Features and Characteristics of Real Estate

Investing in real estate can be made in either residential or commercial real estate. For instance, an individual might purchase a home not just for personal use but also as an investment, expecting the property value to increase over time. Similarly, a company might invest in a commercial property to generate rental income.

1. Residential Real Estate

Residential real estate includes individual single-family detached homes and multi-family attached units sharing at least one wall. It stands as the largest sector in the real estate market, constituting over 75% of global real estate values in both size and value.

Although the average value of a home is less than that of an office building, the total space required for residential purposes, accommodating people, is much larger compared to the space needed for office use and retail shopping.

2. Commercial Real Estate

Commercial real estate primarily includes office buildings, retail shopping centers, commercial and residential rental properties, and warehouses. For example, a shopping mall that houses multiple retail stores is a type of commercial real estate.

Rental properties in this sector are leased to tenants. This means that the owner of the property does not use the property themselves but instead rents it out to others. The tenants pay rent to the owner, providing the owner with a steady stream of income.

Comparison between residential and commercial real estate is summarized in the following table:

\begin{equation*}
\begin{array}{l|l|l}
  & \textbf{Residential Real Estate} & \textbf{Commercial Real Estate} \\
\hline
\text{Typical Property} &
\begin{array}{l}
\cdot \text{Homes occupied by owners;} \\
\text{single-dwelling residential units}
\end{array} &
\begin{array}{l}
\cdot \text{Offices, retail spaces, industrial sites,} \\
\text{storage facilities, hospitality venues,} \\
\text{and buildings with mixed purposes} \\
\cdot \text{Properties for residential renting} \\
\text{or leasing}
\end{array} \\
\hline 
\text{Source of Equity} &
\cdot \text{Homeowners} &
\begin{array}{l}
\cdot \text{Owned privately by proprietors} \\
\cdot \text{Held publicly by shareholders}
\end{array} \\
\hline
\text{Source of Debt} &
\begin{array}{l}
\cdot \text{Directly: Financial institutions (banks)} \\
\text{via residential home loans} \\
\cdot \text{Indirectly: Backers in MBS} \\
\text{bundling home loans}
\end{array} &
\begin{array}{l}
\cdot \text{Directly: Financial institutions (banks)} \\
\text{via commercial property loans} \\
\cdot \text{Indirectly: Backers in MBS} \\
\text{assembling commercial property loans}
\end{array} \\
\hline
\text{Source of Return to Investors} &
\begin{array}{l}
\cdot \text{Personal Use} \\
\cdot \text{Asset Value Growth}
\end{array} &
\begin{array}{l}
\cdot \text{Rental Income} \\
\text{from the property} \\
\cdot \text{Growth in Value or Capital}
\end{array} \\ 
\end{array}
\end{equation*}

Investing in real estate, whether residential or commercial, requires a significant amount of capital and carries certain risks, such as property damage, market fluctuations, and tenant issues. However, it can also provide substantial returns through appreciation and rental income. Therefore, it is important for investors to carefully consider their investment goals, risk tolerance, and financial situation before investing in real estate.

Real Estate Investments and Traditional Equity and Debt

Real estate investments share certain similarities and differences with traditional equity and debt classes. For instance, just like shares of a company, they can be held privately or publicly traded. An example of publicly traded real estate investments is Real Estate Investment Trusts (REITs).

Equity investment in real estate involves either direct or indirect ownership with claims to the residual cash flows from the property. These cash flows can be either variable or fixed, depending on the property investment. For example, rental income from a residential property would be a fixed cash flow, while profits from the sale of a renovated property would be a variable cash flow.

Debt investment typically involves direct mortgage lending from financial intermediaries. An example of this would be a bank providing a mortgage loan to a homebuyer and then selling that loan to an investment bank, which then packages it with other loans to create an MBS.

Unique Characteristics of Real Estate

• The initial capital outlay is typically substantial.
• Real estate is characterized by its inherent diversity, where no two properties are identical. Each property is distinguished by factors such as location, age, tenant credit mix, lease terms, and market demographics.
• There exists a variety of real estate investment options, ranging from direct to indirect investments. These encompass liquid investments in stable, income-generating properties to less liquid investments with extended development timelines.
• Achieving diversification across the full spectrum of real estate investment alternatives can be a complex endeavor.
• Indexes representing real estate performance in the private market are not directly accessible for investment.
• Additionally, the pricing mechanism in the private real estate sector is often nontransparent, given its reliance on historical prices that may not accurately mirror present market conditions. Further contributing to this opaqueness are high transaction costs and limited transaction activity.

