Real Estate Economy Basics

The real estate economy is an important component of the general business economy, subject to the same four types of fluctuations. They are discussed here. Specific cycles are the most pronounced and important trends that appear in the real estate sector. They can be observed in all phases of real estate: land development, building, sales, finance, investment, rental, and redevelopment.

Most sectors of the real estate economy are subject to both long and short cycles. Long-term cycles last from 15 to 22 years and short-term cycles about 3 years.

New Constructions

A controlling factor in the building cycle is the availability of money and credit in the mortgage and constructions markets. In general, when the economy is strong and prices are rising, the Federal Reserve tightens the money supply to control inflation. The resulting higher interest rates make real estate investments less attractive because builder must either pass the higher costs on to consumers or accept lower profits. Either situation slows the rate of construction. Conversely, interest rates decline during a recession, making constructions of new projects more feasible.

Forecasting The Economy

An extremely important indicator for forecasting the economy is the monthly report of housing starts, published by the Census Bureau between the 16th and the 20th of each month. (You can find the reports here as also on HUD website.) Housing starts, along with auto sales, are the first to rise in an economic recovery and the first to drop in a recession. Not only does new housing have a direct effect on the market but housing-related purchases such as furniture and appliances also fuel a rebounding economy.

Building Permit

Building permit data are release with the housing starts report. Because permits are secured about a month ahead of constructions starts, reviewing the increase of decrease in building permits gives a pretty good idea of what housing starts will do in the next month.

Next

After reviewing the general economic situation, it is time to review the advantages and disadvantages of investing in real estate.

Advantages of Investing in Real Estate

The advantages of investing in real estate include leverage, good return shelter from federal income taxes, and personal control of the asset.

Leverage

Leverage is the use of other’s people money to increase your return. Few other investments offer the high leverage real estate does. Stocks and bonds typically require at least 50% down payment, mutual funds want 100% invested. Yet, real estate investments can be made with 25% down payment and, in many cases, less.

Good Returns

Many careful and astute investors achieve excellent returns, often exceeding 20%.

Income Tax Shelter

Most investment opportunities such as saving accounts, bonds, stocks, and mutual funds require that the investor pay taxes on all current income (dividends). Real estate investors often provide tax-deferred cash flows (you can read about it here), primarily because of cost recovery deductions (depreciation). This allows the investor to avoid paying taxes on the cash flow until the property sales.

More Personal Control

Many investors are uncomfortable with the notion of entrusting their assets to other persons or companies with little or no control over the use of those assets. The purchase of real estate gives you much more control over the investment’s operation and management. This is true even if you employ a property manager, as the manager is under your control.

Disadvantages of Investing in Real Estate

As an investor, you have to be aware of any disadvantages so you can make an educated decision. Disadvantages of investing in real estate include management time, high capital requirements, poor liquidity, personal stress, and high risk.

Management Time

Along with the advantage of personal control comes the disadvantage of the amount of time required to manage the property. Continuing review and management of an income property’s operations is absolutely essential. A prudent investor takes an active role in overseeing management. The investor must seek a higher return on the investment to compensate for the time requirements.

High Capital Requirements

Real estate requires a substantial capital investment. You need funds to acquire the property and must have reserve funds available to make major renovations when required or to cover unexpected events. If vacancy rates are high, you will find it difficult to sell the property and may need to inject more money into the real estate to pay its operating costs and debt service to carry through the hard times.

Poor Liquidity

Investment real estate is a complicated purchase, event in the best markets. Land-use requirements, environmental audits, maintenance inspections, leases review, and new financing all take a substantial amount of time. As a seller, you must understand that it could a while after putting the property on the market before it sales.

I have real-time market data available on my website for Breckenridge and Summit County. Review it here. 

Personal Stress

Many first-time real estate investors suffer rude awakings when they discover that property management isn’t just about cash flow projections and planning, but also about personal interactions with tenants. Because an owner’s first few properties usually are not large or profitable enough to justify hiring a manager, an owner is left with the task.  When the mortgage payment is due, slow-paying tenants can become an irritation. Tenant complaints take time and interpersonal skills to resolve. Tenants sometimes leave a property in poor conditions when they move, requiring a large contribution of time and money to restore the premises for the next tenant. Eviction is sometimes necessary and is usually distressing to both landlord and tenant.

High Risk

It is said that the longer the asset is held, the greater the chance of catastrophe. Many examples exist of seemingly good real estate investments gone bad. It could result from overbuilding in the market causing high competition and lower rents. Environmental laws also may require expensive retrofitting. Or a major employer may relocate to another area, causing widespread unemployment. Insurance does not cover this dynamic risk. To overcome dynamic risk, you must analyze a property carefully before purchasing, then manage it effectively.

Static Risk

Static risk is the risk that you can insure. Examples include fire, windstorm, accident liability, floods, appliance contracts, and worker’s compensation.