Property or Real Estate investments are not a liquid asset, as they are not easily interchangeable with cash. Hence, identification of the land or property for investment can take a lot of time and energy as the investor first needs to get familiar with the market dynamics. Here is my opinion on some of the financial aspects of real estate which you should be familiar with.
- Pricing or Valuation of Property: Some of the most common appraisal methods for arriving at the right valuation of the property includes price comparison. This can be done through sources like market listing, real estate brokers, public agencies or auctions and similar property sale. You can use cost approach which is a summation of all construction cost less of depreciation and is ideal for new construction, and income approach suitable for property on rentals.
- Mortgage Loans: Purchasing a property can be very expensive and a buyer often needs a mortgage loan to finance the purchase. The loan offered by banks is generally used to collateralize by the property itself. The Loan to Value (LTV) ratio is an indicator of the risk taken by an investor. Leverage is the term used for the amount paid by the investor against the amount paid by the bank in a mortgage. Most banks consider 20% of the valuation as minimum leverage requirement for a loan. Also choose your type of mortgage loan wisely. There are Fixed rate loans and Adjustable Floating rate loans available – choose whichever suits you the most. You can also negotiate a good deal on interest rates, lower property insurance premiums and waiver of loan processing charges from the financers of the loan. Go through the terms and conditions of the financers in detail as there may be fraudulent elements or harsh fines on default. Many REITs and Pension funds often invest in real estate with zero leverage to minimize their risk.
- Net Operating Income or NOI: Banks generally charge some interest and loan processing charges on the mortgage, but they are recovered along with the principal amount in form of monthly installments or EMI. These additional costs create a negative cash flow for an investor right from the start of loan. However, investor also gains positive cash flows in the form of rentals received, depreciation of the property, increasing equity and appreciation in property value. Over a period of time as the sources of positive cash flow grow in value, an investor may partially or completely offset the negative cash flow generated due to loan costs. The difference between positive and negative cash flows is called Net Operating Income or NOI. It essentially means rents less of expenses. The higher the NOI the better of the investor will be. There another important financial term called Capitalization rate which is the ratio of NOI to Purchase price. In an ideal scenario, this ratio gives you an idea about how many years an investor will take to recover the costs of his real estate investment.
Real estate investments carry high risk and offer high return as well; hence, I would recommend you to do a careful research. Remember, only proper financial planning can help you reap the best returns.