Wednesday, August 16th, 2017

Financial Risk on investing Real Estate

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Financial Risk on investing Real Estate

A real-estate-investment program will consume large amounts of your time, subject you to considerable financial risk, and force you to engage in the generally unpleasant task of dealing with tenants and maybe employees and subcontractors.

No investment is without risks.” The enormous increase in the quantity and value of real estate assets absorbs huge amount of savings. The way the savings are allocated to the real estate sector affects not only the long-term elasticity of supply of real estate space, but also the financial stability of the economy.

High capital mobility can trigger financial crisis when the problem of excessive lending becomes apparent.

A severe mismatch in maturity between assets and liabilities of domestic financial institutions makes the economy vulnerable to external shocks that raise the cost of short-term funding. A vicious cycle of capital outflow and credit deterioration ensues.

Real estate shows vulnerability to short-term liquidity difficulty due to the maturity mismatch and high intermediation cost.

Real Estate Credit and Financial Risks:

Funding real estate credit with money supply also contributes to asset price inflation and volatility. Absent a long-term private debt market where households can invest their savings, the opportunity cost of equity capital, especially that of homeowners, would be determined by the return on savings deposit, which is low due to short maturity and high intermediation cost. The required return on assets would be determined by the cost of funding, which is a weighted average of the cost of equity and that of debt. Investing investment in unimproved land leads to financial risk. The increase in equity financing in the real estate sector—partly due to the high cost of bank loans relative to that of equity, as reflected by the lending interest margin—contributes to a lower opportunity cost of funding. The narrowing spread between real estate capitalization rates and the real cost of loans, especially in the residential market, is indicative of the increasing influence of the lower opportunity cost of equity of speculative investors. Furthermore, the components of real estate funding cost—the cost of credit, linked to the best lending rate, and the opportunity cost of equity, determined by savings interest rates— are closely linked to short-term interest rates and are thus volatile. Consequently, real estate valuation tends to be volatile.

o There is generally limited marketability in real estate (depending on the nature and location of the property.)

o There is also a lack of liquidity, in that there is no guarantee that the property can be disposed of at its original value, especially if it must be done within short period of time.

o A relatively large initial investment often is required to buy real estate.

o If ownership in investment property is held directly by the investor, there are many “hands-on” management duties that must be performed.

o Real estate is often considered high risk because if is fixed in location and character. It is particularly vulnerable to economic fluctuations such as interest rate changes and/or recession.

o The Tax Reform Act of 1986 eliminated many of the previously –available tax advantages relating to real estate

The high financial leverage in the real estate sector, both for homeowners and real estate firms, greatly increase the credit risk of real estate loans. In Real Estate, the variables that drive residential real estate prices can be grouped into macro forces and micro forces. Macro forces include mortgage interest rates, economic strength (the business cycle process in Real Estate), demographics, and federal taxes. Micro forces include local economic strength, state and municipal zoning, neighborhood features (such as quality of schools), and the condition of the property itself.

In Real Estate, horizon risk occurs primarily with fixed income securities, such as bonds, when the buyer locks in a rate for an extended period of time and the expected return on the investment decreases as a result of changes in the inflation rate over time.

In Real Estate, the risk that an investment’s value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying with different durations.

Unimproved land, Low-income housing focus on financial risk. Within real estate, money used to purchase property for the sole purpose of holding or leasing for income and where there is an element of capital risk is deemed a real estate investment.

Overcoming Financial Risks of Growing Real Estate Credit

The financial fragility of the economies affected by the crisis can be attributed to four major sources:

* Currency mismatch
* Maturity mismatch in funding domestic investment
* Asset price inflation
* Poor credit allocation.

The possibility of a reduction in the value of a security, especially a bond, resulting from a rise in interest rates. This risk can be reduced by diversifying the durations of the fixed-income investments that are held at a given time.

Real estate sector plays a central role in the financial fragility, particularly in these East Asian economies disrupted by the financial crisis. The real estate sector absorbs a major portion of domestic credit. Real estate loans are typically of long-term nature and thus contribute to the maturity mismatch of the lending institutions that rely on short-term funding. Since real estate produces local services and thus local-currency income, real estate loans also contribute to the currency mismatch when these loans are funded by foreign capital. Moreover, credit misallocation is likely manifested in overbuilding in the real estate sector. Finally, real estate market is typically the center stage of asset price inflation, exposing the borrowers and their banks to high credit risks. Furthermore, in economies where the information process supporting credit decisions is inadequate, financial institutions tend to rely on real estate collateral for credit allocation.

Rising Real Estate Wealth and Sources of Price Volatility

* Demand for residential real estate rose with population and income.

* The significant expansion in real estate wealth was accompanied by substantial Volatility in prices and rents.

* To understand the sources of real estate price volatility it is useful to decompose changes in prices into changes in rents and in capitalization rate (or rental yield). Underlying this decomposition is a distinction between the market for real estate space and that for real estate assets. In the space market rents adjust according to vacancy rates that reflect the supply and demand conditions; in the assets market prices adjust according to asset valuation (capitalization rates) and rents.

* Accordingly, the causes of real estate price volatility can be divided into two sources:

1. Real economic activities affecting the supply and demand for real estate space
2. Financial conditions affecting asset valuation.

Advantages of Real Estates

* The potential for high return in real estate exists due, in part to the frequent use of financial leverage. Financial leverage is the use of borrowed funds, as in a long-term mortgage, to try to increase the rate of return that can be earned on the investment. When the cost of borrowing is less than what can be earned on the investment, it is considered “favorable” leverage, but when the reverse is true, it is considered “unfavorable” leverage.
* There are potential tax advantages in real estate, as well. First, for personal use residential property, there is the opportunity to deduct interest paid (first and second homes, within limitations) their may also be deductions for property taxes. If the property is income producing, other expenses may be deductible, as well, such as depreciation, insurance, and repairs. Also real estate can be traded or exchanged for like-kind property on a tax-free basis. And, lastly, if the sale of investment real estate results in a profit, the gain is normally a capital gain. (Note: Real estate investment was dealt a blow under the Tax Reform Act of 1986, and the related rules are somewhat complex, as it relates to passive business activities, so your tax adviser should be consulted concerning any tax implications for your specific situation.)
* Some consider real estate a good hedge against inflation.
* Good quality carefully selected income property will generally produce a positive cash flow.
* As a real estate owner, you may be in a position to take your gains from real estate through refinancing the property without having to sell the property, therein triggering a taxable capital gain. Real estate is advantageous, in this respect because good quality properties can be used to secure mortgage loans up to a relatively high percentage of current value.

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Comments

4 Responses to “Financial Risk on investing Real Estate”
  1. Investing is my way of earning money both online and offiline, right now i am into venture capital.”‘`

  2. investing will always be a part of get rich programs, sometimes you need to be a risk taker to succeed.`:*

  3. investing is really good specially if you have lots of capitalization to start with,,-

  4. investing is tricky, sometimes you win and sometimes you loss. Risk takers win of course ‘`:

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