INCOME – A stream of money an investment produces (cash flow),
APRECIATION – A passive increase in value from scarcity and inflation and,
VALUE GAIN – An active increase in the value from the development and good business management of the investment.
The Basics of Income, Appreciation and Value Gain
Income is the most popular type of ROI because it generally meets the needs of most investors. An income return is usually a fixed income investment and is very liquid. Common types are Corporate and Government Bonds, Treasury Bills, and Savings Accounts.
Be careful of inflation since it can decrease the value of a fixed income investment. For example, if you put money in an account that gave you 7% interest, but inflation was at 3%, your real return is only 4%.
Appreciation is speculating that something will increase in value over time, such as collectibles. There is no guarantee of an increase in value and it is very difficult to measure any increase precisely.
I saw an episode of Pawn Stars last night on TV and someone brought in a rare Nintendo system from 1995. Unfortunately for him, about 6 months earlier, someone found a cargo crate filled with the same Nintendo systems that were brand new in the box. It went from being worth $300 to $80 just like that. I also saw on American Pickers where the guys found a Schwin Autocycle for $1,000, but since only 10 have ever been found, it was worth close to $5,000!
Value Gain Investments leverage the knowledge and ability of the owner to create a positive return. There may also be an increase in value from inflation. Two examples would be developing raw land or buying stocks. The disadvantages are the risks associated with market trends, fluctuation in management and economic unpredictability.
Mixed Return investments are a combination of 2 or 3 of the ROI categories. For example you could buy a stock that pays dividends.
Dividends = Income
Inflation = Appreciation
Company Growth = Value Gain
For real estate you could:
Take a mortgage = Income
Own a piece of undeveloped land = Appreciation
Develop the Property = Value Gain
When comparing investment opportunities, they need to be reviewed on a case by case basis. You need to ask yourself:
- What are your needs in terms of security and income?
- What are your investment goals?
- What are your tax requirements?
Real Estate As An Investment
Most real estate investors want low risk and high returns, but expect high returns for higher risks. Real estate investing is speculative and may not produce the right amount of income an investor wants, needs or expects.
Inflation plays a role in appreciation. Although real estate can be sensitive to inflation, it often maintains it’s real value better than other investments. When land scarcity inflates property values, the land appreciates in value.
You could increase potential returns by improving/expanding the property or by creating a different use for it. If you have a 10 acre piece of land and then develop a town home community or have an industrial site than can become residential, you might gain value. Creative and proactive property management can greatly increase a property’s value.
All property improvements and personal property may be eligible for depreciation deductions for an added tax advantage.
Remember that real estate can also be used as collateral since it is tangible and ownership is recorded and legally protected from third party claimants.
Real Estate Investment Disadvantages
You need to know the good, the bad and the ugly when it comes to any type of investing. If you only smell roses you might find yourself in a pile of something else later on!
Lack of Liquidity
Real estate is not easily converted into cash. The market is limited to people who want the property and who can afford it. Financing requires considerable time and effort.
Term of Investment
Usually real estate is a long term investment (minimum of 3-5 years but more likely 5-7 years) before gaining value from inflation and good business management. Just as we’ve seen during the past decade, real estate can depreciate in value. Although, investors that bought in 2000 saw huge appreciation and even with the downturn in the market have still realized some gains. Short term gains are possible, such as “flipping”, but are very speculative.
Business Management
Real estate requires ongoing management of sales, rentals, maintenance, operation, customer and employee relations, tax related issues and tax reporting. Property owners must devote personal time and effort to managing the property OR hire a professional property manager.
Property Hazards
Losses can be recovered through insurance but is rarely a profitable procedure. If a multi-family home is destroyed in a fire, you might not be able to build and re-lease for months if not years and you lose the income that was coming every month.
Legislative Concerns
Issues such as land use laws, environmental controls, rent controls, and development set-asides could affect your bottom line. Land use laws and environmental controls may restrict development which effects property values as well as rent controls limit gross rental income. Development set-asides affect the investment return such as low income housing only.
Hopefully this will give you a basic idea of investing in real estate. It should have answered most of the concerns I hear on a daily basis. Everything doesn’t always turn out as pretty as you see on TV. It takes time, patience and effort to make the right decision.
Prudential Fox & Roach is an independently owned and operated member of
Prudential Real Estate Affiliates, Inc., a Prudential Financial company.
Equal Housing Opportunity.
No comments:
Post a Comment