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Basic Forms of Real Estate Investments

Basic Forms of Real Estate Investments

Basic Forms of Real Estate Investments

Real estate can be categorized either as non-residential (commercial) or residential property. It can also be classified as for rent or owner-occupied. Commercial real estate refers to four large rental types: shopping centers, office buildings, industrial warehouses, and residential rent. The four form the core of property types because of their market size, low risk or reward profile, and income stability. A core real estate investment strategy refers to a conservative investment style where high-quality, well leased, low leverage core property types are used to avoid real estate-specific risks. Hotel properties are not included in the core categories because of the high cash flow volatility associated with leasing the rooms for a night and the importance of marketing, branding, and property operations.

Capital position describes a form of investment whose structure is based on debt and equity. A debt investor loans funds to companies buying real estate property or those that are investing in securities based on real estate lending. Since many real estate properties are used as collateral for mortgage loans, the debt investor prefers to claim the real estate. The value of the real estate less the amount owed to the debt investor is the value of the equity investor’s interest. An equity investor has an ownership interest and may invest in shares of a company that owns real estate properties. The owner of the property has control over the decisions that concern the property.

Real estate investment can be categorized into two investment distinctions, private and public real estate investment. Private real estate takes the form of residential or commercial property owners. Property owners can accept capital from passive investors and form a partnership where the owners become general partners who manage the partnership. The passive investors become limited partners in the partnership. Public investors own properties indirectly by buying stocks, partnership units, or trust units in publicly listed companies. The benefit of this indirect investment in real estate is that the investor will have access to professional management and low minimum purchase requirements for a portfolio of properties.

While REITS are restricted only to owning and operating real estate properties, real estate operating companies own and can also develop real estate properties. To avoid paying corporate income, REITs must distribute part of or all of their earnings to investors.

Another form of indirect investment is mortgage-backed securities (MBS). The MBS generally gives the trust certificates rights to receive cash flows from an underlying pool of mortgages that are in turn secured by real property. Real estate investment is defined in capital markets term using four quadrants through which capital can be invested. The quadrants are formed from two dimensions of investment.

  1. The first dimension tells us whether the investment is made in the private or public market. The public market involves indirectly investing in real estate through ROEC, REITS, or MBS. In contrast, the private market involves direct investment in an asset, such as developing or buying real estate properties that directly claim the asset. There is also indirect investment in the private market through commingled real estate private equity fund or limited partnership, which can reduce tax leakages and investor liability.
  2. The second dimension deals with the investors’ capital position in the underlying real estate. This can be through debt and equity. Equity investors have rights to cash flows from properties while debt investors lend money to owners, and in return, they get principal and interest repayments on the money lent.

Equity investors expect a higher return than debt investors due to the risk they take. When the amount of debt on a property increases, the risk of debt and equity will increase, and so will their expectation for higher returns. Since debt investors in real estate do not participate in the value addition of the underlying real estate and expect to receive their return from the promised cash flow, debt investments are like bonds and other fixed-income investments. Adding an equity real estate investment to a portfolio can have diversification benefits. This would be the case if the equity returns to equity investors are less positively correlated with returns to bonds and stocks.

Characteristics of Real Estate Investment

  • Unique asset and fixed location: Real estate investments are unique assets since buildings vary in size, use, age, location, and quality. Real estate investments are tangible immovable assets.
  • High unit value: Real estate unit value is high. This is, particularly, the case in the private real estate market, where the amount required to invest in private real estate is a barrier to entry. This leads to the development of REITs which allow partial ownership of an indivisible asset.
  • Management incentive: Real estate investment requires a lot of active management in maintenance, rent collection, and leases negotiation. This active management brings in an additional cost of holding the investment.
  • High transaction costs: High transaction costs arise due to the involvement of professionals, lawyers, brokers, and appraisers in the buying and selling process.
  • Depreciation: Due to regular usage, the value of a building will always depreciate.
  • Need for debt capital: The large capital required to buy and develop real estate makes it important to have access to funds. Real estates are sensitive to the cost and availability of debt capital.
  • Illiquidity: It is hard to market and sell real estate properties, making it difficult to liquidate them.
  • Price determination: Due to the low number of transactions in the real estate market, it is difficult to determine prices accurately. The bid-ask spread is relatively wide, and value estimates rather than transaction prices are used to determine the price.

Risk Factors

The following are the risk factors of real estate investment:

  • Property demand and supply.
  • Business conditions: Changes in macroeconomic conditions affect real estate investments since expected, and current returns are also affected.
  • Demographics: The age and size of a population affect the demand for real estate.
  • Excess supply: As recession risk increases later in the real estate lifecycle, the demand for housing reduces. At the same time, the construction will lead to an oversupply of real estate property, followed by declining rent and real estate returns.
  • Valuation.
  • Cost and availability of capital: Since other assets compete with real estate for debt and equity, the willingness of investors to invest in real estate will always depend on the availability of debt. A shortage of debt capital and high-interest rates reduce demand for real estate and consequently, reduce prices.
  • Availability of information: Adequate information helps an investor make better investment decisions in real estate. Over the years, real estate indexes have been introduced in the market to help investors benchmark their peers’ properties to better understand the risk of real estate compared to other assets.
  • Lack of liquidity: Liquidity risk refers to how quickly an investor can dispose of or liquidate the property investment. This significantly affects how fast an investor can repay debt financing once a property is disposed of at a premium.
  • Rising interest rates: Real estate investments, such as fixed income, are negatively affected by high-interest rates because an asset’s present value reduces as discount rates rise. Real estate value, however, only declines at the initial stage but increases as time goes by.
  • Property operations.
  • Management: Management risk reflects the ability of asset and property managers to make the best decisions concerning properties.
  • Lease provisions: Lease provisions allow owners to recover part of or all the loss in purchasing power due to inflation. This allows real estate owners to preserve returns using a combination of expense pass-throughs and rent bumps. Even with such contracts, it is still not enough to cover unexpected rises in inflation unless they are tied to an inflation-linked index. During economic downturns, when demand for housing is low, landlords can increase the rent in line with inflation.
  • Leverage: While real estate transactions are highly leveraged, an additional increase in leverage increases the risk because, upon default of a loan, the lender has the first claim on the cash flow and the property’s value.
  • Environmental: Environmental conditions such as soil and groundwater contaminants related to previous owners can greatly affect a property’s value.
  • Obsolescence: Changes in regulation, tenant taste, preferences, and technology affect the demand for real estate.
  • Recent and ongoing market disruption: The recent rise in cloud computing technology and offsite IT backup systems have led to the growth of data centers while simultaneously reducing the spaces business need for onsite server systems.

Question

Amanda Jane is looking to diversify her portfolio by adding real estate. She is looking for an asset that she can liquidate in one year. Which form of investment is most likely appropriate for her:

  1. Mortgage-backed security.
  2. Shares of REITs.
  3. Commercial property.

Solution

The correct answer is B. Share of REITs are traded publicly and have higher liquidity than direct ownership.

A is incorrect. Mortgage-backed securities are debt investments in real estate whose income are secured on real estate assets. They are not as liquid as share of REITs but are more liquid than commercial property.
C is incorrect. Commercial property on average take more than one year to sell thus they are not as liquid as Share of REITs and Mortgage-backed security.

Reading 35: Real Estate Investments

LOS 35 (a) Compare the characteristics, classifications, principal risks, and basic forms of public and private real estate investments.

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