Market Fragmentation and Specialized Skills

Real estate markets commonly exhibit fragmentation owing to their distinctive characteristics, including geographic location and potential uses. The property’s worth is dictated by local dynamics of demand and supply.

Moreover, the diversity in real estate demands expertise in specialized areas. To thrive as a real estate investor, one must have knowledge of zoning regulations, construction expenses, and the specific conditions within the local market–aspects that are typically not relevant to stock or bond investors.

Real Estate Investment Structures

Direct Real Estate Investment

Direct private investing in real estate involves purchasing a property and originating debt for one’s own account. For instance, if you were to buy a residential property with the intention of renting it out, you would be making a direct real estate investment.

The ownership can be free and clear, meaning the property title is transferred to the owner(s). Initial purchase expenses associated with direct ownership may include legal expenses, survey costs, engineering/environmental studies, and valuation (appraisal) fees.

Advantages of Direct Real Estate Investment

• Control: The owner possesses exclusive authority to determine the timing of purchases or sales, select tenants, and establish lease conditions. Owners derive cash flow returns from property usage, rental income, and the possibility of capital appreciation.
• Tax benefits: Owners can reduce their taxable income by utilizing non-cash depreciation expenses associated with the property and taking advantage of tax-deductible interest costs. For instance, if you own a rental property, you can deduct expenses like repair costs, mortgage interest, and property taxes from your taxable income.
• Diversification:  Real estate has historically shown a low correlation with other asset classes. Adding real estate to a portfolio has proven to enhance diversification and reduce overall risk.

Disadvantages of Direct Real Estate Investment

• Complexity: Owners must allocate their time to property management. Moreover, the acquisition process is more intricate and involves tasks such as property selection, negotiation of terms, thorough due diligence, title search, contract evaluation, and property inspection.
• Need for specialized knowledge: Owners must possess knowledge of both broad market trends and specific local market attributes, necessitating a grasp of the particular conditions in the area. For instance, investing in a rental property in San Francisco would mandate comprehension of the local rental landscape, tenant protections, and municipal regulations.
• Significant capital needs: Owners must have the means to access a potentially substantial sum of debt and equity capital due to the substantial initial financial commitment required. For example, acquiring a commercial property might require an initial payment representing 20-30% of the property’s total value.
• Concentration risk: Owners, especially those with limited resources, are unable to establish a comprehensively diversified real estate portfolio via direct investment. As an example, if you possess one rental property, your real estate investment is concentrated solely on that particular property.
• Lack of liquidity: Real estate investments often involve considerable challenges in terms of speed and transaction expenses, which are generally elevated. If an investor finds themselves in a situation where they must rapidly sell a property, they may need to accept a reduced selling price, and they will also incur real estate agent fees along with other related transaction expenses.

Real estate investors can choose to handle all aspects of property investment internally. However, in commercial real estate, it’s common for investors to enlist advisors. These professionals assist in identifying investment opportunities, negotiating agreements, conducting due diligence, managing property operations, and providing support for eventual divestment.

Indirect Real Estate Investment

Indirect real estate investment involves pooling assets from multiple investors to acquire one or more properties. The exposure to real estate is achieved indirectly and can be accessed through various investment instruments, both public and private. These investment instruments encompass limited partnerships, mutual funds, equities, Real Estate Investment Trusts (REITs), exchange-traded funds (ETFs), and joint ventures.

Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts (REITs) are tax-advantaged trusts specializing in the ownership, operation, and sometimes development of income-generating real estate assets. REITs typically fall into three primary categories: equity REITs, mortgage REITs, and hybrid REITs.

Equity REITs make direct investments in properties or do so through partnerships and joint ventures. Mortgage REITs, on the other hand, provide financing in the form of real estate loans (mortgages) or invest in Mortgage-Backed Securities (MBS). Hybrid REITs combine both strategies.

The key advantage of the REIT structure lies in the avoidance of double corporate taxation. REITs can sidestep corporate income tax by distributing dividends equivalent to 90%–100% of taxable net rental income.

Reporting for Equity REITs

Equity REITs, like other publicly traded companies, must disclose earnings per share following generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS), which define net income.

