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Building Wealth, Commercial Real Estate, Income, Plan, real estate

Tools of the Financial Trade: Real Estate Investment for Building Wealth

This is the second in a series of articles about Real Estate Investing as a Financial Tool.  Read the series from the beginning or click on the links below to learn more about each of the strategies presented.

Real Estate Investment is a versatile financial tool and can be used to help achieve any or all of these investment objectives:

  • Wealth Building
  • Portfolio Diversification
  • Tax Advantages
  • Appreciation Potential
  • Cash Flow Creation
  • Community Support
This post will explore how real estate investment can be used as a strategy to effectively Build Wealth for your overall portfolio and/or financial goals. 

Wealth Building

Real estate investments can help you to acquire assets capable of growing equity and increasing investment capital.  This strategy can be applied quickly or slowly over time, depending on the project, goals, individual capabilities and appetite for risk.

Fast Track

‘Flippers’ use real estate as stepping stones to amass lump sums of equity in a relatively short period of time.  Most often, they purchase a property at well-below market price (often foreclosures or fixers), then turn around and sell as quickly as possible for a profit.

This can be a great way to build significant capital in a relatively short period of time (less than a year).  However, it can come with some significant drawbacks, notably the time, expertise and labor required to prepare the property for resale, higher taxes on short-term gains, and of course the ever-present profit-eroding ‘Unexpected’.  This includes repairs, property expenses, debt and carrying costs, market changes, purchase/sales costs, selling period, etc. that weren’t adequately planned for or anticipated.

It’s easy to get excited when calculating all the potential profits on a transaction but many people forget to also prepare a potential ‘worst-case scenario’ or a contingency plan for the unexpected or underestimated costs that are bound to come up.

Since profits from this method are usually only realized when the property sells, having to hold it even just a few months longer than anticipated can quickly erode returns, especially if financing is involved.

Similarly, many people purchase new construction homes with little or no money down with the intent to sell in a year or two as phases are added, the neighborhood stabilizes and values appreciate.  In the 2008 housing market crash, many buyers purchased without proper due diligence and adequate investment capital.  When financing froze and home sales literally came to a screeching halt, people found that they were unable to sell, unsuited to being an impromptu landlord or unable to afford the monthly costs of owning a rental home, in some cases even with a tenant in place.  Timing is a critical factor, especially when banking on future profits to make up for interim negative cash flow.

Building wealth rapidly is an exciting prospect but be sure to do your homework up front.  Inexperienced and/or under-capitalized investors can quickly find themselves in over their heads and/or with a very expensive learning experience!

Project-by-Project

Slower-paced wealth building usually involves a slightly longer time frame, often 3-5 years or so.  This strategy is typically used with development and construction or ‘value-add’ projects, where an investor will purchase, lease or option a project property and take specific, calculated steps to improve or add to its overall value over a certain length of time with the intent to then re-sell and realize profits.

Land development can range from working with the local city to establish zoning, permitting, platting, subdividing, etc. to putting in the infrastructure (roads, curbing, utilities, etc.) for future construction and actually building on the land.  Each step of the development process can add value to the property, with  investment capital and costs recouped through sales or refinancing.  Many developers look for ways to control the risks involved in the development and construction process, such as lining up a lease or buyer for the property before building or prearranging for higher-cost construction financing to convert automatically to a lower-rate permanent loan after a set period.

Development and construction projects can be quite lucrative but can also carry significant risk to initial investment capital and hefty up-front costs.

Value-add project improvements can include capital or cosmetic repairs like upgrading units, replacing a roof, repainting, resurfacing parking lots, as well as strategic asset management action like leasing vacant space to increase net income, restructuring or extending leases, putting more efficient management systems in place,  fractionalizing ownership, refinancing with a different/better loan product, etc.

Funds to pay for capital improvements are either calculated into the purchase price up front and/or paid for by  existing cash flow from the property.  Strategic actions usually will need a stabilization period for the property to show consistent performance at new income or expense levels.

Investors using this wealth-building model either become, joint-venture with or hire a project manager who is responsible for executing the improvement plan for adding value to the property.  Expertise is obviously an important factor and depending on the scope of the improvements, may involve a great deal of coordination with sub-contractors or other professionals.  Timing can still be a major factor in realizing profits with this wealth-building method, especially if there are heavy up-front costs or if the building is completely vacant.

A detailed cost analysis is essential for any development or improvement project, along with a healthy cushion or reserve fund for the ‘Unexpected’.

Long-Term Outlook

One of the biggest criticisms of real estate is that the investment capital or equity cannot be as easily converted to cash as liquidating a stocks and bonds account.  However, building wealth patiently over time with real estate is how many business and family dynasties were created.

‘Buy and Hold’ is a term often used with much longer investment time frames, often 10 years or more.  Long-term wealth-building can been used strategically in an investment portfolio to achieve various long and short-term objectives depending on what is purchased and how it is structured.

Land-banking is the practice of buying an empty lot or raw piece of land with the anticipation that it will become more valuable over time.  Ever hear of the phrase, ‘Dirt Cheap’?  Unimproved land is less expensive to purchase and costs less to own than property that has a building already on it.  Land-bankers strategically purchase in areas that they consider to be or will eventually be ‘in the path of progress’ as towns and cities grow and develop new communities.  This can happen quickly, take years or may never happen at all if development is slow, takes a different path than anticipated or if environmental or other challenges arise that make development difficult or cost-prohibitive.

Investment Real Estate can be any residential or commercial property purchased for growth and/or profit potential.  Many people buy a second home or break-even rental property in anticipation that eventually over time, it will appreciate in value as most real estate has done historically overall.  This is often referred to as an ‘Appreciation Play’.

Income property is purchased with the expectation that it can generate enough income through rents or leases to ideally provide a source of income for the investor or to at least cover its own expenses for property tax, insurance, ongoing maintenance, repairs and other expenses associated with ownership.  Even property free and clear of any financing will have operating and administrative costs that need to be planned and prepared for.

One of the truly powerful wealth-building abilities of real estate is the ability to leverage your initial investment and increase its earning and growth potential exponentially.

If part of the purchase price is financed there will be loan payments to account for but if those costs are also covered by income generated by the property, the tenants ultimately pay down your loan, thereby increasing your equity and building your wealth in the process.

Obviously, financing adds another variable and additional risk to the equation.  Operating costs and loan payments are due regardless of vacancy or other interruptions in income.  Highly leveraged properties and under-capitalized, inexperienced owners can be a dangerous combination.  Investors need to carefully examine the past and projected performance of the property as well as their ability to manage the asset.  Again, a reserve fund is a wise way to help manage property cash flows and avoid being prematurely forced to sell.

Leverage is simply another tool and can be used as responsibly or irresponsibly as the investor wielding it.

Bottom line:  Build wealth at a pace with which you feel comfortable and can afford.  Expect the Unexpected. Partner with discretion, integrity and experience.  Any investment or project is only as good as the people involved.

This is the second in a series of articles about Real Estate Investing as a Financial Tool.  Read the series from the beginning or click on the links below to learn more about each of the strategies presented.

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About Jacqueline Ross, CCIM

Jacqueline Ross, CCIM is an experienced investor, educator and real estate professional. She founded Investment Strategies, Inc. to help property owners and investors nationwide strategically plan to create income, build wealth and achieve personal and financial goals. Learn how to tap into 'lazy' equity and get your investments working for you.

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