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What You Should Know about Acquiring and Building Investments for the Real Estate License Exam

For Real Estate License Exam purposes, absorb the building investment terminology, and wherever you see math, make sure you understand the basic idea. An investor may buy one investment property and leave it at that. But great empires of wealth have been built by buying, selling, and holding multiple properties for investment.

Leverage your investment

Leveraging is using borrowed money to increase the return on your investment. One reason real estate is such an attractive investment is that other people’s money is available for you to invest. The beauty of leveraging is that the less of your own money you use, the higher the rate of return on your investment.

The fact you most likely use borrowed money to buy your home is also leveraging. But the fact is that you buy your home for one reason and an investment property for a different reason, and the advantages of leveraging a real estate investment have a direct bearing on the profit you make on the property.

The formula to calculate the percentage profit based on using borrowed money, namely using leverage to increase your profit, is a two-part equation.

Part 1: Selling price – purchase price = profit (in dollars)

The second part of the equation presumes of course that there is a profit. Leveraging doesn’t really matter if there’s a loss.

Part 2: Profit ÷cash investment = percentage of profit

Here are two examples of leveraging at play. You buy an investment property for $500,000 with $100,000 of your own cash and the rest financed with a mortgage loan. After several years, you sell the property for $600,000. You made a profit of $100,000. If you do the math:

Part 1: $600,000 (selling price) – $500,000 (purchase price) = $100,000 (profit)

Part 2: $100,000 (profit) ÷$100,000 (cash investment) = 1 (or 100 percent of profit)

You buy the same $500,000 property, only this time you pay all cash. You again sell it after a few years for $600,000. You made the same $100,000 profit. But the math this time is:

Part 1: $600,000 (selling price) – $500,000 (purchase price) = $100,000 (profit)

Part 2: $100,000 (profit) ÷$500,000 (cash investment) = 0.2 (or 20 percent of profit)

Comparing the first example with the second example shows how you can make the same amount of money, $100,000, with only a $100,000 investment, instead of tying up $500,000, all by using other people’s money — namely the mortgage loan.

Now that you’ve seen how basic leveraging works, think about the investor who has $500,000 cash. Instead of paying cash for one $500,000 building, he puts $100,000 cash into five $500,000 buildings.

Using the example above, he would reap 100 percent profit on each of the buildings and make a total of $500,000. Investors generally want to invest as little of their own money as possible and, of course, make the most profit in the shortest time.

Make sure you can handle a math question calculating basic leverage and understand that leveraging is the concept of using borrowed money to extend the impact of your own cash investment.

Pyramids

Pyramiding is building multiple investments from one investment. You really need to think in terms of an upside down pyramid or triangle for this to make sense. Essentially, you start with one investment property and use the profits from it to buy two. Then, in turn, you buy four.

So, the upside-down pyramid has the pointy end down — that’s the one property you start with — and from there the pyramid expands up and out — that’s the result of your addition of more investment properties. You can sell each property and buy more properties, or refinance a property and use the resulting cash to buy more. In pyramiding, you’re always aiming to increase the total number of properties you own.

The down side of pyramiding, of course, is your increasing debt load, which can be very sensitive to economic conditions. And, of course, investing in more and more buildings presumes an adequate profit greater than expenses. But pyramiding is one way that people build a real estate investment portfolio over time and end up controlling a number of properties.

Vacant land

Traditional real estate investment advice says to avoid investing in vacant land, meaning land that’s undeveloped. Here, buying vacant land refers to buying a piece of empty land and waiting for it to grow (appreciate) in value. Sometimes people wait for time to take its effect, hoping that property values will rise.

Sometimes people are simply waiting for development to reach the property or a new highway to be built. In these cases, investors aren’t doing anything to add value to the property. Some people have made money with this investment strategy, but in general, vacant land is not recommended as a good real estate investment.

Vacant land produces no income while you own it. The only profit to be made is when you sell it. And that profit usually depends on factors over which you have no control, such as where a new road is built. Meanwhile, you have to pay taxes on the land and possibly maintain it in some way depending on where it’s located.

On the other hand, if you do something to increase the value of the property, it may become a good investment opportunity. You may be able to build on it or get the local government to permit commercial development, which usually is more highly valued than residential development.

Vacant land also can be rented (leased) on a long-term basis to someone who wants to build something on it. Exam questions on this subject, if any appear, are pretty simple. Just remember that vacant land is not considered a good investment because it costs you money without generating an income.

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