By Alexander Bermudez
How many times have you heard the statement, “ If only I had bought property, back when it was so cheap”? Even the most successful real estate investors have been known to mutter these words from time to time. Suffice to say, the best time to buy has always been in the past, short of that, and providing the property can achieve the economic objectives of the investor, now is as good a time as any to start investing in real estate.
The population of the world is continually expanding and with this, comes accelerated migration to areas with the greatest economic opportunities. As demand rises, prices of well-situated real estate will trend upwards, triggering a surge in development until equilibrium is achieved, thus the market cycle. However in mature markets or areas constrained by geography, new development (supply) is stunted, creating an imbalance. Rents and capital appreciation, in constrained markets will invariably outperform the broader markets, due to the increasing demand and limited supply.
That being said, it is far more prudent for prospective buyers to focus their analysis on free cash flow rather than speculating on future appreciation. As with all real estate investments, ‘cash flow’ is the true asset being acquired.
Cash flow is expressed as ‘net operating income’ (NOI), which is gross scheduled income minus vacancy allowance and expenses. The NOI formula has no provision for mortgage costs and thus eliminates the impact of fluctuating interest rates, while comparing the relative profitability of various real estate investment opportunities.
Assume two buildings, each with a ‘gross scheduled income’ of $100,000. The vacancy allowance for each building is $5,000. One building however, has annual expenses of $30,000 (NOI of $65,500) while the other building has annual expenses of $45,000 (NOI of $50,500). Presuming no other differences between the two buildings exist, prudent investors will inevitably opt for the property with the greater NOI.
A word of caution; investment real estate in well established, affluent or ‘low risk’ neighborhoods will exhibit noticeably lower ‘net operating income’ (NOI), when compared to similar properties in marginal, less affluent or ‘high risk’ neighborhoods. This is particularly important if an investor intends to personally manage the property, as affluent neighborhoods will be far less demanding on one’s time, relative to properties in less favorable areas.
Yields will also vary according to the age of the improvements; an older building with a higher risk of incurring unexpected maintenance costs, due to obsolescence will tend to exhibit a better yield relative to new construction. This is the nature of all investing; as the rewards increase so does the risk.
Investors will have to carefully balance their aspiration for yield against the shortcomings of lesser neighborhoods. When equilibrium is reached that satisfies both the risk tolerance and the yield expectations of the buyer, a transaction will likely ensue.
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