Key Elements to Consider When Selecting an Investment

The eight basic elements to check when investing are:

1. Risk—This is the probability of getting your money back. High risk means low probability; low risk means high probability. For investors this is frequently the most important element. Well selected real estate investments usually carry a medium risk. They are not as safe as insured Certificates of Deposit (CDs), or as risky as untested new stocks.


2. Yield—Is the return on an investment or the amount of profit stated as a percentage of the amount invested; the rate of return. The yield on rental property is measured as the ratio of the after-tax income from the property relative to the investor's cash investment. Here are two important concepts:
   
   Return OF an investment refers to the recovery of the original investment. In real estate this means getting your down payment, buyer's closing cost, and any other cash added back in your pocket.
   
   Return ON an investment refers to any money beyond the original investment. In real estate this is the money you receive after getting your original investment back. This includes annual cash flow and/or proceeds after the sale of the property.


3. Appreciation—Is an increase in value or price of an investment caused by an increase in demand and/or inflation. Although any individual rental could drop in value, real estate on the whole has historically increased in value. Real estate is often referred to as a "hedge" against inflation.


4. Leverage—Refers to the ability to use the investment as collateral for a loan, and the impact borrowed funds have on the investment's return. The use of borrowed funds to purchase property can be such that the acquired property will increase in value so that the investor will realize a profit not only on his/her investment, but also on the borrowed funds.


5. Taxation—Is the impact an investment has on the investor's liability for the payment of federal, state, and local taxes. Some investments, like savings accounts are fully taxable, while others like certain municipal bonds are tax-free. Real estate rentals, through the use of depreciation write offs and tax deferred 1031 exchanges, can be excellent tax sheltered investments.
     IRS on Real Estate Taxes


6. Liquidity—Refers to the time it takes to convert an asset to cash that is a reflection of its market value. Many things can be quickly converted to cash at a drastic discount, such as pawn shop items. But, liquidity in an investment sense, means the time it takes to sell an investment in a normal market. Highly liquid means the investment can be sold quickly. Low liquidity means it will take considerable time to sell the item. Illiquid means it is extremely difficult to sell for cash. Listed stocks and bonds are highly liquid investments. The sale occurs quickly, and the sale proceeds are close at hand. Real estate usually has low liquidity. It takes time to market the property, close escrow, and get the cash.


7. Management—Refers to the amount of personal or hired time, it takes to run the investment. Some investments, such as CDs are almost management free; while real estate is frequently management intense. Dealing with tenants, repairs, and so on takes time and costs money. If a person does his or her own management the cost can be measured in what they could be earning doing something else. Some real estate rentals take less management time than others, such as net leased property.


8. Timing—Refers to the length of time one must wait to receive cash flow from an investment. $1,000 in a month is better than $1,000 in a year. The sooner an investor gets the money, the quicker it can be reinvested to earn even more money. Real estate rentals can generate current cash flow from monthly rentals, and future cash flow when the property is sold or refinanced with a cash out.

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