Looking to invest in real estate in 2014? In this post we share some of our best tips on real estate investing for the year ahead. Let’s start with the macro environment. Interest rates are very low and are likely to trend upwards. The U.S. has been running large budget and trade deficits, and selling government bonds to finance these deficits. It is apparent that many buyers of our bonds, such as the Chinese government, would prefer to have some other place to park their savings, but there is no alternative reserve currency on the horizon.
Now let’s add a few subjective observations. On the plus side, America is in the midst of an oil and gas boom driven by new drilling technologies. On the negative side, U.S. public schools are generally failing to educate young people for the jobs of the future, and income and wealth gaps between rich and poor have widened dramatically, hollowing out the middle class that was the driver of America’s growth historically.
Below are some tips on how to think about real estate investment in 2014, and some pitfalls to avoid. After that, we provide some tips and recommendations.
1. Keep Your Expectations Realistic. Low interest rates mean that earning a good return without taking on too much risk will be difficult. The U.S. keeps interest rates low in an attempt to spur the economy and lighten the load of servicing its debts, however the flip side is that investors have few attractive options. In other words, investors need to keep their expectations relatively modest, or else they risk being disappointed.
2. Don’t Get Caught Flat Footed by Rising Interest Rates. The prospect of interest rates rising over time is negative for the value of most types of income property. Recent ultra-low rates on mortgages for high quality income property have allowed investors to bid up the price since they could generate relatively attractive income after debt service by virtue of very low debt service. If rates rise, future buyers will need to factor in much higher loan payments on a given loan amount, meaning that in order to generate the same cash flow after debt service, they need to pay less for the property. This effect is mitigated to the extent that rents rise as interest rates go up.
3. The World Has Changed in Important Ways. Some investment strategies that worked wonderfully in the 1960s, 70s and 80s may not work as well in the decades ahead. For example, investing in shopping centers and office builldings is very different now.
4. Online Shopping Can Hurt Shopping Centers. In the case of shopping centers, retail sales are increasingly shifting online. Also, the increasingly concentration of wealth and income means that for most families, disposable income is not growing the way it used to.
5. Demand for Office is Stagnant. In the case of office buildings, companies are planning ever-denser offices, with more employees working in a given amount of space as businesses encourage more collaboration and squeeze costs. A recent survey projects the average space per employee dropping from 225 square feet in 2010 to 151 square feet by 2017. The demand for office space is dropping as this trend continues.
Now let’s look at Arixa’s best tips and recommendation for real estate investors in 2014:
6. Look for Opportunities to Create Real Value. In spite of all the challenges, savvy developers still find great investments every day. The key is to find a motivated seller and/or to be able to enhance the property substantially at a reasonable cost. For example, expert developers who renovate homes are frequently able to add two dollars of value for every one dollar they spend on a renovation. They buy the smallest and worst home on a given block and make it into the best home. In neighborhoods with strong demand this formula will continue to work for many years to come.
7. Consider Being a Lender. Since the financial crisis that started in 2007, banks have pulled back from lending in many areas. This has created a variety of opportunities to make loans that provide attractive income while also being well-secured. If you don’t have experience as a lender, work with someone who does to identify investments that fit your risk profile.
8. Find an Experienced Investor and Learn. If you don’t have a successful track record as a real estate investor, get started by working with someone who does. Real estate investment can be enjoyable and profitable, but it has its pitfalls. Avoid making amateur mistakes by investing alongside a seasoned pro and studying how they do what they do as much as possible. Even investors who want to be passive need to employ a high level of diligence—both in evaluating the investment manager/operator, and the specific projects in which the manager has invested and plans to invest.
9. Remember that Real Estate is Hyper-Local. An investor I met, who was advised by a terrible broker, sold a 24 unit apartment property in Southern California which she owned free and clear and bought a 200 unit building in Arizona. She ended up losing her entire investment. Don’t be tempted by ultra low prices unless you really understand the dynamics of that particular market. It is hard to really understand a wide variety of markets. Pick a few places where you can become an expert.
10. Pick Your Partners Carefully. Even a very favorable acquisition can turn into a mediocre investment if you pick the wrong partner to operate the project. Study the past performance of the operating partner/sponsor and speak to their past financial partners and investors. Don’t make the mistake of thinking “this time will be different” or “this deal is so good, it will be fine” even if the partner has a checkered history. The frustration will be such that even if you make money, you will regret the decision.
11. For Experts Only: Consider Working with Under-capitalized Developers: At the same time, if you are an expert real estate investor and you can negotiate to keep control of all major decisions, then money can be made by partnering with developers who have great projects but can’t raise the capital needed to take advantage of an opportunity, perhaps because of a past bankruptcy. Just be prepared to take over at any time if necessary to protect your investment.