IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

R50 Introduction to Alternative Investments

Part 4


5.  Real Estate

Key reasons for investing in real estate are listed below:

  • Potential for competitive long-term returns (income and capital appreciation).
  • Rent for long-term leases will lessen the impact of economic shocks.
  • Diversification because of low correlation with other asset classes such as stocks, bonds.
  • Inflation hedge.

Investment characteristics of real estate are as follows:

  • Unique characteristics (no two properties are identical).
  • Fixed location.
  • Operational management.
  • Local markets can be very different from national or global markets.

5.1.     Forms of Real Estate Investment

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

  Debt Equity
Private Mortgages

Construction lending

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.

5.2.     Real Estate Investment Categories

Real estate properties can also be categorized based on use:

Residential Property

  • Properties such as residences, apartment buildings, and vacation homes, purchased with the intent to occupy.
  • Most home buyers cannot fund the home entirely with cash. Instead, it is leveraged equity, i.e., they borrow money (loan/mortgage) to make the purchase.
  • Financial institutions lend money (debt financing) through mortgages for purchasing a home. A due diligence of the borrower is done to ensure that he has the capacity (sufficient cash flows) to make the payments on the loan on time, he is making the remaining equity investment in the home, and adequate insurance is in place on the home.

Commercial Property

  • Undertaken by investors (both institutional and HNIs) with limited liquidity needs and long time horizons.
  • Primarily comprises office buildings purchased with the intent to rent.
  • Direct investment: can be equity or debt financed.
  • Debt financing: lender must ensure the borrower is credit worthy. The property must generate enough cash flows through rent to service the debt. How much loan the borrower can get (based on loan-to-value ratio) depends on the value of the property.
  • Equity investing: Requires active and experienced management.

Timberland and Farmland

  • Timberland functions as a factory and store. The return comes from the sale of trees, wood, and other timber products. It has low correlation of returns with other asset classes. By not harvesting, storage of timber becomes easy. The trees can be harvested based on the price: more harvest when price goes up and delayed harvest when the price is down. Three return drivers include growth, change of lumber (cut wood), and underlying land price change.
  • Farmland is perceived to provide a hedge against inflation. Two types of farm crops include crops that are planted and harvested, and permanent crops that grow on trees. Return drivers for farmland are harvested quantities, commodity prices, and land price appreciation.

5.3.     Real Estate Performance and Diversification Benefits

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:

  • Appraisal Index: Uses estimates of values as inputs to the index. The appraisal values are based on comparable sales and cash flow analysis techniques. This means that actual transaction prices are not used by the index because real estate assets do not transact very often and managers do not take the effort to revalue property frequently. Ideally, the properties are supposed to be appraised once a year, but some properties may have been appraised more than a year earlier.
  • Repeat Sales Index: Uses repeat sales of properties to construct the indices; the change in the price of properties with repeat sales is measured in this method. These indices suffer from sample selection bias because it is highly unlikely that the same properties come up for repeat sales every year.
  • REIT Index: It is constructed using the prices of publicly traded shares of REITs to construct the indices. The accuracy of the index depends on how frequently the shares of the index trade.

5.4.     Real Estate Valuation

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:

  • Comparable sales approach
  • Income approach
  • Cost approach

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.

Income Approach

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.

Cost Approach

The cost approach involves estimating the value of land and then the cost of building the property using current costs.

REIT Valuation

There are two approaches to estimate the intrinsic value of a REIT:

  • Income-based
  • Asset-based

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

5.5.     Real Estate Investment Risks

Like any investment, real estate investing has its risks if the outcome does not turn out to be as per expectations.

  • Property values are subject to variability based on national and global economic conditions, local real estate conditions (more supply than demand or demand more than supply), and interest rate levels.
  • Ability to select, finance, and manage real estate properties. This includes collecting rent, maintenance, undertaking repairs on time, and finally disposing the property. Economic conditions may be different when the property was bought and when it is sold.
  • Expenses may increase unexpectedly.
  • Leverage magnifies risks to equity and debt investors.

Alternative Investments Introduction to Alternative Investments Part 4