Games with profitability: how to make money on real estate abroad
When I started working in this direction, I was faced with the fact that by the word “profitability” everyone understands something of their own.
For some, profitability is the net profit minus all expenses and taxes, for others – IRR, that is, an indicator calculated on the basis of cash flows taking into account discounting and the conditional sale price in 10 years, for the third – annual revenue divided by the value of real estate. And everyone is right in their own way.
Because of the ambiguity of interpretation, investors often compare warm to soft, make the wrong decisions, choose low-quality objects, or simply waste time. It is important to understand how a business partner makes calculations, and synchronize the understanding of profitability and risks.
Many clients are interested in objects with high profitability, but when it comes to buying, very few people will acquire a low-quality asset, even if it is highly profitable. The majority seeks to acquire real estate in good condition and in a safe area with a yield of at least 5–7%. But in most cases, high yield means that the object is not in the best location. It is impossible to buy high-quality real estate cheaply, as the demand for it is high in hot markets.
One of our clients owned an office building in the center of Berlin. He recently received four offers from large institutional buyers who were willing to purchase an object with a yield of 4% without deducting expenses. At the same time, I showed the building to a Vietnamese client, who agreed only on 5%, despite the fact that the quality of this object and the current situation on the market do not imply the possibility of buying something like that with such a return. As a result, the building was sold within a month to a Canadian buyer with a yield of 4%, and the Vietnamese is still looking for the perfect object in the center of Berlin, which will bring him 5% per annum.
Buyers often misunderstand how income is calculated when using a loan. Customers are not used to the fact that debt financing can be cheaper than the cost of renting an object. Therefore, it is difficult for them to realize that at the expense of a loan, the return on invested capital can increase substantially.
For example, when buying investment property in Germany, you can count on a loan of up to 50% of the value of the object at 2-3% per annum. with a rental yield of 6.5%, the return on invested capital (IRR), taking into account the loan, can reach 7–8%.
In addition to rental business, in recent years, many investors have become interested in value-added projects. The plan is usually as follows: to buy, build or repair, to achieve high rental income, increase the cost and then either own the object or sell it.
If such a scenario is implemented with the help of a developer, then the project yield will be different from what the investor actually receives, since the share of the developer will be deducted from it. For example, a project IRR may be 30%, of which an investor will receive only 15%.
Manipulations with financial model
Companies that implement value-added projects often manipulate financial models to artificially overstate the indicators: they change the cost of debt financing, the loan amount or the rate of return on capital, underestimate costs, or are too optimistic about revenue. All this may overestimate the economic attractiveness of the project several times. If expectations are not realized, the investor risks not to receive the declared profitability.
In this case, it is recommended to carefully study financial models, and also work only with the developer who is willing to invest in the project a substantial amount of his own funds – this is how he risks not only the investor’s money, but also his own.
Most investors understand that profitability is directly proportional to risk. However, many are willing to buy an object with a higher yield, not always aware of the risks it is associated with and what they will do in the event of a negative scenario.
For example, we implement development projects in Greece without project financing, fully at our own expense. at the same time, we achieve profitability for the investor at the level of 12–15% minus all expenses and taxes. One of the clients said that in Germany it is possible to make money on the construction of 15% (which, by the way, is not so easy). But we must understand that in Germany the project will most likely be 70–80% credited, that is, in the case of a negative scenario, there is a risk of capital loss. In Greece, there is no such risk, but there is a danger that it will not be possible to sell, and we will remain with illiquid Greek real estate, which will bring low profitability. Which scenario is worse – to lose everything or get less profit?
When the partners evaluate the financial characteristics of the projects, it is necessary to decide in advance on each term, what is the calculation method and what risks does the strategy carry. Otherwise, there is a high probability of misunderstanding, loss of time and money.