Getting Real about Real Estate

With all of the recent news about the real estate market, it is probably a good idea to take a look at the different kinds of real estate that are available.  In general, real estate breaks out into “residential” and “commercial” properties.  The key difference between these categories we will be examining is the way that they are valued.  This is very important because price increases & decreases are driven by the means of valuation.

Residential Real Estate

Residential real estate represents the places where people live.  Generally speaking, residential units tend to be occupied by the person that owns the property.  Prices for residential real estate are based on the sale prices for comparable properties in the local market.  In general, the market for residential real estate moves up or down based on the relative mix of buyers and sellers.  When the number of willing buyers exceeds the number of sellers, the buyers will bid-up the prices to purchase their desired property.  Conversely, when the number of buyers dips below the number of sellers, prices must come down in order to persuade the buyers to submit an offer on your property.

Commercial Real Estate

Commercial real estate is rented out to business tenants.  They pay rent in return for the use of the real land and buildings that are on top of it.  Prices for commercial real estate are based on the capitalization rate or “cap rate.”  The capitalization rate of real estate is the net operating income (Operating revenue, less operating expenses).  This tells the investor what rate of return the real estate asset will produce.  Based on this framework, the primary driver of commercial real estate values will be the relative level of rents that generate operating income.  Granted, CAP rates for commercial real estate are frequently bid up & down based on the relative mix of buyers and seller in the market.  However, the operating income is always the primary variable for valuation.

Investing in Real Estate

What this means to most of us is that we will be better off investing in real estate that produces an income (Either as a commercial property or residential rental), because its value will depend on our ability to generate operating income instead of the whims and fancies of the local market.  In the case of your personal residence, you are investing in a property with a highly reliable, fantastic tenant . . . namely you.  In the case of second and third properties, the best way that any of us can protect the value of this investment is to create a reliable stream rental income that turns the purchase into an investment.

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