Real Estate

An individual or institution can purchase real property for private use, 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 can either occupy their properties or lease them. A lease is an agreement that transfers the use of the property from the owner to a tenant for a predetermined period in exchange for compensation.

Real estate investing can be classified as follows:

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

Reasons for Investing in Real Estate

• Income generation and capital appreciation build competitive long-term returns.
• Multiple-year leases with constant rent lead to stable income generation in numerous economic cycles.
• 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.

Categories of Real Estate

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

Residential  Property 

The residential property applies to any direct equity investment in a residence. An individual or family can venture into such an investment. In this arrangement, one buys a home, but, in most cases, one rarely pays for it in full. This is because the property might be too expensive for one to pay for it in a single installment. As such, one borrows money with which to facilitate one’s acquisition of the property.

In most countries that have developed mortgage markets, lenders seek to foot between 10-20% of the purchase price. In case of any appreciation (depreciation), the value of the residential property increases (decreases), 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 the financial market for indirect debt investment. For instance, this can assume the form of residential mortgage-backed securities (RMBS).

Commercial Real Estate

Commercial property is popular among institutional funds and high-net-worth individuals with long investment horizons and limited liquidity requirements. Commercial property is usually complex and illiquid and requires regular management.

Commercial real estate performance depends on management and economic and market conditions. Besides, real estate performance depends on debt financing issues such as terms of debt.

Direct investment in commercial real estate may require financing through loans. For loans to suffice, the lender will determine the borrower’s creditworthiness and determine whether the property can generate the requisite cash flow to service the loan.

REIT Investing

Real estate investment trusts (REITs) are tax-advantaged investment vehicles that allow individuals to invest in real estate assets without actually owning physical property. REITs own and manage income-producing properties such as apartment buildings, office buildings, retail spaces, and industrial facilities, among others.

Investors can buy shares in a REIT, which gives them partial ownership of the underlying real estate assets. REITs generate income by collecting rent from their tenants and distributing a portion of that income to their shareholders in the form of dividends.

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 using leverage. Equity REITs have the same features as direct leveraged equity investments in real estate.

Mortgage-backed Securities

Mortgage-backed securities (MBS) are investment products that are created by pooling together mortgage loans and then selling securities that represent an ownership interest in that pool. The mortgage loans that are pooled together are typically residential mortgages, such as those used to purchase homes or other properties.

The MBS are sold to investors and are typically structured into different classes or tranches, each with its own level of risk and potential reward. The cash flows from the underlying mortgage loans are used to pay interest and principal payments to the holders of the MBS.

Forms of Real Estate Ownership

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

In a private direct investment, an investor purchases a property and uses debt to finance the purchase. The ownership can either be free and clear or debt-funded. In a free and clear transaction, the seller expressly transfers property ownership 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.

A property attracts additional costs, including legal expenses, survey costs, engineering, environmental studies, and valuation fees. Maintenance and refurbishment charges may also be incurred. Specifically, in case an investor uses debt to acquire property, they may incur debt closing costs.

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

In yet another aspect of direct investing, investors join hands to form joint ventures to invest in real estate. Joint ventures allow investors to benefit from 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 and interest expenses to reduce taxable income and lower their income tax bills.

Disadvantages of Direct Real Estate Investing

• Property management requires a lot of time.
• The local real estate market requires expertise.
• It is capital intensive, i.e., getting started 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 a 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 a loan is partially amortized, it will not be fully repaid. The part of the loan that hasn’t been repaid is called a balloon payment. Moreover, borrowers may opt for fixed-interest, floating, or adjustable rates.

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

If a borrower sells a property before the maturity of a 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:

• Property-based loans.
• 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 a fund–similar to mutual funds investing. 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, selling, or aligning the redemption requests with 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 GPs to generate stable returns mainly from income. The real estate beta, market selection, management, and implementation determine these returns.

Real Estate Investment Trusts (REITs)

Real estate investment trusts are investment vehicles, thanks to which 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 than private real estate investments. This is because public REITs are more liquid, and have low trading costs and higher transparency than private real estate investments.

Risk and Return Characteristics of Real Estate

Returns

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

Listed securities are similar to equity indices since major exchanges report security pricing. An index is considered more reliable when the corresponding shares are frequently traded.

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

Besides an appraisal, academics, practitioners, and industry associations develop repeat sales indices based on the transaction in question. The repeat sales index tracks the price change when a repeat sale is executed. However, sample selection bias affects repeat sale indexes.

For efficient use of indexes, investors should learn how to construct them. In addition, investors should know the indexes’ limitations.

Risks

Like any other investment, real estate might fail to meet performance expectations. This is because property values are affected by national and global economic factors, interest rate levels, 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 than in well-funded properties or steady operations. In property development, risks include regulation problems (such as environmental regulations), delays in construction, and the cost of unexpected changes in the budget (cost overrun) and financing risk.

Real estate is also characterized by the use of leverage to maximize investor returns. Leverage can amplify both the losses and profits for equity investors, bringing about the risk of an investor’s failure to service 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.