Many of them also present alternative metrics, such as net asset value or various forms of cash flow, like funds from operations (FFO). FFO incorporates adjustments for depreciation, distributions, and preferred dividends to provide a more accurate estimate of future dividends.

Advantages of Publicly Traded REITs

• Publicly traded REITs provide investors with greater transparency.
• A REIT investor only needs to buy or sell REIT shares instead of buying or selling real estate directly.
• The REIT has the flexibility to retain ownership of the company’s underlying real estate, unlike open-end funds that must sell assets when faced with mass redemptions.
• REITs have the expertise to manage the properties in order to align the interests of the REIT with those of its investors.

However, a disadvantage of REITs is their higher correlation with the public equity markets when compared to private real estate. This is similar to how an investor in a publicly traded company.

Indirect Real Estate Investment Strategies

Core Real Estate Strategies

Real Estate Investment Trusts (REITs) and other private real estate funds are organized as open-end funds with an indefinite lifespan. This format enables investors to inject or withdraw capital at any point during the fund’s existence, similar to the structure commonly seen in mutual funds.

Open-end funds generally provide access to well-tenanted, top-tier commercial and residential real estate in prime markets. These are commonly known as core real estate strategies. Investors anticipate core real estate to generate consistent returns, primarily driven by property rental income.

Closed-end Funds

Investors in search of greater returns may be willing to embrace increased risks associated with activities like development, redevelopment, repositioning, and leasing. In such cases, finite-life, closed-end funds are a more prevalent choice. For instance, an investor might opt for a closed-end fund with plans to revamp a deteriorating shopping center, aiming for substantial returns once the project is finalized and the property is leased to new tenants.

Value-add Real Estate Strategies

To achieve increased returns, investors may pursue value-added real estate strategies. These approaches encompass more extensive redevelopment and repositioning of existing assets. For instance, a value-added strategy could entail acquiring a dilapidated apartment building, conducting a full-scale renovation, and subsequently leasing the apartments at a higher rental rate.

Core-Plus Real Estate Strategies

Investors may place their emphasis on core-plus real estate approaches, which involve value-add investments demanding minor redevelopment or enhancements for leasing any available space. For instance, a core-plus strategy could entail the acquisition of an office building with some unoccupied areas, implementing property improvements, and subsequently leasing the vacant space to new tenants.

Opportunistic Real Estate Strategies

The most speculative real estate approaches encompass substantial redevelopment, repurposing assets, tackling substantial vacancies, or betting on substantial enhancements in market conditions. As an example, an opportunistic strategy could involve the acquisition of a vacant industrial structure, transforming it into a fashionable loft apartment complex, and subsequently renting the apartments at a premium price.

Mortgage REITs and Hybrid REITs

Mortgage REITs and hybrid REITs direct their investments towards real estate debt, usually Mortgage-Backed Securities (MBS). These debt-focused REITs can take the form of both privately held and publicly traded funds.

Question 

Which of the following best describes a core-plus real estate strategy in real estate investments?

1. It involves buying properties in prime locations with no need for upgrades or redevelopment.
2. It involves buying properties, making significant structural changes, and selling them for a profit.
3. It involves buying properties with some vacant space, making modest upgrades, and leasing the vacant space to new tenants.

The correct answer is C.

The core-plus real estate strategy is accurately described in Choice C. This strategy involves buying properties with some vacant space, making modest upgrades, and leasing the vacant space to new tenants. The core-plus strategy is a moderate-risk real estate investment strategy that falls between the low-risk core strategy and the high-risk value-add and opportunistic strategies. It involves acquiring properties in good locations that are generally well-leased but may require some minor improvements or have some other manageable issues.<br>

The goal of the core-plus strategy is to generate a moderate level of income and some capital appreciation by improving the property and increasing its occupancy rate. The improvements are typically less extensive and less risky than those undertaken in a value-add strategy, and the properties are usually of higher quality than those targeted in an opportunistic strategy.<br><br>

A is incorrect. This description refers to a core real estate strategy, not a core-plus strategy. A core strategy involves buying high-quality properties in prime locations that are fully leased and require no improvements. The goal of a core strategy is to generate stable income with low risk.<br><br>

B is incorrect. This description refers to a value-add or opportunistic real estate strategy, not a core-plus strategy. These strategies involve buying properties that require significant improvements or redevelopment, with the goal of selling them for a profit. These strategies are higher risk and potentially higher return than a core-plus strategy.