Real estate is one of the world’s oldest investment activities. Humans have always required shelter, from the days of living in caves to the modern day real estate era of duplexes and sky scrapers. Real estate investing involves the purchase, ownership, management, rental and/or sale of real estate for profit. It has proven quite a profitable investment outlet for many investors, particularly over the medium to long term. However, contrary to the popular ‘safe as houses’ phrase, there are risks. It is important to note that real estate is an asset class with limited liquidity relative to other investment asset classes. Real estate is also capital intensive and highly cash flow dependent. If these three risk areas are not well managed, it is possible for an investor to fall into negative cash flow, and if this persists, the investor may be forced to sell the property at a loss or even go into insolvency. This is probably one of the primary causes of investment failure.
Investors profit from real estate in at least four different ways. Real estate appreciation occurs when the property becomes more valuable than when it was purchased due to a change in the real estate market, greater demand for the property, the land around the property becoming scarcer or busier or upgrades are put into your real estate investment to make it more attractive to potential buyers or leasing parties. Cash flow income arises from the rental streams that emanate from property such as an apartment building, office blocks, rental houses, etc. Real estate-related income is that generated by ‘specialists’ in the real estate industry such as real estate brokers, who make money through commissions from buying and selling property, or real estate management companies, who get to keep a percentage of rents in exchange for running the day-to-day operations of a property. Ancillary real estate income refers to that arising from mini-businesses within a bigger real estate investment that allows the investor to make money from a semi-captive collection of customers. A good example of this is vending machines within an office development.
There are different categories of real estate investment. Residential real estate investments are houses, town houses, apartment buildings, housing estates and vacation homes where an investor can expect rental income as well as exposure capital appreciation. Commercial real estate investments consist mostly of office buildings. This is quite an interesting area for investors as rental income from this type of investment is typically governed by long leases and offers a steady income. However, commercial real estate is often highly capital intensive. Industrial real estate consists of warehouses, petrol stations, factory-office multi-use property, factory–warehouse multi-use property, heavy manufacturing buildings, industrial parks, light manufacturing buildings and research and development parks. Retail real estate investments consist of shopping malls, strip malls and other retail storefronts. These are becoming ever more popular in Nigeria as the middle class expands and they offer investors attractive investment yields. Real Estate Investment Trusts, or REITs, trade like stocks and own a portfolio of underlying real estate or real estate mortgages. They work like a mutual fund, whereby the issuer of the REIT is a professional real estate investment company. They pool funds together from different investors and issue units in exchange. The funds are then used to create a property portfolio, which could consist of both residential and commercial property. A REIT must pay out 90% of its profits to investors to remain a trust.
As with any other investment decision, there are always key things to consider and look out for. They may make the difference between making and losing money. It is not an exhaustive list, but some of the key things are listed below:
(a) Location: This remains one of the foremost success factors in siting a real estate development. Certain locations have a better ability to ensure that real estate developments continue to attract patronage all through the business cycle and result in a greater ability to generate returns from the investment made. The location of a property investment is, of course, highly dependent upon the end use to which the property investment is to be deployed. The investment profile of a property located in a well-established location will be quite different from the same property in a run-down area.
(b) Infrastructural Development: Knowledge of new projects coming up in a neighbourhood such as access roads, a shopping mall or a rail line can significantly improve the value of the property. New roads and rail lines mean improved access to a certain area, thereby making the area more attractive to prospective tenants and investors. It can, however, also reduce the value of the property if, for instance, the new rail line runs close to the house, with the noise from the trains constituting a nuisance. The same applies to shopping malls or airports as they will bring with them new jobs and naturally employees looking for accommodation. Imagine the increase in value to an area previously without power supply and a contract is awarded to install and connect power lines to that area.
(c) Inflation Outlook: Inflation affects the value of money and investments. For an investment to give real returns it has to be above inflation. So a property returning 5% per annum in an economy where inflation is 10% cannot be said to be really profitable.
(d) Interest Rates: Most real estate investments are financed with debt. This occurs especially when leveraging occurs. In leveraging you pay for a property by contributing an amount as capital and funding the rest by a mortgage loan. In the event that interest rates rise, it means that your cost of funding will rise, thereby reducing your profit margin. It also makes it harder to sell the property as the potential buyer has to consider the elevated interest rate that he has to pay, thereby making the purchase less attractive. It might lead to the potential buyer asking for a discount to cover elevated interest rates.
(e) Population Growth: Growth in population means an increased need for housing. Not just for housing but also for service providers for the growing population. These service providers (bank branches, new stores etc.…) would have to acquire or rent property to operate from. So, population growth is an important factor in real estate investment. Also, migration to a particular area by the population would be another factor. In Lagos, Nigeria, the growing middle class seems to prefer living in the Lekki area, which has led to an increase in house prices and rent and also to the proliferation of shopping malls and supermarkets.
(f) Projected Economic Growth/Wellbeing: A growing economy with a growing middle and upper class means more demand for everything, from clothing to food and to property. A growing economy also means more investible income, with people looking to buy their first house or for other real estate investments. To put it in perspective, an economy in recession means job losses or cost cutting by firms. This means fewer people with investible income to acquire real estate. It also means that people who have lost their jobs will start to default on their mortgage or rent payments. This will eventually lead to forced sales of property, bearing in mind that forced sales are normally at a discount. The final outcome will be decline in real estate value.
(g) Government Policies: Policy shifts may affect the real estate market. It could be in terms of increased or reduced taxes or an effect of capital gains on property investments. The recent change in capital gains tax by the Chinese authorities led to a scramble by investors to sell off their property holdings to avoid paying the 20% capital gains tax. Other policies such as increase in lending rate for second or third home buyers also can affect the market.
Nigeria is a country of over 160 million people with a housing deficit of over 16 million housing units. Ordinarily, this would constitute a huge opportunity for investors as demand clearly outstrips supply. However, we have not seen this gap being met due to the high cost of real estate in Nigeria and the inability of the masses needing property to afford it. Urban migration has led to demand for housing units in cities such as Ibadan, Port Harcourt, Warri, Enugu, Benin, Lagos and Abuja, with the housing deficit still unmet. Factors such as the high cost of land, elevated interest and mortgage rates, and poor infrastructure continue to adversely impact upon the availability of affordable, quality housing stock within the country.
For portfolio investors, analysis has repeatedly shown that real estate enhances diversification and acts as an inflation hedge. A low correlation to both stock and bond returns suggests that real estate investments have the potential to lower overall portfolio risk while the ability to increase rental rates in times of high inflation affords the opportunity to maintain the real value of a portfolio. Real estate should therefore be a constituent of most investors’ portfolios. Whilst this may be difficult for the average investor to achieve on account of a relatively high investment outlay, professional investment managers are well positioned to package that exposure to investors through mutual funds and real estate investment trusts.