Real estate appraisers explain cautions for investing in rundown properties
Suddenly, what do you think about real estate investment?
“It’s a large amount, so I’m scared” “I worry about being ripped off by real estate agents”are not uncommon concerns for many people.
Indeed,the world of real estate has a large information gap, and it’s not rare to be exploited by real estate agents.
In this article, from the perspective of a real estate appraiser, we summarize the cautions of real estate investment to help beginners avoid being taken advantage of.From a real estate appraiser’s perspectiveabout the cautions of real estate investment.
1. What are the types of real estate investment?
Real estate investment can be broadly divided into two types.
Types of real estate investment
①“Physical assets”to purchase and rent for income (income gain) or to sell for profits (capital gain).
ex. detached rental homes, entire apartment buildings, or subdivided units (individual condo units)
② Without owning physical assets,“securitized real estate”(real estate investment trusts) can be purchased to obtain dividends (income gain) or to sell for profits (capital gain).
ex. J-REITs, etc.
② securitized real estate, in simple terms, is like everyone contributes money to buy a revenue-generating property such as an office or apartment, and then distributes the rental income as dividends to all.
Common points are,① and ② both allow investors to obtain income gain or capital gain. The difference is that① involves investors owning the physical asset, whereas ② does notown the physical asset.
By the way, for both ① and ②, the appraisal of income properties is my specialty as a real estate appraiser, and I have appraised hundreds of revenue properties including housing, offices, commercial facilities, logistics facilities, hotels, and raw land managed by J-REITs and foreign funds.
2. Merits and demerits of purchasing physical assets and securitized real estate
In rough terms, the merits and demerits are as follows, and real estate investors invest in either (or both) depending on their goals.
① Physical assets
- Merits:High yield relative to the principal. Value-up through renovations by yourself is possible.
- Demerits: Since you buy as an individual,the property price is high and the entry barrier is high. Liquidity upon sale is poor (hard to sell quickly). Vacancy risk has a major impact.
② Securitized real estate
- Merits: Since it’s securitized and everyone contributes,you can buy from as little as 10,000 yen. Liquidity upon sale is high. Since it isn’t tied to a specific property, it spreads risk.
- Demerits:Lower yield relative to the principal. For example, with J-REITs, yields are at a lower bound due to price surges. You cannot add value by yourself.
3. Investment in dilapidated properties
In my practice as a real estate appraiser, I have tended to see more securitized, pristine revenue properties, but as an investor I also want sturdy physical assets besides financial assets, so I’m interested in older single-family homes and apartment buildings with time.
Investing in physical assets is difficult for beginners, so my suggestion is to start with a business model that can be reversed if you fail, namely“Purchase dilapidated properties for cash at a low price, renovate, and rent out cheaply to earn rent,”and then scale up gradually. The key is to start small.
Here is an article on how to save money to buy properties.
However, with the recent real estate investment boom, it’s hard to find good dilapidated properties… Especiallyfrom 2017–2018, expected yields were at the lower end, the peak of the real estate investment boom. Going forward,financing tightness after the Slug/SHG crisis may lead to a drop in real estate prices is likely.
I recommend waiting a bit until real estate prices settle, but if you must have something now, you are in an era where prices are high, so good properties must be sought yourself.
Amidst peak demand for real estate investment, you can only acquire dilapidated properties at low prices that others ignore. But such propertiescan be improved through renovation yourself, and the more you push, the more your effort is reflected, which is a major advantage.
It suits people who can work steadily on their own.If you have no friends... yes, like me.
Dilapidated properties yield high yields, but higher yields also mean higher risk and price volatility.“Yield equals risk”, you can regard it as correct.
4. Real estate agents’ asking prices are higher than investor perspective
I often hear from real estate agents, butAgents’ asking prices for investment properties are basically high.
If you’re buying to live in, that’s fine.
But for investment properties, you need a certain cash flow and yield, which is hard to achieve with general asking prices.
5. What real estate agents will never tell ordinary people
Especially in the real estate industry,information asymmetrydrives outcomes, and the less you know about real estate, the more you lose.
Real estate agents and builders,due to labor shortages and rising labor costs,construction costs remain high, are trying to maximize margins, so it’s natural they think “buy cheap from landlords and sell high to end users.” Landlords and end users get scammed often. Indeed,
there are articles about landlords being scammed by real estate brokers.
