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Real estate: categories, benefits, and risks

Real estate investing includes both direct and indirect ownership (equity) and lending (issuance of mortgages or purchase of mortgage-backed securities). Real estate includes residential, commercial, farmland, timberland, etc. Some investors classify farmland/timberland as commodities.

Investors add real estate to their portfolio because of their total return potential, relatively stable cash flows, less than the perfect correlation with other asset classes, and potential inflation hedge. Characteristics of real estate include large unit sizes (indivisibility), uniqueness, fixed location, operational management requirement, and government regulation.

Forms of real estate investments

Real estate investments may be classified into equity and debt, both private and public:

  • Private equity investments include direct ownership through sole proprietorships, JVs, etc.
  • Public equity investments through shares in real estate companies and REITs.
  • Private debt investments include mortgages and construction lending.
  • Public debt investments include mortgage-backed securities, CMOs, etc.

Direct ownership is typically unencumbered, and its ancillary costs include legal, survey, engineering, appraisal, etc.

Leveraged ownership is in the form of mortgages which are secured loans backed by real estate. In addition to the initial purchase costs, these may incur mortgage arrangement fees. Providers of mortgage loans expect a steady stream of payments and may have to take ownership if there is default. They may invest in whole loans or through mortgage pass-through securities.

Public equity investments include (a) real estate limited partnership, which is managed by general partners who specialize in real estate management, and (b) real-estate investment trusts (REITs), which raise funds by issuing shares, which they invest in a diverse portfolio of real estate. Securitization of mortgages provides investors to invest publicly in real estate debt, such as mortgage-backed securities, and collateralized mortgage obligations. These are typically carried as part of fixed income instead of alternative investments. The fee structure of limited partnership and REITs is similar to private equity.

Real estate investment categories

The majority of real estate investments can be categorized as either residential or commercial, while others include REIT investing, mortgage-backed securities, and timberland and farmland.

Residential properties refer to single-family residences occupied by owners who have a direct equity investment a significant part of which is financed through a loan. Financial institutions typically originate such mortgage loans which enable them to have a direct debt investment which is either held on their balance sheet or securitized in the form of residential MBS and sold to other investors.

Commercial properties are owned with the intent of leasing or renting them out. These include residential buildings, offices, retail, industrial, warehouses, hospitality, etc. Equity commercial investments are appropriate for institutional investors and HNWI because they require long-term horizon, are illiquid, and require professional management. Debt investments in commercial property take into consideration the equity position, economic conditions, owner’s creditworthiness, valuation consideration (loan-to-value is important).
Shares of REITS and CMBSs provide indirect equity and debt stake in commercial properties.

REIT investing can take the form of debt or equity. Mortgage REITs invest in debt and are similar to fixed income. Equity REITs have a direct but leveraged investment. They are typically required to distribute the majority of their income to their investors to maintain tax-advantaged status.

Mortgage-backed securities are created through the process of securitization, which involves issuing securities/tranches with different seniority ranking backed by a pool of mortgages.

Timberland provides total return which is less correlated with other asset classes. Since a producer can adjust its harvesting rate in response to price changes, it offers flexibility. Its return depends on biological growth, commodity prices, and land prices. Farmland typically provides an income that is less flexible because harvest cannot be changed in response to price changes. They include row crops, which are annual crops, and permanent crops, such as vines, etc. Its return depends on harvest quantities, commodity prices, and land prices.

Real estate performance and diversification benefits

Real estate indexes have three categories: (a) appraisal indexes, which are based on expert estimation carried out typically annually, but some values may be older which may understate volatility, (b) repeat sales indices, which are based on actual past transactions, but they may suffer from sample selection bias (sales transactions may have a certain tilt due to economic conditions) and REIT indexes, which are based on publicly traded shares of REITs.

Before using a real estate index, it is important to understand its construction and note any limitations. A high correlation may exist between global and regional real estate markets. Further, broad market equity and REIT have high mutual correlation but a low correlation with bonds.

Real estate investment risks

Real estate values depend on economic conditions, particularly interest rates, and local market conditions. Risks stem from challenges in operations management and/or changes in government regulations. Property development is subject to increased risks such as regulatory issues, construction delays (and any change in economic conditions in the meantime), and cost overruns. Financing problems may arise, and they may have a contagion effect (i.e. problem in one project may create financial distress for other projects of the same developer). Further, the use of leverage in equity investments may result in negative returns during financial stress.

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