Four elements can be evaluated when making an investment in real estate:
1.
YIELD
Yield is also known as rate of return. It is the amount of money earned on the amount of money invested over the life of the investment. The desired yield or return on an investment depends on the investor’s objective. An investor whose main objective is to protect as much capital as possible, may be willing to pay a higher price, resulting in a lower yield, than one who is mostly interested in achieving a maximum cash flow and income. One who invests for appreciation rather than income will be willing to accept a lower initial return for future equity appreciation. Risk-averse investors also generally pay more for proven properties, thereby taking lower returns.
2. SAFETY
The yield should always be balanced with the safety of the investment. There are three basic risks faced by a real estate investor. The first is the loss of capital. The second is the loss of return on capital. The third is capital that is lost because the investor, for whatever reason was unable to invest it. This is sometimes called loss of “opportunity cost.” International investors may incur a fourth risk called “country risk.” This can include anything from currency losses to nationalization of property or unfavorable regulatory changes.
3. LEVERAGE
Leverage is using borrowed money to build one’s own wealth. Positive leverage is using borrowed funds to finance an investment where the yield on the investment exceeds the cost of the funds borrowed. Negative leverage is the opposite. When an investor enjoys positive leverage, he or she makes a profit on the loan itself. Even negative leverage can sometimes be beneficial if an investor gains control of a rapidly appreciating asset, or is able to use currency trends to an advantage.
4. CONTROL
Some investors want to be passive by simply investing their money and allowing others to operate the investment. Other investors want to be active and manage many or all aspects of the investment themselves. For real estate acquisitions, international investors will naturally be looking at the commitment involved in managing, repairing and visiting the property.
Yield, Safety, and leverage relate to conditions of the market in which the investment property is located. The investor cannot hope to obtain desired yield, safety or leverage without paying attention to market trends such as inflation, supply, absorption, interest rates and price fluctuations.
The issue of control, however, varies from property to property and is not specifically dependent upon the market.
TIME VALUE OF MONEY
In addition to considering the elements of an investment, an investor will want to understand the underlying principle of the time value of money (TVM). TVM states that the value of money received today is greater than the value of money to be received in the future. This principle incorporates the following ideas:
A. Risk
There is virtually no risk if you have the money in hand and are not anticipating the future receipt of money from an investment.
B. PURCHASING POWER
Because of the effects of inflation, money in hand today will purchase more goods or services than money in the future.
C. OPPORTUNITY COSTS
You can invest money today to earn interest that will result in a larger sum at some point in the future. On the other hand, money that is to be received in the future cannot earn interest until it is received. This lost opportunity to earn interest is called the “opportunity cost.”
Key components used in calculating the time value of money (TVM) are:
1.Compounding:
Compounding determines the future value of an investment made today. This may be a single payment or a series of payments. Interest earned is reinvested to earn additional interest.
2. DISCOUNTING;
Discounting determines the present value of money received in the future. This may be a single payment or a series of payments. The more time it takes until maturity of the mortgage or note, the greater the discount.
The interest rate applied to calculate future value (FV) or present value (PV) also incorporates the ideas of risk, purchasing power and opportunity costs.
Measuring Investment Performance
Yield and the rate of return are interchangeable terms used to measure investment performance – the percentage return on each unit of money invested.
There are two types of return or yield:
A. There is return OF capital or the initial amount invested.
B. There is return ON capital or the profit that the investment generated.
There are many ways to measure specific yield quantities. Some of these ways measures both return of capital and return on capital. Others only measure return on capital. The method chosen to measure yield will vary with each investor’s unique objectives and assumptions about a property.
This article is based upon legal opinions, current practices and my personal experiences in the Puerto Vallarta-Bahia de Banderas areas. I recommend that each potential buyer conduct his own due diligence and review. The National Association of Realtors has provided information for this article.
