Real estate is the world's largest asset class, and for good reason: It’s both capital-intensive and relatively accessible. According to Savills World Research, the value of global real estate reached an estimated $280.6 trillion at the end of 2017, making up more than 77 percent of the world’s wealth.
Real estate is often the primary source of wealth for individuals and the biggest investment many make in their lives. Consider the building you’re in right now. It may be owned by a company or person to whom you or a business pays rent. It could be your home that you own or pay a mortgage on, or a hotel you’re paying to stay at.
Because of its accessibility and history of high returns, real estate is an incredibly popular alternative investment option for individuals. But how can you get involved in real estate, and how do you know if a property is a wise investment decision?
To succeed as a real estate investor, you need to understand the four key factors to consider when analyzing a potential investment. Before diving into these factors, here’s a primer on the five types of real estate and how to invest.
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If you’re interested in entering the world of real estate investment, there are five types of real estate to consider:
- Office
- Industrial
- Housing (multi- or single-family)
- Hotel
- Retail
Each type of real estate has nuances, including lease length, building permits, and property laws. Make sure to research these nuances by geographic location when deciding which real estate investment type makes sense for you.
There are several ways you can get involved as an individual investor, including owning property outright and contributing capital to a real estate venture or real estate investment trust (REIT). Each has its advantages and disadvantages, namely when it comes to control over the investment property and opportunities for diversification.
Owning property provides you with the most control over your investment. For instance, imagine you decide to buy an apartment building in Boston and do so by leveraging debt. As the landlord, you can choose who to lease the apartments to, how much to charge for rent, and how much money to put into the property to increase its appeal and value. Owning one building doesn’t make for a diverse portfolio, however, leaving you vulnerable to anything that could damage the building or its appeal, such as a fire or pest infestation.
On the other hand, contributing to a real estate venture, fund, or REIT gives you less control over investment properties but more opportunities to diversify. For instance, say you contribute a small amount of money into an apartment building in Chicago, another sum into a new office building in New York City, and a bit more into a retail space in Denver. While the managing body controls the investments, you’re able to spread out your contributions to mitigate risk and potentially tap into returns from several unique properties.
There’s no single correct way to invest in real estate, but there are several factors to consider when selecting an investment opportunity.
Related: 7 Types of Alternative Investments Everyone Should Know
Factors to Consider in a Potential Real Estate Investment
To analyze a real estate investment opportunity, you need to consider four factors. These factors can be visualized using the real estate diamond framework, introduced by Harvard Business School Professor Arthur Segel in the online course Alternative Investments. It shows how four factors—product, people, external environment, and capital markets—are interconnected in the real estate investment space.
The visual shows a factor in each corner of the diamond with arrows indicating that it influences the others. As such, it’s critical to consider all four factors when analyzing a real estate investment. Here’s a breakdown of each factor and its many facets to consider.
1. The Product
In real estate, the product is the building and the land it sits on. When assessing an investment opportunity, one major advantage of real estate is being able to physically see, touch, and experience property for yourself. The goal with any investment is to increase the product’s value so you can earn a return. With that in mind, assess the product for anything that may decrease its value.
Consider items such as:
- Infrastructure: Is the building physically sound and up to code? Are there built-in design flaws—for instance, floor plan, fixtures, or wall thickness—that could make the space unappealing?
- Signs of damage: Think mold, plumbing issues, faulty heating and cooling systems—anything that could make the space unlivable.
- Physical location: Is the property close to highways, public transportation, offices, parking, green space, or stores and restaurants? Consider the appeal of renting the space from the renter’s perspective and of visiting the space from the perspective of their business’s potential patrons.
- Local supply and demand: What are vacancy and absorption rates like in the area at the time?
- Projected costs: Are there any improvement projects that need to be done? How will maintenance requests be handled? What are property tax rates like in the area?
The property itself provides much to consider when analyzing an investment opportunity, but it doesn’t exist in a vacuum.
2. The People
Something unique about real estate as compared to other types of investments is the flexibility of its deal structure and how much of an investment’s success relies on maintaining good relationships.
In Alternative Investments, Segel lists just a few of the people you need to have a positive relationship with when investing in a new building:
- Fire chief
- Police chief
- Building architect
- Neighbors
- Lawyers
- Contractors
- Subcontractors
- Roof inspector
- Elevator inspector
“The list of relationships you need to manage goes on and on,” Segel says. “It’s these various ad-hoc relationships and working with many kinds of people—that’s what makes this business so much fun.”
Because of real estate’s flexible deal structure, Segel advises investors to brush up on their negotiation skills.
“Because real estate has non-standard pricing and flexible deal structuring, everything and any transaction is a negotiation,” he says.
When analyzing a potential investment, consider the relationships you have with the people involved. If there are existing strained relationships, perhaps this isn’t the right investment for you. With so much riding on how you interact with others, it can literally pay off to have a good rapport and negotiation skills.
Related: Why Real Estate Agents Need to Keep Their Negotiation Skills Sharp
3. The External Environment
While any investment is risky, the real estate field is especially susceptible to factors outside the investor’s control. Because your investment is in a physical building or set of buildings, the way your investment performs will be impacted by countless external environmental factors, such as:
- Weather and natural disasters
- Changes in local or national laws
- The coronavirus (COVID-19) pandemic
- Shifting demographics in the area
- Technological advancements
One example of a technological advancement Segel describes in Alternative Investments is the rise of 3D-printed homes. Most often used in areas that need more housing at a rapid pace, 3D-printed homes aren’t extremely expensive to create and could change the way the real estate industry looks at new builds.
“Every property type is affected by these new technologies,” Segel says. “It’s going to be fascinating to see how this industry adapts.”
While it’s impossible to account for the multitude of external factors when analyzing a potential investment, it’s useful to consider as many as possible and be prepared for the unexpected.
4. The Capital Markets
Once you’ve determined that a property is a good investment choice in terms of the people involved, external environment, and product itself, how will you fund your investment? This is where capital markets come in.
Capital markets are defined in Alternative Investments as the channels through which those who have capital to invest connect with those who can put that capital to profitable use. It’s worth noting that capital markets are governed by local laws, real estate market structure, and investment trends, so when deciding where to invest, consider the capital markets available to you and how they may differ from each other.
Because real estate is a capital-intensive industry—meaning you need a lot of cash upfront to invest—many choose to finance investments using debt, commonly referred to as “employing leverage.” Debt secured by a property is referred to as a mortgage, which makes up the largest asset class in the United States.
The other investment method at your disposal is equity, which grants you a share of a property’s profits in exchange for upfront investment in the purchase of it. Typically, an equity investor’s returns will be seen when a property is refinanced or sold outright.
Both debt and equity can be employed through private and public market channels when financing real estate investments. Private real estate transactions typically occur between the two principals involved, whereas public real estate transactions are often made between parties representing others. Private transactions are most common in real estate, but public transactions present an opportunity for higher liquidity.
When analyzing a real estate investment opportunity, consider which capital market makes the most sense for your financial situation and goals.
Making Wise Real Estate Investments
To effectively analyze a potential real estate investment, you need to consider each facet of the real estate diamond. By considering these four factors, you can gain an informed picture of the investment opportunity and decide if the property is worth it.
While the real estate diamond presents a clear visualization of key factors to consider, the real estate investment space is nuanced and requires dedicated study to master. If you’re interested in deepening your knowledge of real estate and other alternative investments, consider taking the online course Alternative Investments to gain the skills necessary to make wise investments and build diverse portfolios.
Are you interested in expanding your analysis skills for real estate and other alternative investments? Explore our five-week online course Alternative Investments and other finance and accounting courses.
