Term Paper on "Is Real Estate a Solid Investment?"

Term Paper 7 pages (2020 words) Sources: 3 Style: APA

[EXCERPT] . . . .

Real Estate as a Solid Investment OPPORTUNITY

Traditionally, real estate has been a safe investment opportunity that, generally, yields positive returns without some of the instability and risk associated with other types of financial investment, such as stock market investment. While the returns may be more modest and require more patience before they are fully realized, the real estate market is often safer, in addition to offering non-monetary benefits, such as the pride of ownership, independence, and the knowledge that one's monetary investments are also contributing to strengthening and stabilizing the American economy.

Financing, Positive Cash Flow, and Leveraging: Ordinarily, real estate investments involve a mortgage instrument through which a lending institution such as a bank finances the majority of the cost of property acquisitions to purchasers who can demonstrate sufficient assets, income, and overall credit history to pay off the lender's interest (or lien) in the property over time, as per the specific terms of the mortgage agreement. Usually, a prospective buyer/mortgagee must demonstrate the ability to take on the mortgage obligation by documenting income and assets, along with disclosing any existing financial obligations before a lender agrees to provide financing that commonly amounts to approximately 80% of the property value.

In return, the lender charges a monthly finance fee in addition to the monthly payment on the principal amount of the lien. A buyer who qualifies for a mortgage may secure title (subject to the lender's lien) to property by actually investing a comparatively small percentage of the property's real value. The advantages are many, in that the buyer may then enjoy the benefit of the property and, in the most conservative scenario, continue earning interest on money that he would otherwise have had to contribute toward the purchase. More often, buyers hope to benefit financially in other ways as well, by leveraging their money in one way or another.

Real estate offers the opportunity to generate rental income, whether from commercial leases or housing units rental. Both types of arrangements are potentially lucrative, but require either first-hand attention on the part of the buyer or a third party hired by the buyer to manage the property and address tenant issues. It is possible to approach property ownership and management as a career in and of itself, in which case the buyer or his agents handle tenant issues, perform repairs, and collect rent. The purchaser may also choose to simply approach property ownership as a single investment, benefiting from the net monthly income after expenses such as mortgage financing fees, taxes, and insurance. Government subsidies offer another potential opportunity, except that, by their nature, they require that the property owner relinquish any right to prescreen prospective tenants. Generally, government subsidized housing offers the property owner a more conservative return that is guaranteed, as opposed to higher returns without the guarantee of receiving monthly rental. Private rental always carries the risk that a tenant will default on his rental obligation, leaving the owner the responsibility of following landlord-tenant protocols in enforcing the obligation through the legal system.

Subsidized housing eliminates this risk but may also increase other risks to the property having to do with social realities that sometimes prevail in public housing facilities.

As alternative to acquiring real estate for the purpose of generating rental income, one may also invest in real estate with the express hope of improving it to increase its value in order to sell it at a profit. This is know as "flipping" the property. Generally, the idea is to purchase real estate that is being sold at a loss, or that is undervalued because of easily rectifiable problems that can be addressed to increase its sale value.

Tax Benefits:

Real estate ownership offers certain tax advantages as well. Generally, the Internal Revenue Service considers real estate a "depreciating asset." Therefore, property owners may deduct a certain percentage of the property value as a tax write off on the annual tax return. This is a type of deferred taxation, because the total amount of tax savings represent a cost basis that must be deducted from the ownership equity upon any subsequent sale.

However, property ownership also affords the opportunity to further invest the deferred tax benefits by "rolling over" the entire amount of the accumulated tax savings into a more expensive property, as often as one wishes to do so pursuant to what is known as the "1031 Rule." Finally, whether one purchase real estate for personal use, to rent commercially or publicly, or to "flip" it for profit at a later date, the financing fees associated with the mortgage are also entirely tax deductible.

Property Appreciation:

As a general principle, property values increase as a function of population increase, for reasons that are somewhat obvious. According to most accepted statistics, forecasters predict a 50% population increase in many housing markets by the year 2050.

Areas with a high influx of residents experience housing "booms" in which investors seek to acquire as much property as possible to satisfy the expected increase in need. As in economics in general, demand increases the value of supply and this is especially true of real property appreciation in expanding housing markets. Recent examples of real estate booms include areas of the Southwest like Las Vegas and parts of Arizona, as well as northern parts of Florida like Tampa.

For example, a real estate purchase might typically involve a transaction whereby the purchaser qualifies for financing 90% of the value of a home. If the actual value of the property is $100, 000, the purchase requires just a down payment of $10,000. In a booming real estate market, the value of such a house could increase to $150,000 two years later. The appreciation amounts to a profit $50,000 less the initial investment of $10,000, which constitutes a 5-to-1 rate of return.

Naturally, real estate may also depreciate over time, in which case, the depreciated value represents a loss to the purchaser, since his obligation to the lien holder remains unchanged. In this respect, real estate investment is similar to stock market investment, because both rely on accurately predicting the future market strength of the principal. However, whereas stock values are determined by too many variables to permit precise prediction, the real estate market fluctuation is much more predictable, at least to the larger extent that psychology and cyclical behavior relate to real estate fluctuations..

Because housing demand is closely linked to the strength of the economy and the interest rate, the so-called "bubbles" of opportunity may also burst when those elements change. The risk of investing in property ownership during extreme booms, is that it is generally accepted that the larger the bubble the more susceptible it is to bursting. That is one reason that real estate acquisition in areas of steady long-term growth is often more prudent and more advisable than investments in areas of fastest growth. North Carolina is an example of a steadier real estate market than the South and Southwest, because its steady growth is a function of being a strong financial center of business where major financial firms like Bank of America are situated.

Implications of the Current Subprime Mortgage Crisis:

As recent headlines make clear, approximately two million Americans are now at risk of losing their homes to mortgage default. This is certainly an important consideration for anyone contemplating real estate investment. To a large extent, the roots of the current subprime mortgage crisis go back to the 1970's, when Salomon Brothers pioneered the concept of mortgage security investments (Lowenstein, 2007).

Essentially, financial institutions and investment banks realized that by accumulating many individual mortgage obligations that were non-liquid by themselves, they could trade the combined equity they represented that was backed by many individual mortgage obligations. In doing so, they created opportunity, both for responsible real estate purchases as well as for irresponsible (or unrealistic) real estate purchases (Markels, 2007).

Lenders began looking at mortgages less as long-term obligations that required sound financial qualifications of purchasers to guarantee the institution's investment, and more as short-term opportunities that could be negotiated in a manner that is much more characteristic of liquid investments (Lowenstein, 2007). For the last five years, the strong economy and low interest rates favored real estate investment.

Eventually, because their own risks end on resale, lending institutions became less stringent about qualifying criteria of purchasers and a significant percentage of home buyers misrepresented their earnings and secured mortgages on unrealistically expensive property for their situation (Clark, 2007).

The situation was so prevalent in some areas that the term "no doc mortgage" evolved to describe transactions without any documentation of financial information whatsoever. Certain areas were overbuilt to supply the high demand that usually accompanies a strong economy and higher interest rates contributed to mortgage defaults in many of those areas. Numerous mortgage companies like American Home Mortgage went into bankruptcy, and others, like Countrywide Financial were saved, in their case, by Bank of America at a cost of $2 billion. This… READ MORE

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