CHAPTER ONE INTRODUCTION 1.1 BACKGROUND TO THE STUDY Real estate investing involves the purchase, ownership, management, rental and/or sale of real estate for profit. Improvement of realty property as part of a real estate investment strategy is generally considered to be a sub-specialty of real estate investing called real estate development. Real estate is an asset form with limited liquidity relative to other investments, it is also capital intensive (although capital may be gained through mortgage leverage) and is highly cash flow dependent (Syz, 2008). If these factors are not well understood and managed by the investor, real estate becomes a risky investment. The primary cause of investment failure for real estate is that the investor goes into negative cash flow for a period of time that is not sustainable, often forcing them to resell the property at a loss or go into insolvency. A similar practice known as flipping is another reason for failure as the nature of the investment is often associated with short term profit with less effort (Clayton, 2007).
Management and evaluation of risk is a major part of any successful real estate investment strategy. Risks occur in many different ways at every stage of the investment process. For instance mitigation strategy for fraudulent sale is to verify ownership and purchase title insurance. Real estate owners often assume risk on their property exposure in response to unavailability of coverage. While risk retention by ‑ financially sound companies may help to reduce their cost of risk, absence of insurance is not always desirable. In many cases, property owners are required under the terms of their loan covenants to maintain full insurance to value, with restrictions placed upon the amount of deductibles they may carry (Fisher, 2005). Additionally, under high-deductible or self-insurance programs, operating companies no longer have a budgeted premium, and payment of unexpected retained losses creates potential cash flow problems. Finally, property owners or management of companies have no ability to charge the full cost of retaining property risk to their clients. Although real estate markets represent a large proportion of total wealth in both developing and developed countries, the real-estate derivatives markets are still lagging behind in volume of trading and liquidity with has greatly influenced project viability (Black, 1986). Over the last few years there has been increased activity in developing derivative instruments that can be utilized by asset managers to reduce real estate risk. The possibility of financial loss occurring as the result of owing a real estate investment and its implication on project viability will be focused on in this study. Real estate risk might arise from such things as liability, legal issues, partner problems that can force a sale, fire or theft, loss of rental income and purchasing property with an imperfect title.
1.2 STATEMENT OF THE PROBLEM
Real estate management is a particularly difficult challenge because of its tendency towards liquidity. Typically, even published indices in real estate are based on annual appraisals of large properties, not actual transactions. The recent unprecedented recession has resulted in major long term distress across the real estate industry, and has had severe implications for owners, developers, managers and investors alike. Environmental and construction exposures, catastrophic modeling, stricter lender requirements, and complex requirements involving distressed banks are just some of the risks facing the real estate industry. The researcher however will examine the real estate risks and its implication of project viability.
1.3 OBJECTIVES OF THE STUDY The following are the objectives of this study:
- To identify the risks involved in real estate investments.
- To examine the effect of real estate risk on project viability
- To identify ways to minimize risk in real estate investment.
1.4 RESEARCH QUESTIONS
- What are the risks involved in real estate investments?
- What is the effect of real estate risk on project viability?
- What are ways to minimize risk in real estate investment?
1.5 HYPOTHESIS HO: real estate risk does not affect project viability HA: real estate risk does affect project viability 1.6 SIGNIFICANCE OF THE STUDY The following are the significance of this study:
- Result of this study will educate the general public, investors and estate managers on the real estate risks, how it can be minimized and its implication on project viability.
- This research will also serve as a resource base to other scholars and researchers interested in carrying out further research in this field subsequently, if applied will go to an extent to provide new explanation to the topic.
1.7 SCOPE/LIMITATIONS OF THE STUDY This study on real estate risk and its implication on project viability will cover all the risks an investor is exposed to in real estate with a view of understanding its effect on viability of project. LIMITATION OF STUDY Financial constraint- Insufficient fund tends to impede the efficiency of the researcher in sourcing for the relevant materials, literature or information and in the process of data collection (internet, questionnaire and interview). Time constraint- The researcher will simultaneously engage in this study with other academic work. This consequently will cut down on the time devoted for the research work. REFERENCES Black, D., Success and Failure of Futures Contracts: Theory and Empirical Evidence, Monograph Series in Finance and Economics, Monograph 1986-1. New York University, 1986. Clayton, J. “Commercial Real Estate Derivatives: They‟re Here… Well, Almost.” PREA Quarterly, Winter 2007), pp. 68-71. Fisher, J. D., ‟New Strategies for Commercial Real Estate Investment and Risk Management‟, Journal of Portfolio Management, Vol. 32, 2005, pp. 154-161. Syz. Juerg M. Property Derivatives. (Wiley: Chichester, 2008)..