Have you ever read Mark Twain’s famous quote, “Buy land, they’re not making it anymore”? Without a doubt, other people have told you their advice about real estate investment. They say that investing in physical real estate, the traditional way, is a “surefire method” to achieve positive ROI. Additionally, they claim it is without the volatility we associate with the stock market.
Or maybe you have a friend or acquaintance who invested in multiple properties successfully, and after doing that for a while, no longer needed to work 9-5. The world of investment literature is rife with such stories. These stories tell of success and time-tested proverbs and sayings approving of investment in property. However, homes are quite expensive, and when so much money is on the line, even small errors can have major financial consequences. Below are some errors in judgement that first-time real estate investors in Japan make.
Imagine surveying ten people about whether they think that buying on margin in the stock market is a wise choice; the majority will probably say “no.” 50% of that majority will likely inform you that it is a horrible plan. Next, if we specify the condition that the money we are using to buy on margin requires interest payments, therefore the debt basically snowballs year after year during the repayment period, then the proposition becomes much more severe.
Now, imagine in this scenario simply changing the word “stock” to “real estate”, or even better, “home.” The answers would differ greatly from before. The majority of people advocate buying a home. Many regard homes as the most expensive consumer good the average person will buy in his or her life, and are usually bought with a mortgage, which is a form of debt. It is common to pay the down payment out of pocket, but the amount of equity the buyer will actually have in the piece of real estate is unlikely to be more than 10-20% of the total price of the home. We call this “leverage.” This is the same as using US$10,000 from a brokerage account to buy US$100,000 in stocks or derivatives.
SOMETHING TO CONSIDER: What would happen to our derivative investor’s initial investment of US$10,000 if his or her position,
valued at US$100,000, decreased in value to US$75,000?
If you cannot come up with a satisfactory answer to the question above, or if it looks difficult-to-understand, it would be wise to review your knowledge of mortgages prior to making any major decisions with your finances. If you are a property investor, there are three possible cases in which a sort of margin-call could affect you:
Currently, the apartment building or condominium complex you own has an occupancy rate of 85%, and the revenue generated is sufficient to cover your mortgage, leaving a little bit for you afterwards. If the tenancy rate then falls to (for instance) 83%, then this “little bit for you” goes up in smoke. If the tenancy rate falls to 80% the cost of repaying the mortgage exceeds revenue from the tenants, and out-of-pocket payments will be necessary until you manage to get the occupancy rate back to a break-even level.
You have one unit and one renter. The percentage of the mortgage payments for that unit covered by his or her rent payments is either 100% or 0%. If he or she moves out, 100% of the mortgage repayments become an out-of-pocket cost.
LTV means “loan to value.” The bank gives you the green light to buy property with an LTV of 80%. For that piece of real estate, you pay 20%. The other 80% is paid for by the bank. The market corrects or even falls, or, perhaps, to make matters worse, there is a sudden drop in the market. That piece of real estate has seen its value decline by 10%. Therefore, the bank’s right to decrease its exposure results in it asking you to refill your equity by the amount of shortfall that has resulted (i.e to put in more of your own money so that the bank still only has 80% exposure despite the decrease in value). Will you have enough money for that? If so, then you will be fine, but if not, the bank could foreclose on your property, or you might have to declare bankruptcy.
You have a variable-interest loan from the bank.
The rate just went up. Previously, making your mortgage repayments only required 83% tenancy, but this is now not enough. Mortgage repayments become an out-of-pocket expense. Wait, you can’t pay? Again, foreclosure or bankruptcy. Getting a variable-interest loan and ending up over-leveraged is one of the most serious errors one can make.
Ignorance of the Law and Errors in One’s Understanding of the Law
Over the past few decades, Japan has revised the building, fire, and safety codes numerous times. As you take a look around at the cityscape, the buildings were constructed using different rules and regulations, and the rules and regulations in place at the time that one building was constructed may very well differ from those at the time that another was constructed.
In other countries, when regulations are updated frequently, buildings built previously using older building rules and regulations are commonly grandfathered in; they were in compliance at that time, and therefore the authorities give them a free pass, as long as the building adhered to the rules and regulations at the time it was constructed. In cases in which this is impossible, the owner has the burden of getting the building up-to-code, making sure there are no errors in how the building adheres to the codes. Otherwise, he or she must have it torn down. It is out-of-the-question and illegal to resell the building.
In Japan, things are different. Hundreds of thousands of non-compliant or illegal properties are on the market at any given time. Maybe they are illegal because of safety requirements, zoning rules, or construction stipulations (e.g. structure-to-land coverage ratio). It is completely legal to sell a property that is currently has errors with compliance. By law, the seller must disclose certain infringements to potential buyers, it is not necessary to disclose all of them. Not knowing what to look at could change your bargain acquisition into a lemon that you will not even be able to get rid of—because the other potential buyers can all see how sour it is.
Failing to Calculate Yield And ROI Correctly
Gross yield and net yield are different from one piece of real estate to another. In the case of properties that were constructed a long time ago, for which it costs more money to maintain them, there can be a very obvious difference. At the time of purchase, be sure to ask about the net yield (what you have left over after paying fees and expenses).
After figuring this out (in addition to asking how it was calculated, and that there were no errors) it is advisable to perform the calculation for yourself, factoring in taxes, as well as a budgeting for wear-and-tear (i.e. maintenance and repairs).
Certain real estate agents are less-than-honest. They will quote the gross yield when the tenancy rate is 100%, even though there are currently empty units. If you do the math correctly, you can figure out the break-even point in regard to tenancy rate. After calculating this, you can better measure risk. You can ask whether or not it is worth it.
Judgement Errors in Understanding Liquidity, No Exit Strategy
If you did not think about any of the issues above prior to making a risky investment decision, you will definitely have to deal with re-selling down the road. Liquidity is when we can conduct transactions efficiently for a fair price. In this case: is it easier/more difficult, to sell? Japan has an efficient real estate market. Therefore, the process itself has no issues. Basically, the market does not lack buyers, or money which they can use to invest.
What is the problem, then?
The problem that some owners might have is if the property is in an undesirable location. Or what if it is somewhere with inadequate population demographics? It is logical that investors may not want to use their capital to buy an asset if the cash flows (the income from renting it out) are not reliable, or if it is possible that cash flows may, in the future, stop completely. E.g., suppose that you are the owner of a unit in Toyota City, Aichi Prefecture. Most of the renters are employees of the eponymous company. What would a downturn in the industry do to vacancy? What if that company had financial trouble/went bankrupt?
High yields are tempting to many people. However, you should think about yield within the context of whether or not the property can be resold. Basically, is the yield high enough to make up for the extra liquidity risk in months, years, or decades? What if you can only sell your property by offering 20% off on the purchase price? How much income earned in the past from rental income will vanish? There are any number of things to discuss with your real estate adviser when thinking about making a purchase. You discuss them in order to avoid errors. There may be even more things to discuss if you are unsure if what you have already invested will indeed be beneficial in the long run.