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:
1. To
identify the risks involved in real estate investments.
2. To
examine the effect of real estate risk on project viability
3. To
identify ways to minimize risk in real estate investment.
1.4 RESEARCH QUESTIONS
1. What
are the risks involved in real estate investments?
2. What
is the effect of real estate risk on project viability?
3. 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:
1. 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.
2. 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.