Introduction
This article is meant to be an introduction to the topic and not an exhaustive guide. The
topic is complicated, and I recommend that anyone interested in pursuing this type of
investing seek the advice from the appropriate professionals so that you may be advised
on the particulars of your individual situation.
This article is written in two parts. Part I covers basic information on real estate, and Part
II explains how to use retirement plans to buy, sell and hold real estate.
The strategies discussed can be used in many types of retirement plans such as an IRA,
401(k), SIMPLE, SEP, or other retirement plan. I will use the term IRA or retirement
plan generically to reference these types of accounts.
Part I: Real Estate Basics
Modern portfolio theory suggests that Real Estate is an important part of an investment
portfolio's asset allocation. From asset allocation we get diversification, which means an
overall reduction in risk.
Real estate investments can be made through an indirect purchase of real estate such as in
Real Estate Investment Trusts (REITs) or through a direct purchase of property. It is the
direct ownership of real estate that we will focus on because of its particularly appealing
favorable risk-return tradeoffs that result from its uniqueness and the relatively inefficient
markets in which real estate trades.
Some people follow the theory that the securities markets are efficient, and others do not.
However, I do not know anyone who believes that the real estate markets are efficient.
What this means is that skillfully conducted real estate analysis can really payoff.
The reason why real estate markets differ from securities markets is that there is no good
system for complete and accurate information exchange among buyers and sellers. There
is no central marketplace like there is in the securities markets, such as the New York
Stock Exchange or other exchanges. Instead, real estate is traded in generally illiquid
markets that are regional or local in nature and where transactions are made to achieve
investors? often-unique investment objectives.
Before we discuss how to buy, sell, and hold real estate in self-directed IRAs or qualified
plans, let's briefly discuss investor objectives, constraints and analysis of important
features of real estate that apply whether you are investing in or out of your retirement
plans. Please remember that just because you can use your retirement plans does not
necessarily mean you should use your retirement plans for real estate investing.
Just as a mutual fund manager is responsible for managing securities for its shareholders,
you must realize that managerial decisions about real estate greatly affect the returns
earned from investing in it, and that you are the manager. Thus, you must ask yourself
some tough questions. Are you going to invest in income producing property, such as
residential rentals and multifamily properties like apartments; or, maybe, commercial
properties like office buildings and shopping centers? You may be a real risk taker and
prefer speculative property like raw land and real estate investment properties that are
expected to provide returns primarily from appreciation in value due to location, scarcity,
and so forth, rather that from periodic rental income. If you decided on income producing
property, you may want to ask questions like: What rents should be charged? How much
should be spent on maintenance and repairs? What appurtenances will be transferred with
the property? Are there any looming adverse environmental issues? Along with market
forces, answers to such questions determine whether you will earn the desired return on a
real estate investment. Remember, like other investment markets, the real estate market
changes over time and you need to stay abreast of the macro and micro issues that might
affect your real estate portfolio. Investing in real estate means more than just ?buying
right? or 'selling right.? It also means choosing the right properties for your investment
needs and managing them well.
Managing your properties well will be easier if you have clearly identified your
investment objectives and constraints. As we discussed earlier, do you want income
producing property or speculative property? To select wisely, you need to consider the
available types of properties, and which type you are better suited to.
When setting your objectives, you also need to set both financial and non- financial
constraints and goals. Often this financial goal is stated in terms of discounted cash flows
(net present value) or an internal rate of return (IRR). The risk-return relationship you
find acceptable will be determined by things like:
- How much money do you want to allocate to the real estate portion of your
portfolio?
- Will you use debt financing?
- Do you require positive cash flow?
- How much down payment will you make or how much down payment is required
to achieve your return goals?
You also need to consider how your technical skills, temperament, repair skills, and
managerial talents fit a potential investment. Do you want a building with curb appeal
and that is trouble free? Or would you prefer a fixer-upper?
There are four general features related to real estate investments on which to base your
analysis.
- Physical property
- Property rights
- Holding period
- Location
Physical Property
Through proper inspection of the site and its building(s), you can make sure you are
buying what you think you are buying. Problems can arise if you fail to obtain a site
survey, an accurate square-footage measurement, or an inspection of the building(s). Be
sure to confirm that the purchase and sale agreement accurately identifies the real estate
via its legal description and that it lists all items of personal property that you expect to
receive (such as a refrigerator).
Property Rights
When you buy real estate, what you are really buying is a bundle of legal rights that fall
under concepts in law such as deeds, titles, easements, liens, and encumbrances. Just like
you do a physical inspection, you want to do a legal inspection. Real estate and lease
agreements should not be the work of amateurs, and you should seek the advice of a
qualified attorney when necessary.
Holding Period
When you are evaluating your holding period or time horizon, you need to remember that
the real estate market goes through cycles just like other markets do, and you need to
identify where you are in the cycle. Prices go up and down, slowly and quickly. So before
judging whether prices will appreciate or depreciate, decide what time period is relevant
for your situation and the property you are investing in.
Location
Location, location, location! You have heard it before, and, yes, it really is that important.
For some properties, the area of greatest concern consists of a few blocks. For others, an
area of hundreds of square miles serves as the relevant market area. Understand the
boundaries that are important for your investment so that you can properly analyze
supply and demand.
The last issue I will mention before moving on is determinants of value. In the analysis of
real estate investments, as with all investments, valuation is a key concern. This subject
matter could go on for pages; but I will keep my comments brief, because I feel you
should be working with a qualified professional who can help you with valuation issues.
There are four main determinants of value that will help you evaluate your real estate
investment.
- Demand
- Supply
- The property
- Property transfer process
Demand
Demand is the measurement of people 's desire to buy or rent a given property at a given
time and stems from a market area's economic base. Property values follow an upward
path when employment is increasing, and values typically fall when employers begin to
lay off workers. Population demographics and people's emotional dispositions called
psychographics are also key elements to demand.
Supply
How many other similar properties (competitors) are available in your targeted area? Size
up the competition. The more properties on the market for a given number of buyers or
sellers, the lower the value. The fewer properties on the market, the higher the value. One
other concept to evaluate is the principle of substitution. Are there other properties that
can fill the same need? If so, then there is more supply.
The Property
The property itself is a key ingredient. Look for a property's unique selling advantage.
What makes it different? What is its competitive edge? Investors should consider five
factors.
- Restrictions on the use of the property
- The location
- The size and quality of the site
- Improvements made
- The efficiency of management
Property Transfer Process
This is the process of promotion and negotiation of the property, which can significantly
influence the cash flows a property will provide. Here we are trying to bring efficiency to
an inefficient market. You may want to think of this as creative or efficient marketing.
Once you have gathered all of the pertinent valuation determinants, you can then perform
the valuation and investment analysis, interpret your results, and make a portfolio
decision.
Please find an example of what one evaluation might look like as an exhibit at the end of
this writing.
To summarize the process:
- Set objectives, goals, and constraints
- Analyze important features of the property
- Gather determinants of value
- Perform analysis
- Implement your decision