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Education
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High leveraging is the way to get maximum returns from any real estate investment. In most cases, leverage percentage is about 60-80% of the total property value. This means the real estate industry relies heavily on debt financing. Debt financing is directly impacted by the market interest rates. Hence, as soon as interest rates change there are dynamic shifts in the real estate industry as the cost of capital increases.
T-bonds or risk free bonds are the federal investments that have zero risk associated with them. In order for a real estate investment to be an attractive channel of investment the returns associated should be higher than the T-bond rate of return.
Unlike T-bonds Real Estate investments have a risk associated with them due to several external factors. This risk is referred to as the risk premium which is added to the risk free rate to give the risk adjusted return. This is essentially the return expected from the real estate investment. As the interest rates rise the risk adjusted return is thus pressured outward for the investment to yield significant return above the risk free rate. Hence, as the cost of capital rises the rate of return decreases. In order to restore the rate of return, investors start offering much lesser purchase prices. As a result property valuations start decreasing over time.
As market conditions shift dramatically due to changing interest rates and as there is a gap between buyers and sellers that is still settling; investors move on to other modes of investments due to reduced attractiveness of real estate returns. As a result demand reduces which further drives down the valuation of properties.
Also as the interest rates rise lenders become cautious about the loan amounts processed and as a result there are lesser loan proceeds in the market. This means access to capital is further reduced thus affecting the number of investments made in properties. As the supply increases demand naturally reduces thus directly affecting property valuations.
All in all rising interest rates are a great indicator of short term market activity.
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- Tangible Asset:
Unlike the stock market which is easier to invest in- either with the click of a mouse or simply by downloading an app – Real Estate involves substantial work for acquisition and maintenance. Although hard to acquire it is a tangible asset and can be easily controlled. It can easily be enhanced, renovated, replaced, repaired or scaled. The physical asset makes it usable on a day-to-day basis and can be a form of primary residence, vacation home or investment property. By investing in stock you only own a small percentage of the company and stocks are subject to the economic conditions with lesser control of stock owners. Real Estate investments are less volatile than the stock market and can always be used as a home.
2. Cash Flow:
Having Real Estate in your portfolio can generate a steady and dependable cash flow. If the property is an investment property rental income can be stable passive income while holding the property for appreciation, reaping tax benefits and paying off debts. It can also be used as leverage to get other loans and loans for property enhancement.
3. Tax Advantages:
There are several tax advantages associated with investments made in Real Estate. A deduction can be made for mortgage interest payment and depreciation. The value of property is depreciated over its useful life of 27.5 years in case of residential property. This results in substantial tax savings. Also the 1031 exchange tax provision may be used to swap one property for another while deferring capital gains tax.
4. Appreciation over a long period of time
Over a period of time, the value of a property keeps appreciating if it’s a good investment. Economic conditions may change affecting property value over a short term however generally there is appreciation over a long term. Rental income while the property is held also increases with time. As inflation increases rental income also increases, increasing the annual yield on the property. If the investment is a good one it can prove to be profitable when it is time to sell. Generally investors look for at least 2x to 3x the value of their investment at sale.
5. Building Equity and Leverage
As mortgage payments are made over time more and more equity is built which leads to increased asset value and increases your net worth. This equity can be used as leverage while buying more property making it easier to expand a real estate portfolio. One of the benefits of real estate is that by paying down just 20% of the property value an entire asset can be owned as a physical entity. This asset not only keeps appreciating with time but also provides for a residence or rental income.
6. Portfolio Diversification
Investing in Real Estate leads to an increased portfolio diversity. Real Estate has a low correlation index with the stock market which makes it relatively less volatile. The stock market is subject to various market conditions and investor sentiments. Especially post COVID the stock market has increasingly been subjected to sentiments and emotions making it unpredictable to invest in. At the same time the value of real estate has been steadily increasing and stable over a longer period of time.
7. Hedge against Inflation
As inflation rises the value of properties may rise thereby giving a higher return at sale. With higher inflation rents increase thus increasing the yield on a property.
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