IT IS ALWAYS A CHALLENGE to confidently price real estate. The concern generally heats up when fundamentals are at their cyclical lows and cash flow forecasts are in question. But even in the best of times, the goal for investors is to earn returns at least as good as or better than the rest of the market on a risk-adjusted basis. Still, who can predict what the future will bring.
The investment decision is essentially a choice between consumption in the present or postponed for a future time. Investment in the broadest sense means present sacrifice for expected future benefits. Since the present is relatively well known and the future is uncertain, investment decisions represent certain sacrifice for uncertain benefits. In the case of real estate investment, these benefits generally take the form of future cash flows (rental income) and/or appreciation in property values. However, psychic return which is a positive feeling induced by ownership of real estate is also sometimes considered as a form of benefit derived from real estate investment.
The general investment rule is the higher the return. Having said that, investment risk means how much returns vary from what you expect.
Shares are the riskiest asset class. Share prices are volatile meaning they can rise and fall significantly in the short term. However, over the longer term they have been the better performing asset class.
Cash is the least risky asset class with little risk of capital loss. However, returns are also the lowest.
Everyone has their own personal preference when it comes to investing. You may be prepared to take more risk in order to pursue higher gains over the long term, or you may be more comfortable with a lower level of risk and a lower, more stable rate of return over the long term. Risk is defined as the variation in the expected future benefits; return is the amount of inflow generated by the investment each year. Generally the higher the expected return, the higher the risk of the investment. The fundamental issue is whether the extra return is worth the increased risk.
THE RISK-RETURN TRADEOFF
The two basic sources of financial returns from owning real estate are the annual cash flow from operations (usually in the form of rent) and the cash flow from disposal of the asset at the end of the ownership (typically, sale). However, estimates of both the annual income and the receipts from disposal, which are necessary in order to determine the value of the investment, are usually not precisely known due to uncertainty regarding the future. Hence, risk is an integral part of investing.
The main types of risk that an investor must analyse in making an investment are:
The possibility that the investment will not generate the expected level of net income due to changes in market conditions. The value of investments may decline over a given time period simply because of economic changes or other events that impact large portions of the market. Asset allocation and diversification can protect against market risk because different portions of the market tend to underperform at different times i.e. different locations or different type of properties. Market Risk is also tat times referred to as systematic risk.
The possibility that price increases will be greater than expected and result in a decline in purchasing power. Also relates to the Probability of loss resulting from erosion of an income or in the value of assets due to the rising costs of goods and services.
The possibility that the Government will change policy or laws that affect the investment. Legislations by the government could significantly alter property ownership, transfers of ownership or business prospects of one or more companies, local or foreign, adversely affecting your property investment. This may occur as a direct result of government action or by altering the demand patterns of investors.
The possibility that the investment will not generate sufficient income to cover debt obligations.
The goal of any investor is to form an investment portfolio which has the highest possible expected return for a given level of risk. Alternatively, this may also be interpreted to mean that the investor seeks the lowest possible investment risk for a given expected return. Investors are assumed to be risk-averse which implies that they must be compensated with higher returns in order to get them accept greater risk.
In addition to that, every investment you make should be compared to your personal risk-adjusted opportunity cost. Opportunity cost is defined as the expected compound annual growth rate of return, or CAGR, on the next best available option to you as an individual. For each of us, this is different. The cost of passing up the next best choice when making a decision. For example, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose the asset could have been used for. Opportunity cost analysis is an important part of the decision-making process, but is not treated as an actual cost in any financial statement.
The performance of real estate investments must be judged on the strength of the periodic operating results and on the expectation of the resale values at end of the holding period. The measurement can be made with the help of very simple decision making criteria, or it can be made through more sophisticated financial models i.e. the Internal rate of return, net present values and discounted cash flow analysis.