Real estate is simply the land and or the buildings erected on it. From cradle to grave, our lives are inextricably linked to real estate: majority of us are born inside buildings (hospitals or homes), live, sleep and work inside buildings, partake our leisure activities in buildings (hotels), will die inside a building and will be buried in the land. According to some estimates, the British property market is valued at £8 trillion and about 30% of household wealth is from home ownership. As of January 2020, the US housing market was valued at $34 trillion – almost equalling the combined GDP of USA and China, two of the world’s biggest economies.
So, who are the investors in real estate? The type and sophistication of investors in real estate is very varied. The investors could be individuals (retail investors), family offices or institutional investors. An individual/retail investor is the man on the street; is considered to be less sophisticated than the other types of investors and tends to have less capital to invest. Family offices are investment managers that manage assets of wealthy families and they have the expertise and knowledge required to invest in complicated instruments. Institutional investors include pension funds, endowment funds, mutual funds and insurance companies. Institutional investors manage large sums of money and have the expertise and knowledge to invest in complex assets.
Why should you invest in real estate? What are the benefits of investing in real estate? Before we can look at the reasons why you should invest in real estate, it is important to know the different asset classes. An asset class is a group of investments that show similar risk and return profiles and respond to the same economic factors in a similar way. Broadly, there are 6 basic asset classes available to investors: equities (stock/shares), fixed income (bonds), cash and cash equivalents (money market instruments), private equity, real estate and commodities.
We have provided a summary of the many reasons why you should invest in real estate. This list is by no means exhaustive.
Diversification benefits of real estate.
The old saying that do not put your eggs in one basket is very true when it comes to investing. The risk and return characteristics of real estate are different from the other asset classes we mentioned above. In Portfolio Theory, the risk of an investment or asset class is measured by the standard deviation of its return. Simply put, this is the up and down movement of the returns over a given period. If the returns swing too much, the standard deviation of the investment is high making it too risky. Therefore, real estate added to a traditional stock/bond portfolio adds diversification benefits to that portfolio by lowering the portfolio variance, a measure of risk. The diversification benefit of real estate is the low or negative correlation between the rate of returns of the real estate and other asset classes. Correlation measures how returns move together over a period of time. The correlation coefficient ranges from +1 to -1. A correlation coefficient of +1 means that the rate of returns of the two assets/portfolios move up or down lockstep by the same magnitude and at the same time. If the coefficient is -1, the returns move in exactly the opposite directions. A correlation of 0 means that the returns are completely unrelated. According to portfolio theory, a correlation less than 1 adds diversification benefits by lowering the standard deviation of the portfolio and hence increasing the Sharpe Ratio. The Sharpe Ratio is given by the portfolio’s return in excess of the risk-free rate divided by the portfolio standard deviation.
Sharpe Ratio = (Rp – Rf)/sp
Rp is the portfolio return
Rf is the risk-free rate given by the yield on a 10-year government bond
sp is the portfolio standard deviation
A portfolio with a higher Sharpe Ratio means that it is more superior on a risk adjusted basis than one with a lower one. Research has shown that direct real estate investment offers better diversification benefits to a stock/bond portfolio than indirect investments eg REITS. This is because the rate of return on direct real estate investment has a much lower correlation with returns on stocks and bonds. We will look at direct and indirect real estate investment when we dissect the different strategies of investing in real estate in the next series.
The reason why direct real estate investment offers more diversification benefits to a standard stock/fixed income portfolio is that direct real estate investment is less sensitive to the fundamental economic factors which have been shown to drive equity and fixed income returns. An investor also needs to know that they have to diversify within the real estate asset class according to type and geographic location. Different types of real estate have different characteristics and we will talk about that in another series.
Hedge against inflation.
Beware of the moth that destroys your treasure! Inflation diminishes the value of an asset or the returns on an investment due to a decline in purchasing power. Real estate as a hedge against inflation risk is important in countries with high inflation. Extreme cases, called hyperinflation, occurred in Zimbabwe in 2008 and Germany soon after the First World War. But the inflation hedge depends on the type of real estate you are investing in. Residential apartments with short lease terms are a better hedge against inflation than office buildings which tend to have very long lease terms. This is predicated on the fact that rent on residential apartments is adjusted periodically, typically annually and can match the inflation rate. Leases on offices can be 5-10 years long and this makes it difficult to adjust rentals in line with the prevailing rate of inflation. Office rent is sticky. The bargaining power of the tenants also needs to considered in this situation. If you have a single tenant who provides a high proportion of the rentals, they are likely to resist regular hiking of rentals. For example, a large hospital can rent out your entire apartment for its staff. While it is an advantage to just have one large tenant than dealing with many tenants, a big tenant always has more bargaining power than the apartment owner. This makes adjusting rentals more difficult and such apartments will not provide a good hedge against inflation.
Leverage.
Banks and other lenders are willing to lend huge sums of money to people to buy real estate. In some instances that could be up to 90% of the value of the property. Such high levels of leverage are difficult to achieve with the other asset classes. Leveraging your position in an investment magnifies the rate of returns.
Tax savings.
This is important to all tax paying investors. The nature of direct real estate investment provides tax shields that magnify returns on a portfolio. Buildings, like most real assets suffer from depreciation over time. Depreciation is the expense of an asset allocated to each year over its useful ecominic life. Depreciation expense is subtracted from rental income and therefore reduces the amount of taxes paid per period.
Because of high leverage in real estate, the interest paid per year on most purchases is very high. This reduces the taxable income and hence provides tax savings. Buildings need constant repairs and maintenance to keep them habitable. The costs of repairs and maintenance also reduce the taxable rental income from your property. This, also produces savings on taxes paid per period. It is difficult to enjoy such favourable tax savings with other asset classes.
Cash Flow.
Another reason to invest in real estate is its ability to generate stable cash flows. Cash flow is a reliable measure of value in an investment and many asset valuation models use cash flow to estimate the intrinsic value of assets. Cash flow is what remains after paying your operating expenses, taxes and interest. For leveraged properties with a repayment mortgage, a larger proportion of your monthly repayments will reduce the outstanding balance on your mortgage as time progresses. This means that you begin to pay less interest on the mortgage and hence the cash flow increases.
Capital Appreciation.
Real estate enjoys capital appreciation in the long term depending on the demand and supply in the market. As the economy expands, the real wage rate increases and more people buy properties and more people rent houses. This increase in demand in turn leads to an increase in the price of properties. A reduction in the supply of stock of real estate in the market leads to an increase in the price of properties. In some areas residents lobby local authorities to impose stringent planning permissions to restrict the construction of new houses and hence limit the supply of houses. This in turn leads to price appreciation in those areas.
There is no doubt about the benefits real estate as an asset class brings to a traditional stock/bond portfolio. Having looked at why you should invest in real estate, we think it is important to look at how you can invest in real estate. There are many strategies of investing in real estate, matching the risk appetite, experience, resources, time and circumstances of different types of investors. We will explore these strategies in our next blog.