Have you ever deliberated on real estate investments? Chances are when you think about investing in real estate the first thing that comes to mind is your home. For many people, their home is the single largest investment they will ever make. But have you ever stopped to consider that once you purchase a home it becomes part of your overall portfolio of investments? In fact, it’s one of the most important parts of your portfolio because it serves a dual role not only as an investment but also a centerpiece to your daily life.
Though a home is one of the largest investments the average investor will purchase, there are other types of real estate investments worth investing in. The most common type of real estate investment is income-producing real estate. Large income-producing real estate properties are commonly purchased by high net-worth individuals and institutions, such as life insurance companies, real estate investment trusts (REITs) and pension funds.
One of the main differences between investing in a piece of real estate as compared to stocks or bonds is that real estate is highly tangible, because you can see and touch your property. This often creates substantial pride of ownership, but tangibility also has its downside because real estate requires hands- on management.
Features of Real Estates Investments
One of the beneficial features of real estate is that it produces relatively consistent total returns that are a hybrid of income and capital growth. In that sense, real estate has a coupon-paying bond-like component in that it pays a regular, steady income stream, and it has a stock-like component in that its value has a propensity to fluctuate. And, like all securities that you have a long position in, you would prefer the value to go up more often than it goes down.
The income return from real estate is directly linked to the rent payments received from tenants, less the costs of operating the property and outgoing mortgage/financing payments. Thus, you can understand how important it is to keep your property very well. If you lose too many tenants, you won’t have sufficient rents being paid by the other tenants to cover the building operating costs. Your ability to keep the building full depends on the strength of the leasing market – that is, the supply and demand
for space similar to the space you are trying to lease. In weaker markets with oversupply of vacancies or poor demand, you would have to charge less rent to keep your building full than in a strong leasing market. And unfortunately, if your rents are lower, your income returns are lower.
Capital appreciation of a property is determined by having the property appraised. An appraiser uses actual sale transactions that have occurred and other pieces of market data to estimate what your property would be worth if it were to be sold. If the appraiser thinks your property would sell for more than you bought it for, then you’ve achieved a positive capital return. Because the appraiser uses past transactions in judging values, capital returns are directly linked to the performance of the investment sales market. The investment sales market is affected largely by the supply and demand of investment product. The majority of the volatility in real estate returns comes from the capital appreciation component of returns. Income returns tend to be fairly stable, and capital returns fluctuate more. The volatility of total returns falls somewhere in between.
Some of the other characteristics that make real estate unique as compared to other investment alternatives are as follows:
No fixed maturity
Unlike a bond which has a fixed maturity date, an equity real estate investment does not normally mature. In recent times, it is not uncommon for investors to hold property for over 100 years. This attribute of real estate allows an owner to buy a property, execute a business plan, then dispose of the property whenever appropriate. An exception to this characteristic is an investment in fixed-term debt; by definition a mortgage would have a fixed maturity.
An inefficient market is not necessarily a bad thing. It just means that information asymmetry exists among participants in the market, allowing greater profits to be made by those with special information, expertise or resources. In contrast, public stock markets are much more efficient – information is efficiently disseminated among market participants, and those with material non-public information are not permitted to trade upon the information. In the real estate markets, information is king, and can allow an investor to see profit opportunities that might otherwise not have presented themselves.
High Transaction Costs
Private market real estate has high purchase costs and sale costs. On purchases, there are real-estate- agent-related commissions, lawyers’ fees, engineers’ fees and many other costs that can raise the effective purchase price well beyond the price the seller will actually receive. On sales, a substantial brokerage fee is usually required for the property to be properly exposed to the market. Because of the high costs of “trading” real estate, longer holding periods are common and speculative trading is rarer than for stocks.
With the exception of real estate securities, no public exchange exists for the trading of real estate. This makes real estate more difficult to sell because deals must be privately brokered. There can be a substantial lag between the time you decide to sell a property and when it is actually sold – usually a couple of months at least.
Underlying Tenant Quality
When assessing an income-producing property, an important consideration is the quality of the underlying tenancy. This is important because when you purchase the property, you’re buying two things: the physical real estate, and the income stream from the tenants. If the tenants are likely to default on their monthly obligation, the risk of the investment is greater.
Variability among Regions
Location is one of the important aspects of real estate investments; a piece of real estate can perform very differently among countries, regions, cities and even within the same city. These regional differences need to be considered when making an investment, because your selection of which market to invest in has as large an impact on your eventual returns as your choice of property within the market.
Real estate investments fall into one of the four following categories: private equity, public equity, private debt and public debt. Your choice of which one to invest in depends on the type of exposure you are seeking for your portfolio. You can invest in either income-producing properties or non-income- producing properties. Any leased property is income producing, and vacant properties are non-income producing. You can still earn a capital return on a non-income producing property, just as you would on an investment in a home. The major types of investment properties are offices, retails, industrials and multi-family residential properties. Real estate can produce income (like a bond) and appreciate (like equity). Some of the benefits of adding real estate to a portfolio include: diversification, yield enhancement, risk reduction and inflation-hedging capabilities. However, real estate also has high transaction costs, can be difficult to acquire and it is challenging to measure its relative performance. Buying real estate requires substantial due diligence to ensure that you’re getting what you expect after you close. The way to determine the value of your property other than actually selling it is to have it appraised by an accredited appraiser.
Source: Omega Capital Limited is an Investment management, private equity and investment advisory firm. The
Company is authorized and regulated by the Securities and Exchange Commission of Ghana. Analyst:
Nana Kumapremereh Nketiah (JP)
Sophia Obeng- Aboagye