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| Elements
of an Investment
By Harriet Murray
September 21, 2003 |
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.
HARRIET MURRAY
Harriet
Murray, Broker
For additional information on properties for sale or
lease within the bay, please call or e-mail me at: harriet@casasandvillas.com
Thanks and until next week.
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