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LM01 Overview of Types of Real Estate Investment 2023 Level II Notes © IFT. All rights reserved 2 1. Introduction and Basic Forms of Real Estate Investment Real estate offers investors long-term stable income, inflation protection and low correlations with stocks and bonds. Real estate has a risk-return profile that generally falls somewhere between fixed income and equity. Residential real estate accounts for the largest portion of the real estate market, with the majority of it being owner-occupied. However, this reading focuses on rental or commercial properties such as office buildings, shopping centers, distribution centers, and for-rent residential properties. 2. Basic Forms of Real Estate Investment Real Estate Market Size The global real estate market ($281 trillion) dwarfs other asset classes such as global equity ($83 trillion) and bonds ($105 trillion). At $220 trillion, residential real estate accounts for nearly 80% of the real estate market. Commercial buildings and agricultural/forestry totaled $33 trillion and $20 trillion, respectively. Real Estate Investment: Basic Forms Real estate properties can be classified along two dimensions:  Residential and non-residential  Owner occupied and for rent Exhibit 1 presents the various property types along these two lines of classification. Owner Occupied For Rent (Commercial) Residential Single-family homes, apartments/condominiums, manufactured housing Single-family detached homes and multi-family buildings Non- Residential Office, shopping centers, manufacturing facilities, warehouses, agricultural, other specialty real estate Office, shopping centers, industrial warehouse/ distribution, hotels, agricultural, other specialty real estate Real estate investments can also be classified along two dimensions:  Public versus private  Equity versus private Combining the two dimensions gives us four quadrants: public equity, private equity, public debt, and private debt. Exhibit 2 presents some examples for these quadrants.
LM01 Overview of Types of Real Estate Investment 2023 Level II Notes © IFT. All rights reserved 3 Public Private Equity • Shares of REOCs • Shares of REITs, other listed trusts, exchange-traded funds (ETFs), and index funds • Direct investments in real estate, including sole ownership and joint ventures • Indirect real estate ownership through limited partnerships, other forms of commingled funds, or private REITS and REOCs Debt • Mortgage REITs • MBS (residential and commercial) • Unsecured REIT debt • Mortgages • Private debt • Bank debt Each form has its own risks, expected returns, regulations, legal and market structures. Investors can explore these characteristics and choose a quadrant that suits them.  Private investments involve large investments and are illiquid. They also require property management expertise.  Public investments allow the ownership claim on a property to be divided. This provides liquidity and diversification to the investors. Also, the properties are professionally managed and no real estate management expertise is required on the part of the investor.  Equity investors take on more risk and therefore expect a higher rate of return than debt investors. Their returns have two components: rent and appreciation of property value.  Debt investors get their returns from mortgage repayments and do not participate in the appreciation of value of the underlying real estate. A few important points about these investment types: Real estate investment trusts (REITs): Equity REITs own, operate and (to a limited extent) develop income producing real estate. Mortgage REITs make loans secured by real estate. REITs are exempt from corporate income tax. This gives them a tax advantage over REOCs. Real estate operating companies (REOCs): These are ordinary taxable real estate ownership companies. They are often found in countries that do not have a tax-advantaged REIT regime. REOCs can also be companies that focus on development of real estate, often with the intent to sell. Their primary income source is sale of developed properties rather than rental income. Mortgage-backed securities (MBS): These are asset backed securities that represent the right to receive cash flows from a portfolio of mortgage loans. If the mortgage loans are on commercial properties, then these are called commercial mortgage backed securities (CMBS). If the mortgage loans are on residential properties, then these are called
LM01 Overview of Types of Real Estate Investment 2023 Level II Notes © IFT. All rights reserved 4 residential mortgage backed securities (RMBS). MBS are covered in the fixed income segment of the curriculum. Apart from the publicly traded real estate securities, there are privately held real estate securities such as private REITs and REOCs, privately held mortgages, etc. Example: Form of Investment (This is based on Knowledge check example in section 2 of the curriculum.) An investor wants to add real estate to her portfolio to get diversification benefits. She is concerned about liquidity and may need the money in a year or so. Which form of investment is most appropriate for her? A. Shares of REITs B. Mortgage-backed securities C. Direct ownership of commercial real estate property Solution: A is correct. Adding equity real estate investments to a traditional portfolio will provide better diversification benefits than adding debt real estate investments such as MBS. Within equity real estate investments, publicly traded REITs are a lot more liquid as compared to direct ownership of real estate. Characteristics Real estate has the following characteristics:  Unique asset and fixed locations: Properties are immovable assets and have a fixed location. While all stocks of a specific company or all bonds from a particular issue are identical, no two properties are the same. Properties differ in use, size, location, age, type of construction, quality, and tenant and leasing agreements.  High unit value: Since a real estate property is indivisible, its unit value is much larger than that of a stock or bond. This makes it difficult to construct a diversified real estate portfolio.  Management intensive: Investors in stocks and bonds are not required to be actively involved in the day-to-day management of the companies. However, private real estate investments require active management like maintaining property, negotiating leases, and collecting rents. This creates additional costs that must be taken into account while making real estate investments.  High transaction costs: Many parties such as appraisers, lawyers and construction professionals are likely to be involved in a real estate transaction, which results in high transaction costs.  Depreciation: Properties depreciate as a result of use and passage of time. Property value can also change as the desirability of its location and its design changes from the perspective of end users.  Need for debt capital: Since large amounts are required to purchase properties,