- Asset - What am I investing in?
- Capital - How much money am I investing?
- Profit - How much do I anticipate making?
- Time - In how long?
In keeping with our "small investor" line, I will discuss small asset classes, residential living dwellings of up to four units (the definition for "residential" rather than "income producing commercial" which is any residential over 5 units), small retail centers, etc. Of course not all single family homes, condos, duplexes and small retail centers are made equal. There's a huge difference, for example, between a condo in a garden apartment building out on the suburbs and a condo in a high rise in the city center. The differences, besides the obvious cost, are very important.
Capital is what you are investing. Many new investors make the mistake of looking at just the price of the property without regards to the closing costs of purchase and sale, the potential rehab, the carrying costs and the commission paid at sale. While some costs, like the commission at sale, are paid from proceeds, the rest have to be invested upfront by the investor.
The Asset is what you bought, a condo, a single family home, a little retail center. Your Asset generates income from rents or your Asset can be improved and sold for more money. Your Asset can have both an extrinsic and intrinsic value. The "intrinsic" value is what your Asset is worth. In real estate fundamentals, the value of your Asset is a direct function of the net income your Asset generates and what you as the investor is willing to make in profit as a return on investment. This is called the Capitalization Approach and I'll go over it in detail in the future. The "extrinsic" value of your Asset is a value outside of the fundamentals, it is a value that an investor places on an Asset due to speculation, a feeling that the Asset will be worth more in the future for some unspecified reason.
Profit is what is left after all costs are deducted from the sales price. Profit can be stated as an amount or as a percentage of total capital invested. Consequently a percentage return can be stated as a "cash on cash" return or an internal rate of return (IRR).
Time is how long it took you from "cash in" to "cash out". If you are analyzing a rental property then the "time" can be a year of net income. It is normal for rental properties to be analyzed based on a future sell off date at some future value, the "return" is then calculated not only on the rental income but on the potential future profit.
These four items create the fundamental pillars of real estate investment but we will see how the real money (and peril) in real estate is made by ignoring these fundamentals.
