Recently a friend asked me to give him some advice on an investment opportunity he came across. It was a bank owned oceanfront lot he felt he could purchase for around $400,000. He argued that it had sold just 3 years ago for $900,000 and he projected he could sell this property within 5 years for at least $750,000. My analysis of this investment follows:

Investment 1 (Bank owned oceanfront vacant lot)

On the surface this investment seems quite appealing. It was sold just 3 years earlier for $900,000 and now he could pick it up for only $400,000 or approx “45 cents on the dollar.” This thought process can be misleading, as the value 3 years ago has little to no significance now, and should not play a major role in analyzing this investment. The best indicator of current market value is the actual purchase price, which in this case would be $400,000. Next, let’s focus on his 5 year projected value of $750,000. This valuation would require an average annual appreciation rate of over 13% each year for the next 5 years. Possible....yes, but highly unlikely, and not a rate I would feel comfortable using in a realistic pro-forma analysis.

According to the National Association of Realtors (NAR), the average national annual appreciation rate for residential real estate was 5.4% between 1968 and 2009. According to NeighborhoodScout.com, the average annual appreciation rate for residential real estate in North Carolina was approx 6% during roughly the same time period. Using a more realistic annual appreciation rate of 6% over the next 5 years would result in a Projected Sale Price of $535,000, resulting in a more modest profit of $81,500 and an actual ROI of approx 4% a year.

So what was my advice? I told him if he was satisfied with a more realistic 4% - 6% annual return, and was in a position to purchase this lot with cash, he certainly should consider this investment. However, given current market conditions, my number one investment criteria is SUSTAINABILITY. This is best accomplished by minimizing any potential burden from an investment opportunity. By burden I mean the possibility of injecting additional capital into the investment to sustain it or heavily relying on the necessity to sell after a predetermined period of time. For example, if my friend was to obtain an 80% investment loan at 6% APR to finance this lot purchase, then he could very easily end up with a financial loss if the annual appreciation rate did not maintain at 6%. For me, this is an investment that is controlled too heavily by external factors.

For comparison, consider another actual investment opportunity that is similar in size. The following example shows the purchase of an income producing vacation rental home.

Investment 2 (Income producing vacation rental home)

Which opportunity above is the better investment option, Investment 1 or 2? On the surface Investment 1 may seem more attractive, BUT Investment 2 is much more sustainable. Unlike the vacant lot, the vacation home is generating a net income of $26,600 a year, which produces nearly a 6% annual return without taking any appreciation into account. A sales price of $575,000 equates to an annual appreciation rate of about 5%, which is much more practical in turns of a pro-forma. Best of all, after the initial capital investment of $450,000, the need for additional capital requirements is very unlikely. Further, if the market conditions do not improve within 5 years, there is no sudden financial burden placed on the investor as he could simply wait a few more years to sell. With the second investment, it is reasonable to expect that eventually the annual appreciation rate should average out to around 6% a year. This means the years to come should yield an even higher appreciation rate if the first 5 years don’t go as projected.

While considering real estate investments today, look for investments that are income producing (my rule of thumb is a passive net income of at least 6% of the purchase price, but this may vary given the type of investment) and not dependent on liquidation after a short time period. Additionally, always have a 10% contingency reserve fund to weather through the down cycles. Real estate can be very speculative. Certainly the current market climate does not lend itself to a quick buy and immediately sell, or “flipping”, market. However, a longer term strategy can be far more predictable and less dependent on smaller economic cycles. Given the right investment criteria, this is perhaps one of the best times to invest in real estate!