Why having a game plan before investing in Real Estate is important

/ 21 May, 2019 /        

Real estate is an attractive asset class that has in the recent years outperformed other asset classes generating high returns. In this period, many real estate investors have reaped big becoming multimillionaires, however, a number of people either due to fraud, mismanagement or poor investment decisions have lost millions in the same sector. It is thus important for an investor considering investing in real estate as an asset class to have a game plan to guide their investment in the sector. In this article, we will cover the importance of having a game plan before investing in real estate. We will start with an introduction to real estate investments, the advantages of investing in real estate, the challenges of investing in real estate and thus the reasons why an investor should have a game plan and conclude by giving a sample game plan than an investor can follow when investing in real estate.

Introduction to Real Estate investments

Investing involves growing money over a period. It refers to the purchase of a monetary asset with the idea that the asset will provide income in the future and/or will be sold at a higher price for a profit. Typically, investments can be broadly classified into i) traditional investments such as equities that is shares in the stock exchange and fixed income which consists of government securities such as treasury bills and bonds and ii) alternative investments such as Private Equity and Real Estate. In this article we focus on the real estate an attractive asset class that provides the investor with the following investment opportunities:

  1. Brick and mortar: involves the development of a building or the purchase of a parcel of land, aiming to benefit from future capital appreciation and rental income
  2. Real Estate Investments: this is the conversion of the physical real estate asset into a liquid investable product. This can either be public markets tradable like REITs or privately placed

These options both generate income to the investors mainly through rental yields (or dividends for listed property), price and capital appreciation of the assets.

Benefits of Investing in Real Estate

 The real estate as an asset class has many advantages including;

  1. High returns - Real estate has consistently outperformed other asset classes over the last five years. With returns of about 25% p.a, against an average of 14.2% p.a. in all asset classes. These returns are mainly from the rental yield, price and capital appreciation, driven by the (i) positive demographics such as high population growth at 2.6% p.a. against a Sub Saharan Africa average of 2.3%, who offer demand for the space, (ii) rapid urbanization at 4.3% p.a., versus a global average of 2.0%, in need of space, (iii) an expanding middle class with spending power, and iv) improvement in infrastructure opening up new areas for development.
  2. Security of Returns - Unlike traditional investments whose returns fluctuate with market performance, real estate returns have minimal variance and as the value increases over time, they provide a source of stable and consistent returns
  3. Inflation hedge - Real estate provides a hedge against inflation as the value of the assets grow in tandem or higher than the inflation rate

 

Challenges faced while investing in real estateWhy an Investor Should Have a Game Plan When Investing in Real Estate

Despite the above benefits, Real Estate investors are likely to face challenges which may include;

  1. High capital requirements - Real estate investment is capital intensive requiring huge initial outlays to purchase or develop property in addition to agent-related commissions, lawyers' fees, engineers' fees and many other costs that can raise the effective purchase price. Real estate is also costly to operate because it is tangible and requires ongoing maintenance hence requires property and strategic managers which means costs are incurred and resources are needed to facilitate operations
  2. Lower liquidity - Real estate investments are long-term and not easily transferred and are therefore less liquid than equities and fixed income investments which can be traded easily on a stock exchange.
  3. Informal and unstructured market in Kenya - In Kenya, the real estate market is largely informal and unstructured dominated by private small-scale developers and with inadequate information and no set benchmarks or indices for pricing increasing the possibility of an investor in the sector being defrauded or making losses due to misinformation.
  4. Inadequate expertise in the market - The real estate market has inadequate professionals with practitioners learning under apprenticeship as opposed to industry best practices. This leads to the lack of adequate knowledge required while making investment decisions and in construction leading to development of substandard buildings with cases of collapsing property being witnessed in the market

Thus for an investor to overcome the above challenges and earn the attractive returns in the sector, they have to come up with a game plan. This refers to a set of strategies that an investor can have in place to ensure they choose the right real estate avenues to invest in and achieve their targeted returns.

These strategies include but are not limited to;

Sample Game Plan

  1. Specify your investment objective - You should start by identifying what you as an investor in terms of risk, return, duration of investment, nature of exposure and real estate theme to invest in. This will enable you to plan your resources accordingly and avoid unexpected shocks
  2. Carry out market research- Once you have your objective at hand get more information about the specific theme you want to invest in. How its current performance is, what are the future prospects, who are the key players among others. This can be obtained either from visiting the actual sites or from real estate practitioners who release well laid out research reports. While research does not guarantee success of a project, it reduces the inherent risk by informing the investor of potential hurdles
  • Conducting financial analysis - With the research at hand, an investor should conduct financial analysis to gauge the ventures capital requirements and expected returns. This is important to ensure the expected returns meet the individual’s investment criteria. Through financial analysis, projections on expenses to be incurred, expected returns and growth of the funds invested can be determined and forecasted. This thus facilitates decision making on the most favorable venture and also acts as guide to be used by the investor in fundraising
  1. Putting into consideration one’s cash flows- this is because real estate investment is capital intensive and yet a very illiquid asset class that takes time to obtain back one’s cash. Therefore, it is important that the investor considers his inflows before committing their funds in the long term venture
  2. Conduct due diligence on the prospective investment venture – Due to the unstructured nature of real estate in Kenya and information asymmetry, the investor should conduct proper due diligence on all aspects of the venture including the sellers, the parties he or she is to work with as well as legal restrictions and or guidelines on developing on the particular land parcel or investing in the real estate entity. This ensures the investment is not only available and profitable but also legal and hence the returns are guaranteed. For due diligence an investor should seek the services of a registered lawyer to ensure effectiveness.
  3. Selecting the right partners – The labour intensive nature of real estate makes it hard for a single investor to invest and run end to end. You will thus need to get professionals either as developers, contractors or consultants. An investor should ensure they select a real estate practitioner with vast experience backed by a track record and duly registered by the relevant body. This will reduce the investment risk and increase professionalism ensuring the development is conducted smoothly and the investor gets their target return.
  • Exit strategy – who is the target market and how have you positioned the product to the market. Typical exit strategies in real estate are; a) a buy-and-hold strategy which involves holding rental property for a period of time, during which the property pays for itself through rental income, producing cash to pay all expenses while also producing an annual profit for the owners, b) lease option where the owner of the investment property leases it to a tenant who has a contractual option to purchase the property, c)wholesale- the real estate wholesalers find and buy deeply discounted investment properties that they resell to other investors for a small profit, d)rehabbing- this involves purchasing a house, renovating it and selling it for more than the original investment costs e) seller financing- with this strategy, the buyer gets financing for the house from the bank and the seller receives the total sale in one lump sum. The buyer then provides a down payment directly to the seller, who is the bank in this case and makes monthly mortgage payments for the life of the loan.

Conclusion

Despite the attractive returns earned by investors in the real estate sector in Kenya, many have lost money either due to fraud, mismanagement or poor investment decisions. It is therefore prudent to have an effective workable game plan to guide investment in real estate to ensure you earn your target returns at the lowest risk and with the least amount of sweat.

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