time on the part of the landlord, if he/she is acting also as the property manager
The key to assessing as best as possible all the above benefits and risks is to evaluate thoroughly what can be expected in terms or rental income levels and changes for the particular property in the particular market within which is located over the investment horizon. Similarly, caution is required when assessing the potential for value increases and the price at which the property can be potentially sold a the end of the holding period. Furthermore, the investor needs to have a very good understanding of the sensitivity of the projected rental income and the sales price of the property to the key assumptions on which such projections are based.
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