Real Estate Investments

An individual or institution can purchase real property for private use, as an investment, or both. This explains why the real estate residential market consists of individual single-family, detached homes, and multi-family attached units. Commercial real estate includes office buildings, retail shopping centers, warehouses, etc.

Real estate investors have the option of either occupying their properties or leasing them. A lease is an agreement that transfers the use of the property from the owner to the tenant for a predetermined period in exchange for compensation.

Real estate investing can be classified as:

• Equity investing: Direct or indirect ownership.
• Debt investing: Lending through mortgages.

Reasons for Investing in Real Estate

• Income generation and capital appreciation, which build competitive long-term returns.
• Stable income generation in numerous economic cycles in case there are multiple-year leases with constant rent.
• Real estate historically has low correlations with other asset types.
• Real estate can be used to hedge inflation if there are contractual rent step-ups or regular mark-to-markets.

Forms of Real Estate Ownership

Types of real estate ownership can be classified based on types and sources of capital. The types of capital are debt and equity capital, while the sources of capital are private or public. Forms of real estate ownership are shown below:

$$
\begin{array}{l|l|l}
& \textbf { Debt } & \textbf { Equity } \\ \hline
\text { Private } & \bullet \text { Mortgages } & \bullet \text { Direct ownership of real } \\
& \bullet \text { Construction lending } & \text { estate } \\
& \bullet \text { Mezzanine debt } & \begin{array}{l}
\bullet \text { Indirect ownership } \\
\text { through real estate funds }
\end{array} \\
& & \bullet \text { Private real estate } \\
& & \text { investment trusts (REITs) } \\
\hline \text { Public } & \begin{array}{l}
\bullet \text { Residential and commercial } \\
\text { mortgage-backed securities (MBS) }
\end{array} & \begin{array}{l}
\bullet \text { Shares in real estate } \\
\text { operating and } \\
\text { development corporations }
\end{array} \\
& \bullet \text { Collateralized mortgage obligations } & \bullet \text { Listed real estate } \\
& \bullet \text { Mortgage estate investment trusts } & \text { investment trusts (REIT) } \\
& \text { (REITs) } & \text { shares } \\
& \bullet \text { Exchange-traded funds (ETFs) that } & \bullet \text { Mutual funds } \\
& \text { own securitized mortgage debt } & \bullet \text { Index funds } \\
& & \bullet \text { Exchange-traded funds } \\
& & \text { (ETFs) } \\
\hline
\end{array}
$$

Direct Real Estate Investing

Private direct investment is when an investor purchases a property and takes on the debt to finance the purchase. The ownership can either be free and clear or through debt. In a free and clear transaction, ownership goes directly to the investor without any hindrances, such as outstanding mortgages. On the other hand, owning property through debt involves taking a mortgage or using leverage.

Owning a property attracts a number of additional costs, including legal expenses, survey costs, engineering and environmental studies, and valuation fees. Maintenance and refurbishment charges may also be imposed. Specific to the use of debt, debt closing costs might be incurred.

Real estate investors may decide to manage every aspect of their property investments to maximize returns. Alternatively, they may elect to hire managers (separate account) to take charge of the property. Using a separate account allows a single investor to control the timing and price of a purchase or sale, as well as make operational decisions.

Another aspect of direct investing is where investors join hands to form joint ventures to invest in real estate. Joint ventures allow the investors to benefit from each one another’s skills and resources, i.e., expertise and capital.  A joint venture can be organized as a general partnership or limited liability company.

Advantages of Direct Real Estate Investing

• Only the owner decides when to buy or sell, when to spend, the amount to spend, how to select tenants, and the type of lease terms to use.
• Investors may use non-cash property depreciation expenses and interest expenses to reduce taxable income and lower their income tax bills.

Disadvantages of Direct Real Estate Investing

• A lot of time is required to manage the property.
• It requires expertise in the local real estate market.
• To get started, it requires a significant amount of capital.
• Smaller investors bear the risks of portfolio concentration.

Indirect Real Estate Investing

Indirect investing allows access to real estate assets using public or private pooled investment vehicles such as real estate investment trusts (REITs), exchange-traded funds (ETFs), general partnerships, mutual funds, corporate shares, and mortgages.

Mortgages

Mortgages refer to passive investments in which the lender expects to receive a predefined stream of payments throughout the known term of the mortgage.

Mortgages may call for full or partial amortization. If the loan is partially amortized, the loan will not be fully repaid. The part of the loan that hasn’t been repaid yet is called a balloon payment. Moreover, borrowers may opt for fixed-interest rates, floating rates, or adjustable rates.

The term of a mortgage may vary depending on the type of mortgage. For instance, residential loans generally have maturities of 15, 25, and 30 years in developed markets.

If a borrower sells the property before the maturity of the mortgage, a prepayment fee may be charged. On the other hand, if the borrower breaches loan indenture (defaults), the lender may take possession of the property.

Investments may take place in the form of:

• Loans based on specific properties.
• Direct investment through private markets.
• Participation in a pool of mortgage loans.
• Indirect investment in real estate through publicly traded securities, such as MBS.

Private Fund Investing

A private equity fund is organized into infinite-life open-end funds, from which investors can contribute or reclaim capital during the life of the fund (like mutual funds). The fund is usually managed by a general partner (GP) who accepts subscriptions and redemptions on a quarterly basis. The GP is responsible for buying or selling, or aligning the redemption requests with the awaiting investor subscriptions.

