Key reasons for investing in real estate are listed below:
Investment characteristics of real estate are as follows:
Real estate investing can be categorized along two dimensions: public/private markets and debt/equity based. The four quadrants are filled with examples below:
Basic forms of real estate investments and examples
|Direct ownership of real estate.
Ownership can be through sole ownership, joint ventures, real estate limited partnerships, etc.
|Public||Mortgage-backed securities (residential and commercial).
Collateralized mortgage obligations
|Indirect ownership via shares in real estate development corporations or shares of real estate investment trusts (REITs). REITS are publicly traded shares of a portfolio of properties.|
If you are investing in a debt-based real estate investment, it means you are lending money to a purchaser of real estate. A classic example is a mortgage loan. This is considered a real estate investment because the value of the mortgage loan is related to the value of the underlying property. A debt-based real estate investment could be private or publicly traded. Mortgage loans and construction loans are examples of private debt-based real estate investments. Mortgage-backed securities are often traded on public markets. Hence, these are considered public debt-based real estate investments. Debt-based real estate investments are discussed in the fixed income segment of the curriculum. This section focuses on equity-based real estate investments.
Equity-based investments represent ownership of real estate properties. Ownership can be through sole ownership, joint ventures, real estate limited partnerships, etc. A variation of equity-based investments is leveraged ownership: Assume a building costs $10 million, and you put $3 million of your money and borrow $7 million. This is called leveraged ownership. That is, leveraged ownership is where a property is obtained through equity and mortgage financing.
REITs: REITs combine the features of mutual funds and real estate. An REIT is a company that owns income-producing real estate assets. In REITs, average investors pool their capital to invest (take ownership) in several large-scale, diversified income-generating real estate properties. The REIT issues shares, where each share represents a percentage ownership in the underlying property. The income generated is paid as a dividend to the shareholders.
The value of the shares is based on the dividend. REIT shares often trade publicly on exchanges. It is a way for individual investors to earn a share of the income from commercial properties (office buildings, warehouses, and shopping malls) without buying them. Risk and return of REITs vary based on the types of properties they invest in. Equity REITs invest primarily in residential and commercial properties.
Real estate properties can also be categorized based on use:
Timberland and Farmland
There are a number of indices to measure real estate returns that vary based on the underlying constituents and longevity. There are three categories, in general:
Until a real estate property is sold, its actual value is not known and must be estimated. This estimation process is known as appraising the property.
Common techniques for appraising real estate property are as follows:
These methods are discussed in detail below:
Comparable Sales Approach
The comparable sales approach compares the property being appraised to similar properties that have been recently sold. The properties must have similar characteristics such as location, condition, age, and size. If there is a difference in characteristics, then adjustments must be made.
The income approach can be applied in two ways: the direct capitalization approach and the discounted cash flow approach.
With the direct capitalization method, we estimate a property’s net operating income (NOI) for the upcoming year and then divide by a capitalization rate. The relevant formulas are given below:
NOI = Income to the property – property taxes – insurance – maintenance – utilities – repairs (depreciation and income taxes are not deducted)
Value of the property =
where: capitalization rate = discount rate – growth rate
With the discounted cash flow method, the present value of the property is calculated by discounting future projected cash flows for a finite number of periods. The final resale value is estimated using the direct capitalization method.
The cost approach involves estimating the value of land and then the cost of building the property using current costs.
There are two approaches to estimate the intrinsic value of a REIT:
The income-based method is similar to direct capitalization. There are two income measures: funds from operations (FFO) and adjusted FFO (AFFO).
FFO = Net income + depreciation – gains from sales of real estate + losses on sales of real estate
AFFO adjusts the FFO for recurring capital expenditures.
The asset-based method is based on calculating REIT’s net asset value (NAV).
NAV = estimated market value of REIT’s assets – liabilities
Like any investment, real estate investing has its risks if the outcome does not turn out to be as per expectations.