Question

Joe is an investor who is interested in acquiring a small income property in Manhasset (a suburb of New York City). This property is primarily an office building, but there are two separate retail spaces on the ground floor. Each of the office units in this building are currently being leased, but one of the two retail units has been vacant for the past two years. Also, the tenant in the other retail unit has been experiencing financial difficulties. In general, Manhasset appears to have a surplus of retail space, given that only 70% of the available retail space in Manhasset is currently occupied.

Additionally, Joe has been made aware that this office building may contain asbestos. Note that exposure to asbestos has been correlated to serious health problems, including cancer.

(a) What types of risk are associated with acquiring this income property?

(b) Instead of buying this income property, Joe decides to enter into a five-year purchase option for the building. What is the advantage to Joe of entering into this purchase option?

(c) If Joe decides to move ahead and purchase this income property in spite of the risk, what is something Joe can do to protect himself from suffering financial loss?

Answer 1

(A) In this case, Joe wants to buy an income generating property. Though acquiring a rental property is relatively safe, but there is no guarantee that that he will be successful, given the amount of competition in the market. There are many risks associated with it - such as :

• DYNAMIC CONDITIONS - It can be seen from the past experiences that the real estate economy has gone through ups and downs. Hence, it is difficult to say if the investment will be fruitful in the uncertain future period. The increased demand in Manhasset will now bring down the prices, but there is always a possibility that it might go down further and creating a loss that is higher than the income received from rental incomes.
• ERRORS IN THE CONSTRUCTION OF THE BUILDING : There might be some structural faults with the building to be acquired and which will result in higher costs of maintenance and repairs.
• PROPERTY BEING VACANT : Buying a rental property does not guarantee income, Joe has to find tenants to occupy his property the absence of which will result in negative cashflow that might make him unable to pay his property taxes, mortage or other such expenses.
• BAD TENANTS : There already exists a tenant in the building, having a bad tenant ( who do not pay his/her rentals in a row) is a bad situation. Some tenants even destroy the property and leave you in a situation that is worse than having any tenant at all.
• LOCK YOUR ASSETS : Investments in such property is usually for a very long period of time and hence they lack liquidity. If Joe has an immediate need of cash, then that would not be possible due to the complex processes involved, also selling property under pressure will be a worse decision as it will lead to major losses.

(B) PURCHASE OPTION

It is an agreement between two parties - in this case, one being Joe, to avail the option to purchase the property within a period of 5years. He can excercise, his option to purchase within a period of 5 years. Hence there is an ample time for Joe to know about the profitability of the property.

ADVANTAGES OF PURCHASE OPTION

1. There is comparitively lesser risk than buying it on the very first hand.
2. Chance or likeliness of higher returns.
3. Cost are minimal.
4. Joe has an "option" - he can choose whether or not to buy.

(C) The steps that Joe can take to protect himself from the risks are :

• The investor, specifically Joe in this case, should be aware that the market is a dynamic place and should always be updated with the prices and market functions.
• Consult with a property appraisal professional, so that hidden faults can be brought into light. They can even determine the actual worth of the property.
• Location is the key. A property in the most demanded location ( where there is easy access to amentities) will automatically bring in tenants without much advertisements.
• To protect himself from accomodating bad tenants, Joe should collect relevant information about them such as their credit scores, information from their past landlord etc.
• Foreclosure is yet another risk, that Joe might come across, in order to avoid this proper market research ought to be conducted as well as an emergrncy fund is to be kept aside to meet the emergency situations.