Question

Identify the basic elements of a real-estate investor’s decision situation. What are the investor’s objectives? Is the situation dynamic, that is, are there sequential decisions? What are some of the uncertainties that the investor faces? What are the crucial tradeoffs? What role does the time value of money play for this investor?

Answer 1

The basic elements of a real-estate investor's decision situation:

1. Mindset: Mindset is the foundation for understanding real estate cycles, and strategic investors have a very distinct mindset: they think differently from other investors. They think strategically.

2. Real Estate Cycle: Investors must know, study and understand how the Real Estate Cycle performs and how to read it. If they don’t, investment decisions could be based on market influencers rather than market drivers, which could be a dangerous oversight.

3. Goals: Strategic investors are fully committed to themselves. They enroll in a set of realistic goals, taking into account the phases of the real estate cycle, their target market’s underlying economics and how much time and capital they realistically have to invest in the coming 12 months.

4. Strategy: From their commitment, strategic investors focus on the strategy that will keep them true to themselves and their overall goal. Strategic investors use only specific strategies to create and sustain wealth throughout the inevitable cycles of the real estate market. They analyze key drivers, and adjust their tactics to account for market influencers.

5. Tactics: The strategic investor does not confuse tactics and strategy. Strategy forms the master plan. Tactics are the steps you take and tools you use to achieve the goals in your master plan. You adjust your tactics as market cycles progress – you do not adjust your goal or your strategy.

Investor's objectives:

1. Investment portfolio diversification

2. Utilization of the tax advantages of real estate ownership

3. Profit generation

4. Regular cash flow

5. Inflation protection

6. Building wealth for retirement

The real estate investment decision are sequential and linear in nature but circular in extent. The results are linked back to the inputs.

Uncertainties faced by an investor:

1. Business uncertainity - reflects the possible unsuccessful operation of a project.It is determined by the project type, its management, and the market in which it is located. Each of these factors can affect the expected operating cash flows from a project.

2. Finanical uncertainity - primarily reflects uncertainty about the residual equity return when debt financing is used. It also includes interest rate risk; larger-than-expected increases in interest rates with a variable-rate or short-term loan will increase a property’s debt service. Increased interest rates may also lower the price that subsequent buyers are willing to pay.

3. Inflation - arises when universal risks are higher than anticipated. In the case of inflation, it may be at a higher rate than was anticipated in the discounted cash flow analysis or IRR calculations.

4. Liquidity - relates to whether, and when, the investment can be “cashed out” in the future.  If the economy is suffering through a downturn, financing sources may dry up to a significant extent, reducing the pool of potential buyers to those who don’t require conventional financing.

Risk and the Risk-Return Trade Off

Risk refers to the variability of possible returns associated with a given investment. Risk, along with the return, is a major consideration in investment decisions. The investor must compare the expected return from a given investment with the risk associated with it. Higher levels of return are required to compensate for increased levels of risk. In general, there is a wide belief in the risk return trade off. In other words, the higher the risk undertaken, the more ample the return, and conversely, the lower the risk, the more modest the return.

Real Estate Investment and Time Value of money

It is important for anyone engaged in real estate investing to have a sound working knowledge of the concept of time value of money because it plays a major part in establishing for real estate investors what future cash flows projected from a real estate investment are really worth in today’s money. Why is this important? Because the reality is that the purchasing power of money to buy things collected over time becomes less and less as time goes by.