Whether you're curious about the investment potential of real estate
or simply sick of infomercials promising millions of dollars in
returns from a new and obscure way of investing in real estate, it is
worth learning how wealth is created through real estate.
Tutorial: Exploring Real Estate Investments
We're not looking at strategies for how to profit from real estate.
Instead, this article will focus on the basic ways that money is made
through real estate. And, fortunately for us, these haven't changed in
centuries, no matter what kind of gloss the gurus of the moment try to
put on it.
*Appreciation*
The most common source for real estate profit is the appreciation -
the increase in the value - of the property in question. This is
achieved in different ways for different types of real estate. And,
most importantly, it is only realized through selling or refinancing.
*Raw Land*
The most obvious source of appreciation for undeveloped land is, of
course, developing it. As cities expand, land outside the limits
becomes more and more valuable because of the potential for it to be
purchased by developers. Then developers build houses that raise that
value even further.
Appreciation in land can also come from discoveries of valuable
minerals or materials, provided that the buyer holds the rights. An
extreme example of this would be striking oil, but appreciation can
also come from gravel deposits, trees and so on.
*Residential Property*
When looking at residential properties, location is often the biggest
factor in appreciation. As the neighborhood around a home evolves,
adding transit routes, schools, shopping centers, playgrounds and so
on, the value climbs. Of course, this trend can also work in reverse,
with home values falling as a neighborhood decays.
Home improvements can also spur appreciation, and this is something a
property owner can directly control. Putting in a new bathroom,
upgrading to a heated garage and remodeling to an open concept kitchen
are just some of the ways a property owner may try to increase the
value of a home. Many of these techniques have been refined to
high-return fixes by property flippers who specialize in adding value
to a home in a short time.
*Commercial Property*
Commercial property gains value for the exact same reasons as the
previous two types: location, development and improvements. The best
commercial properties are in demand, and that drives the price up on
them.
*The Role of Inflation in Appreciation*
Of course, there is one major factor we skipped in our summary - the
economic impact of inflation. A 10% inflation of the dollar means that
your dollar can only buy about 90% of the same good the following
year, and that includes property. If a piece of land was worth
$100,000 in 1970, and it sat dormant, undeveloped and unloved, it
would still be worth many times more today. Because of runaway
inflation throughout the '70s and a steady pace since, it would likely
take over $560,000 to purchase that land today - assuming $100,000 was
fair market value at the time and all other factors remained constant.
So, inflation alone can cause appreciation in real estate, but it is a
bit of a Pyrrhic victory. Even though you may get five times the money
due to inflation, many other goods cost five times as much to buy now.
*Income*
Generally referred to as rent, income - or regular payments - from
real estate can come in many forms.
_Raw Land Income_
Depending on your rights to the land, companies may pay you royalties
for any discoveries or regular payments for any structures they add.
These include pump jacks, pipelines, gravel pits, access roads, cell
towers and so on. Raw land can also be rented for production, usually
agricultural production.
_Residential Property Income_
Although it is possible that you may earn income from the installation
of a cell tower or other structure, the vast majority of residential
property income comes in the form of basic rent. Your tenants pay a
fixed amount per month - and this will go up with inflation and demand
- and you take out your costs from it and claim the remaining portion
as rental income. While it is true that you will get an insurance
payout if your tenants burn down the place, the payout only covers the
cost of replacing what is lost and is not income in a real sense.
_Commercial Property Income_
Commercial properties can produce income from the aforementioned
sources - with basic rent again being the most common - but can also
add one more in the form of option income. Many commercial tenants
will pay fees for contractual options like the right of first refusal
on the office next door. These are essentially options that tenants
pay a premium to hold, whether they exercise them or not. Options
income is sometimes used for raw land and even residential property,
but they are far from common.
*What About REITs or MICs?*
Real estate investment trusts (REIT) and Mortgage Investment
Corporations (MIC) are generally considered to be great ways of
getting income from real estate. This is true, but only in the sense
that real estate is the underlying security. With a REIT, the owner of
multiple commercial properties sells shares to investors - usually to
fund the purchase of more properties - and then passes on the rental
income in the form of distribution. The REIT is the landlord for the
tenants (who pay rent), but the owners of the REIT get the income once
the expenses of running the buildings and the REIT are taken out.
MICs are even a further step removed, as they invest in private
mortgages rather than the underlying properties. MICs are different
from MBSs in that they hold entire mortgages and pass on the interest
from payments to investors, rather than securitizing the interest
streams independent of the original mortgage. Still, they are not so
much real estate investments as they are debt investments, and thus
outside of our area of interest.
*Smoke and Mirrors*
Similar to securities with real estate underlying the investment, most
of the alternative "blow your mind with super fantastic return"
methods are merely a layer on top of these two basic steams of income.
For example, there are informal residential real estate options where
you pay a fee to have the right to buy a house at a given time, say
after a month, for an agreed upon price. Then, you find investors who
will pay more than your option price for the property. In this case,
the premium you get is essentially a finder's fee for matching a
person looking for an investment with a person looking to sell - no
different than a real estate agent. Although this is income, it
doesn't come from buying (i.e. holding the deed to) a piece of real
estate.
Similarly, no money down or OPM deals are simply the financing aspect
of the deal - it doesn't change how the buyer is planning to make
money in the long run.
*The Bottom Line*
If someone is trying to sell you on a new way to make money in real
estate other than buying low and selling high or collecting rent,
they're probably trying to sell you on the process of real estate
investing rather than a new mechanism for making profits. Whether the
process is worth it or not is up to you, but know that it doesn't
change how money will be made (or lost) in the end.
*by Andrew Beattie*
Andrew Beattie is a managing editor and contributor at
Investopedia.com.
Source: Investopedia.Com
