Investment in Real Estate
Investment in real estate can provide income in the form of rents, as well as the potential for capital gains. Real estate as an asset class can provide diversification benefits to an investor’s portfolio and a potential inflation hedge because rents and real estate values tend to increase with inflation. Real estate investments can be differentiated according to their underlying assets.
Assets included under the heading of real estate investments include the following:
- Residential property—single-family homes.
- Commercial property—produces income (e.g., office buildings).
- Loans with residential or commercial property as collateral—mortgages (“whole loans”),construction loans.
Residential property⇒ is considered a direct investment in real estate. Some buyers pay cash, but most take on a mortgage (borrow) to purchase. The issuer (lender) of the mortgage has a direct investment in a whole loan and is said to “hold the mortgage.” Issuers often sell the mortgages they originate, which are then pooled (securitized) as publicly traded mortgagebacked securities (MBS) that represent an indirect investment in the mortgage loan pool.
Property purchased with a mortgage is called a leveraged investment, and the owner’s equity is the property value minus the outstanding loan amount. Changes in property value over time, therefore, affect the property owner’s equity in the property.
Commercial real estate properties generate income from rents. Homes purchased for rental income are considered investments in commercial property. Large properties (e.g., an office building) are a form of direct investment for institutions or wealthy individuals, either purchased for cash or leveraged (a mortgage loan is taken for a portion of the purchase price). Long-time horizons, illiquidity, the large size of investments needed, and the complexity of the investments make commercial real estate inappropriate for many investors. Commercial real estate properties can also be held by a limited partnership, in which the partners have limited liability and the general partner manages the investment and the properties, or by a real estate investment trust.
As with residential mortgages, whole loans (commercial property mortgages) are considered a direct investment, but loans can be pooled into commercial mortgage-backed securities (CMBS) that represent an indirect investment.
Real estate investment trusts (REITs) issue shares that trade publicly like shares of stock. REITs are often identified by the type of real estate assets they hold: mortgages, hotel properties, malls, office buildings, cell phone towers, or other commercial properties. Income is used to pay dividends. Typically, 90% of income must be distributed to shareholders to avoid taxes on this income that would have to be paid by the REIT before distribution to shareholders.
Potential Benefits and Risks of Real Estate
Real estate performance is measured by three different types of indices:
- An appraisal index: such as those prepared by the National Council of Real Estate Investment Fiduciaries (NCREIF), is based on periodic estimates of property values. Appraisal index returns are smoother than those based on actual sales and have the lowest standard deviation of returns of the various index methods.
- A repeat sales index: is based on price changes for properties that have sold multiple times. The sample of properties sold and thus included in the index is not necessarily random and may not be representative of the broad spectrum of properties available (an example of sample selection bias).
- REIT indices: are based on the actual trading prices of REIT shares, similar to equity indices.
Historically, REIT index returns and global equity returns have had a relatively strong correlation (on the order of 0.6) because business cycles affect REITs and global equities similarly. The correlation between global bond returns and REIT returns has been very low historically. In either case, diversification benefits can result from including real estate in an investor’s portfolio. However, the method of index construction (e.g., appraisal or repeat sales indices) may be a factor in the low reported correlations, in which case actual diversification benefits may be less than expected.
Real Estate Investment Due Diligence
Property values fluctuate because of global and national economic factors, local market conditions, and interest rate levels. Other specific risks include variation in the abilities of managers to select and manage properties and changes in regulations. Decisions regarding selecting, financing, and managing real estate projects directly affect performance. The degree ofleverage used in a real estate investment is important because leverage amplifies losses as well as gains.
Distressed-property investing has additional risk factors compared with investing in properties with sound financials and stable operating histories.
Real estate development has additional risk factors, including regulatory issues such as zoning, permitting, and environmental considerations or remediation, and economic changes and financing decisions over the development period. The possible inability to get long-term financing at the appropriate time for properties initially developed with temporary (short-term) financing presents another risk.