I recently received an email from a person who had read last month’s column and was asking what the fundamental rules are that property investors talk about so prolifically. I got to thinking that maybe they are not so obvious. In fact, I realised that they may be quite subjective as different investors buy for different reasons and under very different circumstances. So what do we mean when we talk about fundamentals?
In real estate, investment fundamentals are the basic rules based on the actual and current facts surrounding the investment. It is about looking at the basics and applying common sense. The same rules also apply to a residential home, but remember the purpose of a home is quite different where ‘emotion’ must be allowed a place.
Most of the time we look at successes for inspiration, but the lessons that should be shared are those learnt from failures. It’s from failures that we learn the most valuable lessons, which teach us how to win.
In the early 90s I made a really bad investment that took years to recover from. I purchased a block of industrial property consisting of 13 buildings in Jacobs, an old industrial area of Durban. The area was in decay and I thought the value was excellent because rental yield was great.
My exit strategy was to sectionalise the buildings and sell them off to tenants, so I was investing to flip. But the area continued to decline and within three years the tenants had gone, and the entire rental income had collapsed to a point where it was not sufficient to cover municipal rates. There was almost no demand for industrial units in the area — rent or sale. The buildings were old and required ongoing maintenance. In fact some were obsolete and I should have allowed for a complete rebuild.
I was heavily geared at the time and could not reinvest in rebuilding the old structures. Nor could I hold empty buildings that were not generating cash. After five years I had exited completely at considerable loss, but there are a few lessons I will not forget:
1. Location, location, location
In residential or commercial real estate investment, this rule almost always applies. I was too clever to follow the rule thinking that urban regeneration would happen at some stage and my tenants would be happy to buy instead of paying rent. The area was in serious decay already. The key larger industries were already moving out and the small businesses that supported them also soon disappeared as the source of their work vanished. Buy for the area, always. Even more so for residential!
2. Condition of the structure
Don’t overlook the basics. You are going to have to maintain and even modernise the building; it doesn’t matter if it’s commercial or residential. Factor that into your returns. A building does depreciate and it can be very expensive to maintain. Look especially at roofs, gutters and water ingress. Does the building comply with new legislation and are the fire or toilet facilities compliant.
The term ‘flipping‘ is commonly applied to investors who buy a property speculatively to resell for capital growth. Be very aware that this is a risky business, and most of the casualties from the financial crisis of the last few years played out in this space. This is gambling so be prepared to take a few losses with your wins. If a property is a bargain, chances are there is a reason. It’s really about creating long-term passive income.
I offloaded the Jacobs buildings at a loss, but in effect I exited too early. If I had held on longer and focused on the rental income it would have turned into a good investment over time.
All business is built around customers, so when considering an investment look at the potential to attract tenants. Let’s assume you have an industrial building selling for a high yield but purpose built for a particular business. When the lease is up and you start looking for new tenants will you have to change the building substantially to match market requirements? In residential property, this means buy near places of employment, where there is always demand from tenants.
5. Cash Flow
Investment is about cash flow. Buy buildings that you can rely on to provide regular cash flow. A long lease with a blue chip tenant is always good.
It has become harder to borrow funds for real estate investment over the last few years but this is a discipline that may help us to fund more of our portfolio from cash. Beware of not having sufficient cash flow or capital to do what you need to do to attract the best tenants.
When we talk about fundamentals, it’s mostly about using common sense. Whatever your financial advisers say, property is a great way to build long-term security, and you don’t have to give up your day job to do it.