Real estate is an investment class which includes land and buildings. It can offer stable income and potential for capital appreciation. It also offers diversification benefits due to low correlation with other asset classes such as stock and bonds and can act as an inflation hedge.
Investors can obtain exposure to real estate directly or indirectly. Direct investment involves purchasing land and building units and managing them to earn rentals and benefit from capital gains. Indirect investing involves either debt or equity investment using financial products such as mortgage-backed securities, real-estate investment trusts, etc.
In direct investing, investors identify and purchase land and building units directly. It may involve either an outright equity purchase or a mortgage. In a mortgage, the investor invests a certain sum say 20% in the property and obtain a loan equivalent to the remaining amount by putting the property up as collateral. The direct ownership approach has some disadvantages: first, real estate units are large in size and it might be hard to find a combination of units which match our intended strategic asset allocation weights; second, it requires significant active management which might be hard for an investor with no property management experience and third, it has significant idiosyncratic risk because its values are dependent on local market trends. Real estate investment classes relevant for direct investing include: (a) residential property, (b) commercial property, (c) timberland and farmland.
Indirect investing: REIT, etc.
In indirect investing approach, an investor can purchase units in mutual-fund like entities which are specifically created to pool funds from different investors and invest them in a range of real estate units. This approach counters the disadvantages of direct ownership specifically the large unit size and high unique risk. Entities which offer investors equity-stake in real estate include (a) real estate investment trust (REITS) which are exchange-traded funds that specialize in real estate investment of different types; and (b) real estate limited partnerships which pooled vehicles whose units/shares are not traded on exchanges. Investors looking to obtain debt-like exposure can invest in mortgage-backed securities which are bond-like instruments backed by pools of residential or commercial mortgage of varying credit risk.
Real estate valuation
There are three main approaches which can be used to value real estate units for direct ownership:
- Comparable sales approach: a relative valuation approach which values one property with reference to recent market transactions of similar properties in the same or similar location;
- Income approach which has two further variants: (a) direct capitalization approach, which values real estate as a perpetuity discounted at a rate called cap rate and (b) discount cash flow method which forecast the real estate’s net operating income and discount it at a rate representative of the property’s risk; and
- Cost approach, which values a real estate property at its replacement cost i.e. the cost that will be incurred today to reconstruct it.
For indirect ownership in the form of REITs, equity ownership in REIT can be valued using either the direct capitalization approach or by working out the net asset value of the REIT.