Real estate is one of the most practical investments and consists of property, land, and buildings. The real estate sector is often the most difficult sector to invest in. It can be incredibly volatile and risky. However, getting in on this investment type early on can help you gain significant capital over time. One of the most popular investments in real estate is commercial property, which includes office buildings, industrial properties, retail properties and land for industrial or commercial uses.
For context, United States real estate market is the world’s largest financial asset, valued at US$22 trillion in 2009, and US$25 trillion in 2010. Between 2006 and 2010, U.S real estate prices increased by 39% while the average price of a house increased from $258,000 to $322,800 over the same period. Real estate especially in countries like the US is also one of the most scalable forms of investment available with high returns if invested wisely.
How are Real Estate Deals Structured?
Real estate deals can be structured in many ways, with each deal coming with its own set of risks and rewards. The main ways real estate deals are structured is through debt, equity or a combination of both debt and equity. Debt and equity real estate investments can be structured as either commercial mortgages or residential mortgages.
Commercial Vs Residential Real Estate.
Commercial real estate involves the purchase of any business including, but not limited to, shopping malls, office buildings, industrial properties, hotels, gas stations and restaurants. The market for commercial real estate is very liquid with over $1.4 trillion in annual proceeds. The average transaction size for commercial real estate has been approximately $24 million over the last 20 years. Commercial real estate deals are typically structured as either a long-term loan or a combination of debt and equity. Debt is an asset-backed loan that is secured by specific assets such as land or buildings. Equity is a share of the ownership of a specific asset. Commercial mortgages typically involve long-term investments, from 5–30 years, and require large down payments and higher interest rates than residential mortgages.
Residential real estate involves the purchase of single-family homes and condominiums. Residential transactions tend to be smaller than commercial real estate transactions with an average price of $171,500 over the last 25 years. The average annual proceeds for residential real estate have been approximately $329 billion over the same time period. Residential mortgages tend to be collateralized by land and buildings as well as personal property such as appliances and furniture. Residential real estate is typically financed by residential mortgages which account for approximately 30% of the United States gross domestic product (GDP) and roughly 50% of the GDP of developed countries such as Canada, Australia and the United Kingdom. Residential mortgages are short-term, with an average term of 25 years.
The investor will generally seek to earn a return on his or her investment by: The expected return on a real estate investment is dependent on:
1) The amount invested,
2) How long the investor holds the asset and
3) The expected rate of return on their investment. There is no single formula or standard which can be applied to all real estate investments. However, many factors such as the risk involved in each investment and their cost of acquisition can be evaluated to determine return projections.
The forecasted return calculated by an investor involves:
1) The anticipated annual income from the real estate investment and
2) The anticipated appreciation, inflation and brokerage fees/expenses incurred during the investment’s life. Many factors such as: how much will you earn per unit (e.g.: rental), how much do you need to cover your expenses (e.g. mortgage expense), how much do you need to cover the taxes (e.g.: property tax) and how much do you need to sell it for (e.g.: resale price), vary from one deal to the next.
Real Estate Financing
To better understand the differences between these two types of investments, it’s important to first learn about the basics of debt, equity and debt-equity (debt and equity) real estate finance. The primary difference between these two types of financial instruments is that debt-equity investors make payments and receive cash flows from their investment (i.e. the house) while equity-only investors own their investment (i.e. the house).
Debt real estate finance is used to purchase assets such as houses or businesses using assets as collateral. This is commonly referred to as a mortgage, or loan. A home mortgage works in the same way as many other debt instruments such as car loans and business loans, except that real estate mortgages are typically long term and allow for ample refinancing options should the value of the asset drop below the creditors value (or collateral value). The lender receives monthly payments in the form of principal and interest from the borrower. The borrower then typically pays for the house, property taxes, utilities, etc. with these monthly mortgage payments. The lender’s profit comes from interest on the loan, while risk is assumed by both parties.
Real estate equity finance is used to purchase assets such as houses or businesses in return for an ownership share in the asset being purchased. Equity investors are entitled to share in any revenue generated by their investment including rental income and any gains when they sell their investment to a third party.
Real Estate Risks
Real estate investments come with a variety of risks that may include:
1) The risk that property will not be able to be rented out
2) The risk that the owner of the property will not be able to afford their mortgage in a soft real estate market
3) The risk in investments in general and
4) The risk of inflation and other economic factors affecting interest rates or rental income.
There are risks in both residential and commercial investments. While residential real estate is more stable with only 3–5% of all residential real estate transactions failing to close, the inherent risks make seeking some kind of expert advice when an investor chooses this form of investment as a smart choice.