In Japan,REINS (Real Estate Information Network System: Real Estate Distribution Standard Information System) is a real estate network system, but the information can only be viewed by registered real estate agents (licensees); ordinary people cannot access it.
Unlike the United States, where information is shared across the network with the general public, in Japan, simply having property information gives real estate agents an advantage over ordinary people.Real estate agents have the upper hand over the general public.
Thus the real estate industry is a closed world, and there is an overwhelming information gap between agents and general consumers. Moreover, because the industry is old, information does not circulate well, making it hard to close the gap.
Ideally, each property value should be properly assessed by areal estate appraiser.
6. Why do real estate agents’ asking prices feel high?
For investment properties, roughly speaking, there are two prices:“exhaustion price” and“income price”.
Exhaustion price and income price
- Exhaustion price (from the supplier’s view): the sum of land price and building price
- Income price (from the buyer’s view): value estimated from the property's earning power (※)
(※) To obtain the income price, divide rent by yield (income price = rent ÷ yield)
Investors judge property value based on the utility of using real estate (the buyer’s price = income price), but many real estate agents price based on the supplier price = exhaustion price, which reflects the relative scarcity of the property.
Now the relationship between “income price” and “exhaustion price” is as follows.
“Exhaustion price (agents’ asking price) > Income price (buyers’ price)”
For older properties, the building value is almost zero, sothe exhaustion price is roughly the land price. In rural areas, rents cannot be high, sothe income price from investors does not reach the land price.
“Income price < Land price ≒ Exhaustion price”
Therefore, the exhaustion price set by real estate agents tends to be high for investors. In short,the appraisal methods for property value differ between agents and investors.
For example, if you buy a used house from an agent for about 5 million yen (roughly land price), and rent it at 50,000 yen per month, annual rent is 600,000 yen, gross yield is 600,000 ÷ 5,000,000 = 12%.
From there, additional expenses such as purchasing costs, renovation costs, taxes, and insurance are required, so net yield becomes lower.Since you take on risk buying a dilapidated property, you’d want a net yield of around 10%.
7. How to cheaply buy dilapidated properties
So what should real estate investors do? My conclusion is
“Negotiate demolition costs as a bargaining tool to lower the price”. In practice, you renovate instead of demolishing the building and then rent it out.
When appraising dilapidated properties, much of the appraisal subtracts the demolition cost from the land price to determine the appraisal value. Appraisal aims to determine the price that maximizes sale value in the general economic market, hence the belief that“Demolishing an old building to create a vacant lot and building anew to the most effective use increases the property’s value.”.
In the above example, if the used house is priced at 5,000,000 yen (land price), and you deduct 2,000,000 yen for demolition costs, the purchase price becomes 3,000,000 yen. Demolition costs have been rising, so there is room for negotiation, but for typical wooden houses you can estimate around 15,000–20,000 yen per square meter.
If rent is 50,000 yen per month, annual rent is 600,000 yen, and the yield would be 600,000 ÷ 3,000,000 = 20% in this case.A gross yield of 20% is plenty.
Most real estate agents’ asking prices do not account for demolition costs, so that is where the opportunity lies.
Many owners won’t listen to negotiations... well, I think it’s worth trying.
Additionally, to buy below market, you couldparticipate in auctions and public sales. Auctions are appraised by real estate appraisers. However, recent auctions and public sales have seen participation from non-agents, so demand drives prices up and the deal is not as sweet as before. Viewing isn’t possible, so I don’t highly recommend for real estate investment beginners.
8. Summary
To summarize:
- Investment real estate comes in two forms: “physical real estate” and “securitized real estate.”
- Agents’ asking prices are higher than investor perspective.
- There is an overwhelming information gap between real estate agents and ordinary consumers.
- The price discrepancy between real estate agents and investors stems from the difference between “exhaustion price” and “income price.”
- For investors, purchasing properties cheaply is crucial.
- Negotiate demolition costs as a bargaining tool to reduce price.
There are many vacant houses in rural areas, and leaving them as-is benefits no one, sorevitalizing vacant homes is also a wonderful social contribution.
I hope this is helpful for those considering real estate investment.
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