Real estate is the largest asset class in many countries, attracting a higher proportion of people’s wealth than other assets. This is due in part to the perceived simplicity of this asset: everyone lives in a home and has a flair for residential real estate, and some high net worth individuals (HNIs) are also comfortable with commercial real estate investments.
While real estate seems to be ticking all the right boxes, not all real estate investors are equally lucky with the results of their real estate investments – some can talk about their huge real estate profits while others have less fortunate stories to tell. Here are seven ways a real estate investor can minimize the risk quotient of a real estate investment for a predictably good return.
1. Learn about the real estate market in several cities
Most of us invest in real estate very differently than anything else. If you were to buy a stock, you wouldn’t just be buying the stocks of companies based in your city or district. Likewise, you would not open a bank account only with a bank based in your city or just get insurance with a local insurance company.
But when it comes to the biggest investment ever – real estate – we all tend to get very narrow-minded and prefer to invest near where we live. This made sense in the past as it was difficult to access information about the property market in other cities and a local investment was often the only one that the investor knew enough about.
In today’s digital information world, it is only possible with little effort to get to know other markets and cities and to get a comprehensive overview of the overall market before investing in real estate. This is so important because real estate is a highly cyclical industry in which the right time and location for your own investments can significantly reduce risks and increase returns. A broad perspective enables you to avoid mistakes in terms of both when and where to invest.
2. Choose the right city to invest in
In the long term, real estate prices tend to follow the median household income. As the median household income rises, so do real estate prices. Like any other asset class, real estate is subject to boom and bust cycles and there will be times when home prices will exceed normal multiples of household income and there will be times when they are slightly lower than they should be.
Of course, it is best to invest in cities where income and population are rising and yet real estate prices, as a multiple of current income, are not too high. But a typical investor will invest in real estate in locations close to where they live, where they were growing up, or where family life is, as most of the information about investment opportunities comes from talking to friends, family, or colleagues.
The performance of such investments is a hit or miss as it does not take into account the prospects for that location. If the city is growing at a slower rate than the nominal GDP growth rate, the investment may be below average. If current prices are frothy, future returns will not be either.
For predictably good investment, invest in cities that are growing rapidly, have a large number of high-paid employees, and are reasonably priced at multiples of household income.
3. Understand the micro market and its trends
In addition to choosing the city, the selection of micro-markets is also important to the performance of the asset. Locations on or near major arteries or with good access to efficient public transport are preferred by end-users as they make it easier to commute to other parts of the city.
The availability of good socio-cultural infrastructure such as schools, shopping and hospitals are other factors that need to be considered in micro-markets in order to make them less risky. Investors also need to keep in mind that established areas are less risky but can offer lower returns, while emerging locations with planned new infrastructure can offer better returns, but with greater uncertainty about when the profit will be realized.
A well-informed investor ultimately has to make the decision about the location, taking into account the factors mentioned above.
4. Select a project based on its functional attributes
Historically, Indian real estate has had the wrong characteristics – uncertainty over regulatory issues, land title disputes, etc. Because of these factors, buyers preferred to buy from developers who had the resources to make up for these inefficiencies on site. However, as this sector gradually develops like the rest of the economy, increasing importance is attached to the product offered. Instead of focusing on a developer’s ability to deal with regulatory uncertainties, one should focus on the developer’s ability to offer buyers a high quality product.
After a project is completed, its market price depends on the quality of the product, its location and specifications, and this future market price determines the investor’s profit. A nondescript cookie cutter design can become irrelevant in a few years and not achieve a good resale value. Hence, an investor must consider the functional aspects of the design of any project they invest in to reduce the risk of the property becoming obsolete in the future.
Superior design, floor plans, specifications as well as the number and density of fittings are important factors when choosing a property in the residential sector.
5. Choose a project at the right stage of development
Real estate projects, as the name suggests, are projects that need to be carried out. They require a lot of capital, are associated with regulatory risks, and last for many years. And as with most things in life, there are tradeoffs between investing early and investing in a later stage in a project. Investing in a project early on can result in higher returns, but you will also face more uncertainty about regulatory and execution issues.
On the flip side, if you invested towards the end of the project or after it is completed, most of the profits would have already been made by previous investors and you may end up with lower returns, but with less uncertainty about the schedules.
Uncertainty in the time it takes to obtain all of the required regulatory approvals is a factor to consider when considering early-stage projects. Once the developer has obtained the necessary regulatory approvals, the duration of project creation and completion is much more under the control of the developer. Therefore, before investing, one needs to look at the project phase and the list of regulatory approvals pending at a particular phase of the project.
If you don’t want to take these risks, it may be wise to stick to the RERA registered, under construction or completed projects to make your investment.
Once the construction of a real estate project begins, it takes between three and five years, depending on the extent of the development. During this time, factors such as rising raw material costs, rising interest rates and construction freezes due to local lockdowns add to the overall development costs of the project.
While these external factors cannot be eliminated in any market, an investor must shortlist projects that are well funded or that are developed by groups with a solid financial background. This ensures that the project will be completed regardless of cost escalation.
6. Choose the right type of real estate asset
The different sub-asset classes of real estate do not have equivalent risk factors and can develop differently in the same location. In the commercial sector, for example, Grade A offices in high demand markets tend to be lower risk than retail and hospitality sectors in the same location.
This is particularly true for the short to medium term. Corporate tenants usually have a long-term view of their plans and requirements and cannot terminate their rental agreements. However, seasonal consumption trends and occupancy rates in the retail and hospitality industries have a direct impact on their sales and make it difficult for investors to predict their results.
The housing sector is perhaps an even safer place to invest, partly because of its smaller ticket sizes and partly because of the lower potential vacancy times in the event of a tenant leaving. But here, too, there is nothing for free and the lower risk of vacancy in living space also goes hand in hand with lower rental yields.
7. Understand your own financial time horizon
Real estate is a big ticket buy and lacks the liquidity of typical financial assets like mutual funds and bank accounts. Therefore, investors should understand their own personal financial situation and plan for a holding period that is comfortably longer than the expected project completion and exit deadlines.
Finding the right selling price can take some time, especially considering the prevailing demand and supply at the location. The current scenario also needs to consider the occurrence of unprecedented events such as a pandemic to give the asset enough time to perform.
Real estate is a massive asset class and its popularity with investors is well deserved. An investor who exercises caution and care before investing, as described above, can benefit from the security and low volatility of this asset class while avoiding undue risk.
While most investors will seek ownership of an asset as the basis of their investment portfolio, it is important to assess the underlying risks before investing. When you invest in real estate with the right knowledge and perspective, and giving your investment the time it deserves, it can be not only a fruitful investment but a pleasant journey combined with the pleasure of acquiring a hard, tangible asset that no other asset class can compete with.