Given the apparent characteristic of private fund equity, open-end funds expose investors to core real estate – well-leased, high-quality real estate mostly found in top markets. In core-real estate, investors expect that GPs will generate stable returns mainly from income. These returns are determined by the real estate beta, market selection, management, and implementation.

Residential Investment Trusts (REITs)

Real estate investment trusts are investment vehicles thanks to which both private and public investors own income-generating real estate. Their major advantage is the elimination of double corporate taxation, where REITs can avoid corporate income taxation by distributing dividends equal to 90% or 100% of their taxable net rental income.

Publicly traded REITs are more advantageous compared to private real estate investments. This is because public REITs are more liquid and come with low trading costs and better transparency than private real estate investments.

Characteristics of Real Estate Investment Categories

Real estate property is primarily classified either as commercial or residential. Residential properties include mostly owner-occupied, single residences. Commercial properties, on the other hand, include office spaces, shopping centers, industrial warehouses, hotels, etc.

Residential Property

Residential property applies to any direct equity investment in a residence with an aim to occupy it. Such an investment can be either be instituted by an individual or family. In this arrangement, a home is bought but, in most cases, it is rarely paid for in full because the property might be too expensive for the buyer to pay up in a single installment. As such, the buyer borrows money with which they facilitate the acquisition of the property.

In most countries that have developed mortgage markets, lenders seek to have between 10-20% of the purchase price. In case of any appreciation (depreciation), the value of the residential property increases (decreases), and this is amplified in mortgage leverage.

The loans offered to purchase a residential property can remain in the originator’s balance sheet. Alternatively, home loans can be secured and listed on financial market for indirect debt investment, for instance in the form of residential mortgage-backed securities (RMBS).

Commercial Real Estate

Commercial property is prevalent to institutional funds and high-net-worth individuals with long investments horizons and limited liquidity requirements. As such, commercial property is usually complex and illiquid and requires regular management.

The performance of commercial real estate depends on the management, economic and market conditions, and issues with debt financing, such as terms of debt.

Direct investment in commercial real estate may require financing through loans. For loans to suffice, the lender, who is the investor, will determine the borrower’s creditworthiness. The lender will do this to determine whether the property can generate the requisite cashflow to service the loan. In addition, the assessment of the borrower’s creditworthiness is critical in the valuation of the property.

REIT Investing

The risk-return characteristic of mortgage REITs is based on each specific investment. For instance, mortgage REITs have the same characteristics as fixed-income investments. Equity REITs, on the other hand, mainly invest in commercial or residential properties with the use of leverage. Note that equity REITs have the same features as direct leveraged equity investments in real estate.

Mortgage-Backed Securities

An MBS issuer creates a special purpose vehicle (SPV) that buys mortgages from lenders and other mortgage owners to form a diversified mortgage pool. The MBS issuer allocates the incoming streams from interest income and principal payments to individual security tranches sold to investors. Each tranche is given priority-based distribution ranks.

Risk and Return Characteristics of Real Estate

Returns

Indices are primarily used to quantify the total and component real estate returns for both listed and non-listed investment vehicles. The computation of return on real estate is based on the assumption that dividends are invested back into the index.

In the case of listed securities, it is similar to equity indices since the security pricing is reported by major exchanges. An index is considered more reliable when the corresponding shares are frequently traded.

Different types of indexes measure the performance of a private investment. The indexes may also indicate the performance of the private fund, the value of the property, and the operation value of the underlying property.

Repeat sales indices are also developed by academics, practitioners, and industry associations, based on the transaction in question instead of an appraisal. Repeat sales index tracks the price change when a repeat sale is executed. However, repeat sale indexes are affected by sample selection bias.

For efficient use of indexes, investors should learn how to construct them and their corresponding limitations.

Risks

Like any other investment, real estate might fail to meet performance expectations. This is owing to the fact that property values are affected by national and global economic factors, interest rate level, and local factors. Such factors include the ability to fund the management team and the ability of the owners or their agents to operate the underlying properties of the real estate.

There is a greater risk in investing in distressed property and property development as compared to investment in well-funded properties or steady operations. In particular to property development, risks include regulation problems (such as environmental regulations), delays in construction, and cost of unexpected change in budget (cost overrun), and financing risk.

Real estate is also characterized by the use of leverage (as used by direct investors, private funds, and public companies) to maximize the return to the investors. As such, leverage can amplify both the losses and profits for equity investors, bringing about the risk that of an investor’s failure to service the debt at maturity.

Diversification Benefits of Real Estate

Real estate is arguably a lucrative investment since it creates a high and stable current income. In real estate, income generation is a more prevalent source of income than capital appreciation. For this reason, real estate is associated with lower risks because it is linked to long-term leases. The credit quality of the tenants determines the reliability of the rent.

The correlation of real estate with other assets makes it a perfect investment for diversification.

Question

Which of the following is least likely a disadvantage of direct investment in real estate?

1. Large capital requirements.
2. Low correlations with other assets.
3. Extensive time is required to manage the property.

Solution

The correct answer is B.

Real estate’s low correlations with other assets is not a disadvantage but a key reason for investing in real estate.

A is incorrect. Real estate investment is capital intensive.

C is incorrect. Real estate demands investment of extensive time to manage the property.