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CHAPTER 1
VALUATION OF PROPERTY
The Starting Point
Real estate is different than all other forms of investing in several ways: tax benefits, generation of income to pay for mortgages, and more than anything else, the fact that cash flow is more crucial than profits. While this point was made in the first edition of this book a decade ago, it is as true today as ever. In 2008 and 2009, it looked like real estate was done as a viable investment, but this has been predicted many times in the past. The predictions were always wrong.
Today, real estate looks better than ever for investors. Home ownership rates are way down, but rental rates are significantly higher than in the past. For investors, this means that investment property is today more popular than ever before, based on cash flow as well as profit potential. The true meaning of value in real estate begins with profitability, but ultimately it is determined by cash flow.
All investments are judged on the basis of their current and future market value. In the case of real estate, the historical rise in the market value of properties has been consistent and has served as the base for many long-term financial plans. Many people, whether they are investing only in their own homes or expanding into a portfolio of rental properties, have discovered the potential for profits through real estate.
All forms of investing should be based on study and analysis. Real estate properties vary greatly in cost as well as in quality, location, and income potential. A smart place to begin the search for real estate investments is to identify some of the common myths about this market. These myths include the following:
1.Real estate values always go up. Markets always move in cycles. Therefore, every market, including the real estate market, will exhibit periods of strong growth and periods of stagnation and even declines in market values. While these cyclical changes may be temporary, they are part of the investing process.
2.Profit over the long term is the most important criterion. While profits are important to all investors, most people who put their money in real estate cover the majority of the purchase price through financing. Because investors have to generate enough rental income to cover their mortgage payments (along with property taxes, insurance, utilities, and repairs), profits are only one of the measures by which the value of an investment is judged. Of far more immediate concern is the cash flow that you can gain from that investment. As long as rents are high enough to cover all of your expenses and payments, cash flow is positive. But if rents stop or aren’t high enough to provide that coverage, your investment plan could be in trouble. This is where careful planning and analysis of risks is so important.
3.Tax benefits are so good that it’s always smart to carry a mortgage. A common belief is that a mortgage, even one with a high interest rate, is beneficial as long as rental income is higher than the mortgage payments. The argument may be made that interest on the mortgage payment is deductible as an investment expense, so it does not make sense to pay down that mortgage or to get a lower balance initially. This is false. It is always better to reduce your payments and expenses; you will always end up with a stronger cash position with a smaller mortgage and lower payments.
4.You can’t lose with real estate. It would be more accurate to say that the chances of losses on any investment are drastically reduced when you study the market beforehand. It is possible to lose money on any investment, but that invariably occurs because the real risks were not properly evaluated ahead of time. Real estate investors benefit from the historically strong market value growth in real estate, unique tax advantages for investors, cash flow potential from well-selected properties and well-screened tenants, and intelligent analysis in the selection of investment properties. In spite of advertising to the contrary, success in any form of investing is rarely easy or simple. It can be made so with research, which gives you an advantage over most investors.
WHERE AND WHEN TO BUY
The two factors determining real estate value are location and timing. When you begin to study the market, you start out with a large field. Just as a stock market investor starts with a potential investment field consisting of thousands of stocks, real estate investors also face a large number of possibilities and need to narrow down their choices.
Location and timing are concepts that are broadly understood by investors. In the stock market, you have market sectors, size of companies, capital strength, and competitive factors; these are the “locational” aspects of picking stocks. In real estate, location means the specific property and its immediate neighborhood, and also the city or town and larger region where the property is located.
With all investments, timing is everything. If you invest money when prices have peaked, your timing is poor; but the tendency among investors is to have the most enthusiasm and confidence at exactly those moments. If you invest money when prices are depressed, your timing might be good (only time will tell). But the tendency among investors is to be cautious and uncertain when prices have fallen. So the old advice to buy low and sell high applies to all markets, including the real estate market.
You face some artificial indicators when you look at real estate valuation. In a generally strong market, there may be a tendency to believe that all real estate is going to appreciate and that it is impossible to go wrong. Of course, you may see the same false euphoria in the stock market; but in real estate, regional trends may support this belief. Because real estate does not trade on an open exchange like stocks, it is difficult to spot short-term trends or to quantify them, and it is even more difficult to narrow down the location of a sensible real estate purchase.
These artificial indicators can mislead you if, in the search for valid data about the local market, you do not distinguish between broad and narrow f...
