Investment Selection Tips
Having explored some types of real estate investments available in Canada, it's time to share some tips on selecting investments.
Tip #1: Diversify to Mitigate Risk
Different investments will be affected in different ways when financial disasters strike, so having a diversified portfolio with investment distributed across multiple sectors is a good way to mitigate that risk. During lean times, for instance, stocks that catered to budget-conscious consumers perform very well. Fast food supplier McDonalds and budget household goods retailer Wal-Mart are both examples of stocks that perform despite the times, Mainstreet is another. Certain businesses thrive throughout even the direst economic periods because the goods or services they provide are essential.
Tip #2: Know the Risks Involved
Analyzing returns and projecting cash flow is vital to making an informed real estate investment, but equally important are risk analysis and risk management. Risk in this context is defined as "anything that creates volatility in a property or portfolio's expected or actual returns." Investors need to understand how to assess and manage the factors which cause risk, they need to know how to mitigate those risks and shift them to third parties (ie sellers, other brokers, insurance companies, etc.) Pricing those risks is key to determining acceptable premiums.
Five Major Categories of Real Estate Investment Risk:
Analyze the factors relevant to the market(s) in question, both demand and supply. When evaluating demand influences, consider factors such as population base, employment levels, average income, etc. When evaluating supply influences, your competition will be your primary source of information, helping you to determine what your expectations should be in terms of projected vacancy rates, rental fees, and relevant market trends.
Liquidity is the ability to convert an asset to cash while preserving capital. The nature of commercial real estate hampers its liquidity, although property liquidity varies with market conditions. Dropping a price may help sell an asset more quickly, but is also likely to result in less capital. As liquidity risk rises, the required rate of return over more liquid investments rises with it.
- Political and Legal
It's also important that investors are up to date on all relevant existing and pending legislation relating to their investment's industry. Some fee schedules and land use policies create incentives for investment, others represent barriers.
- Management Risks
There are a few important questions to ask: How do management divide operating expenses with tenants? How are the leases structured and what is their duration? How are tenant credit scores? Do they have a diverse mix of tenants? How skilled at promotion, acquisition, and retention of tenants are the managers?
This is where owners have the most say, the greatest influence. Since owners control the proportion of debt financing used to purchase the property, they can control the property's leverage. As leverage rises, so does the volatility of cash returns to the equity position when the unexpected happens. Examine the leverage ratio (total property value divided by the equity).
Loan term risks are also very important: variable rate loans assign risk to the borrower, while fixed-rate terms find the risk assumed by the lender. Remember, it's OK to make an investment that seems a little risky so long as you are fully informed of, familiar with, and so fully appreciate the risk.
Once familiar with these risks, it's time to consider how they'll impact your returns. Most properties generate cash flow from collected rent less operating expenses and debt service. Since both rent pricing and operating expenses generally remain somewhat consistent, they are somewhat predictable since there is a set rent being charged, and expenses are contained by pass-through provisions.
Tip #3: Seek Help When Stuck
Whether you don't know where to start or you've been confronted with a challenge to your investment that you feel powerless to address, when you're stuck it's alright – in fact, it's advisable – to recruit some help. Whether it's from a trusted financial advisor, a well-researched and credible book, experienced friends, wherever it comes from: when you need help, don't just try and go it alone. It will save you money, time, and stress to get the assistance you need. Remember there is no single formula to investment success, every investment will be unique because every investor has different goals, expectations, thresholds, and skillsets. Researching as part of doing your due diligence should direct you toward credible resources and people from which to obtain qualified assistance.
Tip #4: Don't Invest Emotionally
While it's important to trust your instincts, too often emotions can cloud judgment. Your investments don't have feelings or care about you, so remove emotion from the equation when making investment decisions. Approaching investment practically is the best way to ensure you are making prudent decisions in line with both your goals and reality. Some rules to follow:
- Define Your Goals
Even before considering a particular investment, you need to think about your longer-term financial goals. Don't confuse long-term goals with long-term strategy, it's the difference between the destination and the trip. You need to know where you want to go before you can plan the route. Consider your timeline: your age, the phase of your career, and how long you can wait for the return on your investment. The rewarding feeling as you achieve milestones on the path to those clearly defined goals will help you stick to your vision and incentivize you to keep emotion out of your decision making.
- Follow the Economic Trends, Not the News Cycle
There's a reason that index funds outperform the majority of average investors: index funds don't watch the news and average investors do. Funds track numbers, the news tracks stories. That's not to stay you shouldn't read or watch the news – it's important to know what's going on in the world – but you certainly should not make investment decisions based on that information, especially not based on that information alone. That's not to say you should only invest in index funds (remember: diversify and eventually take informed risks) it just means you shouldn't be investing based on what you see in the news.
- The Right Approach
Having defined your goals, you can begin planning your route to achieving them. Deciding the right path often leads to one of two equally problematic scenarios: overconfidence and underconfidence. Overconfidence leads us away from risk mitigation and causes us to reject information which doesn't confirm our position. Overconfidence also causes us to overestimate our return on investment (ROI) which can create financial problems (ie disrupt financial planning) and lead to unnecessary disappointment. Lacking enough confidence also causes problems when investing, sometimes leading us to wait too long and miss an opportunity, or to overcomplicate simple processes. The same issue can cause us to divest too early and miss significant returns. Approaching investment warily and wisely means performing thorough due diligence before investing, allowing you to have a strong apprehension of your position so you can invest decisively and informedly.
- Know When to Take the Risk
There are going to be times when, after analysis, you may determine a particular investment is higher risk than you are usually comfortable taking. Many more conservative investors will simply stick to their comfort zone and choose not to invest, and that is the safest course of action. When investing, however, sometimes the safest course of action can lead to substantially lower returns, to needlessly leaving money on the table. The old saying reminds us, "nothing ventured, nothing gained," and indeed larger returns usually demand greater risk. Once you've been investing for a while, you may want to consider stepping outside your comfort zone should you find the right stock on which to take a risk. Start small, start slowly, but push your limits as your experience increases.
Keep these guidelines in mind when selecting your investments, and we hope you'll enjoy many happy returns!