Property Investment Strategies: A Practical Overview

At a time when European central governments raise taxes on property investments (most recently France and before then, still in 2012, Italy, the UK and other countries) it seems counterintuitive to talk about investment strategies. However even if transaction costs are now higher than ever and will undoubtedly impact negatively on transaction volumes and prices, it is still possible to make sound investments and then get a bonus if and when property taxes will become more favourable.

The present blogpost provides an overview of the most classic investment strategies for luxury property buyers.

Investors in luxury residential real estate can always choose between two different investment strategies: Wealth Preservation and Wealth Generation.

Photo Credit: europhotos / Shutterstock

The wealth preservation approach focuses on purchasing the best real estate on the best roads or simply buying good properties in any prime area. This strategy has been very much in vogue since the beginning of the last financial crisis in 2008, when private buyers started to make ‘safe haven’ investments in response to political and economic instability worldwide, driving prime markets of cities like London or Paris upwards. Even in markets that have witnessed a sharp decrease of average property prices such as Spain or Portugal, the prime areas of main cities such as Barcelona, Madrid or Lisbon have fared much better in comparison.

Provided that the properties are bought at market value, which can never be taken for granted, wealth preservation strategies typically present a “low risk – low return” profile. These properties are located in areas with little or negligible new supply and stable demand, part of which often comes from international buyers. Even though this strategy is more conservative and therefore on average is less lucrative, buying ahead of the curve may reward property investors with abnormal total returns.

On the other side wealth generation strategies are the preferred tool of more sophisticated and risk prone investors who are willing to look at areas with growth potential for higher yields and capital appreciation. Often, as the popular areas become ever more expensive the purchase demand “spills over” into neighbouring areas increasing the value of the properties. Other factors may have an impact on property prices such as new schools, better transportation and infrastructures, trendy shops and restaurants.

Wealth generation strategies carry a “higher risk - higher expected return” profile

Investors employing the wealth generation strategy often buy smaller units, which are easier to rent, and make use of tax efficient tactics. As said wealth generation strategies carry a “higher risk – higher expected return” profile (see graph below) and are often leveraged (see our blog post on private banks financing).

How to make money with luxury real estate

Talking about direct property investments there are three simple ways to make money as follows:

• Buy low
• Renovate
• Sell high

Buy low occurs whena property is purchased significantly below market value. Often this happens when the seller needs to cash in quickly and is willing to accept a lower offer. Some other times it can happen that the owner does not have or does not want to spend money to maintain the property or decides to sell it at a particularly bad time. Other times the seller may be outdone by the buyer’s negotiating skills or may not be aware of property values in their area and sell too low; this generally happens when the price of properties in the specific area has grown significantly in a short period of time. However the opposite case is more common because the seller is generally more familiar with the area and the property than the buyer.

Photo Credit: r.nagy / Shutterstock

The seller may be outdone by the buyer’s negotiating skills

In the Renovate situation, the property is bought for its current market value but has some unrealized potential. After purchase, the owner can increase its value in many different ways from changing the zoning or the floor plan to refurbishing the property or choosing a new design that is particularly appealing to buyers who purchase in the area (see Te Atrium’s collection of high-end property designers). Another effective way is to use home staging techniques which have become more and more sophisticated in recent years. Home staging is the act of preparing a private residence for sale by making the house more appealing to the highest number of potential buyers, thereby selling a property more swiftly and for more money.

If the owner intends to sell right after the renovation the increase in value has to be substantial to offset the transaction costs (to buy and sell the property) and help the owner make an overall profit. Alternatively the owner may decide to rent the property out and sell later on.

With the Sell high strategy the buyer assumes that the market value of the property will go up in the future. This is probably the riskiest strategy because it entirely relies on future events.

Looking at the historical trends you can see that cap rates are not always stable

The Sell High strategy generally relies on what is called “cap rate compression”. The capitalization rate is the net operating income (rent minus operating expenses but before debt service) divided by the purchase price. In other words, it is the cash-on-cash rate of return you would get if you owned the property free and clear. Looking at the historical trends you can see that cap rates are not always stable; on the contrary they tend to fluctuate over time.

During a period of cap rate compression the value of properties increases compared to their corresponding rental value because the demand for those properties exceeds the supply. Investors should always consider that even if they are often presented with regional and national cap rate trends they have to look at local trends in order to make sound investments. Cap rates may in fact move differently from neighbourhood to neighbourhood.

Holding periods

There are two broad categories of holding periods: Long Term and Short term (or “flips”).

Long-term means you hold the property for a few years and generally rent it out in the meantime with the aim of making income returns. If appropriate, the property can be renovated either right after purchase or before the sale, depending on the condition of the property and the market demand.

Flipping is more opportunistic and means selling the property as soon as convenient after you acquire and possibly renovate it; sometimes even before completing the purchase.

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