Alternatives: An Introduction to Investing in Real Estate

Real estate is classed as an alternative asset class. It is defined as physical property or land. There are two broad categories for investing in real estate. The most obvious one would be to purchase the physical property itself, whether domestic or commercial property. While possible, this is a complex and tedious process, which only those with sufficient expertise and capital can successfully do. This is because it often requires a substantial amount of capital to be put down as a deposit or as security against default.  There are then often numerous regulatory checks involved, as well as tax considerations, extensive calculations and negotiations. Along the way, multiple intermediaries and agents become involved, each resulting in further financial costs.

There are two types of investor in this category:

• people or firms buying property to hold and make a capital gain on in future, whilst receiving rental payments in the interim. An investor can choose how much effort and time they are willing to spend on the property, with intermediaries and agents available to assist them for a fee at most levels, such as with getting tenants in and fixing any problems they encounter.
• those who buy the property, invest more money in it to renovate or develop it and sell it on at a profit. These investors are typically more involved in the development of the property in order to maximise their return. The process here involves purchasing the property (sometimes even through an auction), gaining planning permission, developing the house, going through regulatory checks and then selling it on at a profit (hopefully, as if house prices fall dramatically and they need the capital quickly to repay any debt on their often multiple projects, they may have to sell at a loss).

Both of these groups, therefore, would need to have knowledge of and experience in the area and are normally working in the real estate industry themselves, often as a developer or real estate agent. [1]

Another point to note here is that these purchases are often dependent on debt, mainly mortgages. This is because, by maximising how leveraged (how much debt the project has taken on) the project is, the profit in return could also be maximised. A simple example of this would be as follows: consider two property buyers, Sam and Peter, buying two identical properties worth £1 000 000 each. Sam pays for the property in full, whereas Peter pays for the property with a deposit of £300 000 and the rest is borrowed on a 15-year mortgage with an interest rate of 2.85%. After three years, the property value has become £1 140 841 (4.85% increase per year). As you may already see here, the property value is increasing by more than the interest expense, making leveraging efficient. This is because, at the end of the period, Peter has put in £472 224 (300 000 + 4 784 * 36) whereas Sam has put in £1 000 000. This gives Peter a nominal (before inflation is accounted for) return (calculated as the profit received over initial capital invested, ie 140 841 / 472 224) of 29.8%, while Sam only gets 14.1%.

REITs

The second way of investing in property is a lot more suitable for the masses. REITs (Real Estate Investment Trusts) are an investment vehicle that can be invested in via buying individual stocks, mutual funds or ETFs (Exchange Traded Funds). They all pool together investors’ funds to invest in the physical property (equity REITs) or mortgage-backed securities (called mortgage REITs, mREITs). [2] Equity REITs provide a return by collecting rent and capital gains over time, thereby making good long-term investments, whereas mREITs collect the interest on mortgages, making money on financing real estate. Public non-listed REITs and private REITs also exist, albeit not very suitable for the individual investor. REITs can then be split into sectors, similar to equities. These sectors include office REITs, industrial REITs, retail REITs, lodging REITs, residential REITs, timberland REITs, healthcare REITs, self-storage REITs, infrastructure, data centre REITs (these have been doing well with the increase in video conferencing and remote working), diversified REITs and speciality REITs (those which don’t fit into other categories). [3]

The main indicators when choosing to invest in REITs are quite similar to other assets, ie forward earnings per share, dividend yield, management quality and underlying asset values. These, on the other hand, can be calculated by the capitalization rate, the rate of return on a property calculated by net operating property income/property asset value. A risk that would need to be accounted for is liquidity, as a property is relatively illiquid so it may not be the best investment for those who may suddenly need liquidity. For mREITs, the mortgage securities themselves may be slightly riskier, especially during recessions and this current one in particular where offices and retail alike have all had to close, leaving firms unable to meet their rent obligations and leaving landlords with greatly reduced incomes. However, considering that it is very much a long-term investment and secured on the property a lot of the time, with diversification possible, the risk is much more bearable. One can also assess their net asset value which is similar to a balance sheet to check how financially secure the REIT is.

Considerations

Some final considerations on REITs are that they can be seen as a relatively low-risk investment as property prices have on aggregate increased over the long-term. This can be seen in the chart below, with the largest dip being due to the 2008 Financial Crisis, where the housing sector was very badly affected by the amount of bad debt. [6]

They also allow the everyday investor to have access to an otherwise closed-off market. Whilst REITs [4] having to pay out at least 90% of their income in dividends may seem on the surface like a good thing, it does prevent them from reinvesting this income and compounding returns more heavily over time. It also sometimes encourages leveraging and other accounting tricks in order to try to mitigate large swings in income to attract investors. Dividends are also classed as ordinary income, making it less efficient than dividends from other asset classes. REITs also benefit from no corporate tax and allow one to diversify their portfolio. However, they are also sensitive to interest rates, ie as the Treasury yield increases, the price of REITs fall. Overall, while one may want to invest in it, as an alternative and for the various risks involved, it should remain a relatively small part of the everyday investors’ portfolio.

In comparison, while stocks tend to have higher volatility, this may mean they are able to get higher returns during economic booms, allowing investors to benefit from higher returns when available. Bonds, on the other hand, remain a lot less volatile and are seen as an even safer investment option, with returns staying positive throughout business cycles; therefore providing safety during recessions. [5]

Here is a graphical comparison of certain stocks and REITs, to portray the differences in return between the different asset classes throughout business cycles and to highlight how the diversification, as explained above, can help a portfolio mitigate risks and benefit from higher returns over time [7: https://www.reit.com/news/blog/market-commentary/comparing-average-reit-returns-and-stocks-over-long-periods].