Factors to look at when investing in real estate: location and potential returns

Alternative investments like real estate, private equity and structured financial solutions have outperformed traditional investments such as stock and bonds generating returns of, on average, more tha
n 20% per annum over the last five years. Among this, real estate has been the best performer recording returns of on average 25% per annum over the five-year period.

An analysis on performance of portfolios by Cytonn shows that returns on those with real estate exposure in 2015 were 6.7% higher than the returns on portfolios without real estate exposure. Real estate is thus a good investment both for profits and for diversification of an investor’s portfolio to minimise losses.

Despite the high returns, investment in real estate is not foolproof and one can just as easily make losses, especially if the product delivered does not receive expected uptake or occupancy. That is why it is important to explore two key factors that an investor should look at before making an investment.

Location is what will determine how fast a product will move in terms of both renting and selling. While returns, which is mainly touching on how to gauge the level of expected returns from a research perspective, will then be used to guide the investment decision. Based on these factors, you can then invest in real estate sharply, conveniently and earn the highest possible returns from this asset class.

Location – The importance and effect of location on the potential returns from a real estate investment can never be overstated. Being a physical asset, the potential clients must see, test and gauge if the property they are eying meets their requirements before buying or renting. Before selecting a property to develop, a potential investor should critique the location based on the following two key issues:

Infrastructural development – How is the infrastructure around the place, is the site close to a tarmac road, and are there alternative means of transportation? Is there electricity on site, sewer connection? Does the government supply water? If these services are available, then a site is ideal as it will have lower construction costs as the developer or investor will not have to provide them. If absent any plans in the pipeline to develop them and the timelines for the same if in tandem with the timelines the developer hopes to go to market may suffice. Should there be no plans, then the development may be futuristic and the investor may have to hold to the land for some time. Alternatively, the investor may provide the services but often such undertakings are expensive and may drive the price of the property to levels above market making selling hard.

Security – The security of a place often plays a big factor when buyers decide on whether to invest in a property. An ideal location with ease of access and good amenities may not achieve the sales expected if in a place with poor security. Hence before purchasing land, a real estate investor ought to conduct a background check on the security of the place to avoid being stuck with a product due to insecurity and hence make losses in the high performing real estate sector

Returns – While real estate generally earns high returns, it is not often the case and poor choice of investment in the sector without prior research may lead to making losses. Thus, before investing in real estate, an investor ought to gauge the level of expected returns on the product to establish viability. From a market research perspective, an investor can gauge the potential returns of a real estate investment using the following metrics.

Rental yields – This refers to how much the property pays back itself on an annual basis. It is calculated by dividing the annual rental income by the price of the property. A yield of say 5% means the property earns back 5% of its value on an annual basis and will hence take 20 years to recover initial investment, if the property is held as an income generating asset and not sold. A 10% yield means a property will take ten years to pay itself back. For rental yield for example, the higher the yield the better.

Capital appreciation – This refers to the rate at which the property appreciates in value. This can be due to demand or appreciation of land on which the property stands. Capital appreciation is calculated by dividing the current price by the price at a given base period then compounding to get the annual growth rate. It can be used to estimate future prices for modelling and to estimate the selling price at a future time point.

Total Return – This is the total return an investor is likely to get on a real estate investment. It is calculated by summing up the rental yield and the capital appreciation such that on sale of a property, the investor will gain from the increase in value of the property as well as the rental income earned. The increase in the value of the underlying asset is the key differentiating factor between real estate as an asset class and other asset classes.

Occupancy – Refers to how much of a development has been absorbed by the market through renting. Calculated as a percentage, it is obtained by dividing the number of units occupied by the total number of units available. A high occupancy leads to higher returns and low occupancy significantly reduces the return potential of a real estate investment.

Uptake – Refers to how much of a development has been absorbed by the market through sales. This is calculated as the number of units sold divided by the number of units available and is expressed as a percentage. Occupancy and uptake indicate the demand for the real estate development. High rates of the two indicate there is demand and low rates indicate that the market may be oversupplied or that there is no demand.

To get the above metrics, a potential investor has to visit comparable properties in the chosen location and collect data on the same, compute the metrics then make decisions off the findings. While the above does not guarantee the success of a project, it goes a long way in minimising the risk of losses to an investor and is hence worth it.

From the above, sharp real estate investment is very tedious. One has to first look for the site, gauge its attractiveness based on infrastructure, access, amenities, and security and if it checks the box, carry out a research to estimate potential returns. After that the site acquisition begins and it can be as messy as it is tedious involving sale agreements, due diligence documentation to name but a few then get approvals before beginning the development. It is hence hard to do this by oneself unless it’s a full-time job.

To invest sharply, conveniently and stress-free in real estate sector, an investor may also consider three things. Firstly, get a partner. Do not go at it alone get professional help to guide in site acquisition, market research, project, and construction management to make the process faster and quicker.

Secondly, buy real estate projects off plan provided all the above factors are clearly provided and due process has been followed. This enables you to enjoy returns without working for it big time.

Thirdly, consider real estate backed notes and listed property through Real Estate Investment Trusts (REITs). This enables one to enjoy liquidity similar to that of traditional investments such as stocks and earn the high returns in real estate without the hassle of dealing with property.

It is thus possible to structure investment in real estate to suit your needs and still enjoy the high returns of the asset class.

BY ELIZABETH NKUKUU.                                                                                                        

 Writer is Chief Investment Officer and Head of Cytonn Real Estate.

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