Real Estate Investment Trusts - AIWMI · REITS •REITs, or real estate investment trusts, are...

Real EstateCHAPTER 3

Real Estate as an Investment class

Benefits of Real Estate investing

Drawbacks of Real Estate investing

Categories of Real Estate

Forms of Real Estate Investment

REITs

REOCs

Mortgage Backed Security

Due diligence

Real Estate Appraisal Methods

Role of Real Estate in a portfolio

Real Estate as an Investment class•Real estate is "property consisting of land and the buildings constructed on it, as well as the natural resources of the land, including uncultivated vegetation and fauna, farmed crops and farm animals, water and mineral deposits as well as immovable property of this kind. The term may also be used for business of real estate; the profession of buying, selling, or renting land, buildings or housing.

•Real Estate is often termed as Real Estate Market.

•Real Estate can be divided in 3 categories on the basis of its use which are residential, commercial and industrial.






REITs

REOCs


Due diligence



Benefits of Real Estate InvestingReal estate brings in a lot of advantage for the investors. Advantages include:

•Current income: Investors may expect to earn income from collecting rents and after paying operating expenses, financing costs, and taxes.

•Diversification through Real Estate: Low correlation with equity and other asset classes is one of the most important benefits of investing in Real Estate if considered from a portfolio perspective.

•Steady Cash Flow Returns: Nowadays the focus is often on generating high, steady yields with real estate.

Benefits of Real Estate Investing•Inflation Hedge: Like inflation-linked bonds and commodities, real estate provides fractional protection to investors against increasing inflation. Rental income is steady in nature, hence a moderately constant part of real estate income are the income yields.

•Tax benefits: In some countries, real estate investors receive favorable tax treatment.






REITs

REOCs


Due diligence



Drawbacks of Real Estate Investing•New property lead time: Market conditions can change significantly while approvals are obtained, while the property is completed, and when the property is fully leased. During the lead time, if market conditions weaken, the resultant lower demand affects rents and vacancy resulting in lower returns.

•Unexpected inflation: Some leases provide inflation protection by allowing owners to increase rent or pass through expenses because of inflation.

•Cost and availability of capital: Real estate must compete with other investments for capital. Demand for real estate is reduced when debt capital is scarce and interest rates are high.

Drawbacks of Real Estate Investing•Environmental issues: Real estate values can be significantly reduced when a property has been contaminated by a prior owner or adjacent property owner.

•Leverage: The use of debt (leverage) to finance a real estate purchase is measured by the loan-to-value (LTV) ratio. Higher LTV results in higher leverage and, thus, higher risk because lenders have a superior claim in the event of default.

•Lack of liquidity: Because of the size and complexity of most real estate transactions, buyers and lenders usually perform due diligence, which takes time and is costly. A quick sale will typically require a significant discount.

Drawbacks of Real Estate Investing•Availability of information: A lack of information when performing property analysis increases risk.

•Management expertise: Property managers and asset managers must make important operational decisions-such as negotiating leases, property maintenance, marketing, and renovating the property-when necessary.

•Demographic factors: The demand for real estate is affected by the size and age distribution of the local market population, the distribution of socioeconomic groups, and new household formation rates.

Drawbacks of Real Estate Investing•Highly Risky: Real estate has low liquidity in comparison to other investment classes, is capital intensive, even though capital may be gained through mortgage leverage and is very much dependent on cash flow.

•Other factors: Other risk factors, such as unobserved property defects, natural disasters, and acts of terrorism, may be unidentified at the time of purchase. In some cases, risks that can be identified can be hedged using insurance. In other cases, risk can be shifted to the tenants. For example, a lease agreement could require the tenant to reimburse any unexpected operating expenses.






REITs

REOCs


Due diligence



Different categories of Real Estate•Residential real estate investments include houses, townhouses, apartment buildings, and vacation houses which an individual or family rents.

•Commercial real estate investments mostly include office buildings. Having multiple year leases are common for commercial real estate.

•Industrial real estate investments includes industrial warehouses, storage units, car washes and other real estate that enhances sales from customers who are for the time being using the facility.

Different categories of Real Estate•Retail real estate investments include shopping malls, retail storefronts and strip malls. In some cases, in order to provide incentive to tenants to keep the property in good condition, the property owner may ask for a percentage of sales generated along with a base rent.

•Combining more than one of the above types in one project is commonly known as Mixed-use real estate investments. Mixed-use real estate investments are liked by those with a lot of assets as they have an extent of in-built diversification, which helps in managing risk.






REITs

REOCs


Due diligence



Forms of Real Estate Investment•The primary tasks in planning a real estate investment is to determine the type of exposure to the real estate market that is appropriate for ones situation.

•Varying levels of risk and return and be achieved through diverse investing ways. The option will also influence the way of acquiring the real estate.

•The first category of market in which you can participate in is the private market. In this type of a market, one is buying a direct interest in real estate properties. One would own and operate a portion of real estate oneself (or with the help of a real estate manager), and would obtain rents and value changes from the investment.

Forms of Real Estate Investment•Purchasing properties with a number of partners is another form of participating in a market which is known as syndicate or a pool.

•Alternatively, you may invest in the public real estate market.

•Participation in public market requires purchasing of shares in a publicly traded real estate corporation like real estate investment trust (REIT). Once you purchase a real estate security you are basically investing in a company that has bought real estate and is managing for its shareholders. Hence, in this case you take up an indirect exposure to real estate.

•One also needs to choose if one wants to invest in equity or in debt.

Forms of Real Estate Investment•Lending money to an owner or purchaser of real estate is known as Debt investing. It provides steady interest and a security charge from the owner against the property as a credit. After credit term, you again receive balance of your credit principal. Investing in real estate in this kind is very similar to bond investing.

•An equity investment represents a residual interest in the real estate. Equity Investor is actually owner of the company. Equity owner makes a lot of profit when the real estate value increases significantly or you receive increased rents.






REITs

REOCs


Due diligence



REITS•REITs, or real estate investment trusts, are companies that possess or finance income-producing real estate in a variety of property sectors.

•REITs have acquired their model from mutual funds.

•REITs help investors own significant real estate, earn income through dividends and earn total returns, and help communities grow, flourish and revitalize.

•REITs provide an opportunity to invest in portfolios of real estate assets in a similar manner as they invest in other industries, either by purchasing individual company stock or with investments in mutual funds or exchange traded funds (ETF).

REITS•REIT stockholders earn a proportion of income produced through investments in real estate without actually buying, managing or financing properties.

•Majority of REITs run along a basic and uncomplicated business model. The company earns income by renting space and collecting leases on it which is then distributed to shareholders as dividends.

•REITs are required to pay out at least 90 percent of their taxable income to shareholders. Most REIT prefer paying 100% of their taxable income to shareholders.

Categories of REITs•Equity REITs –Most common form of REITs are equity REITs. Income-producing real estate own and control Equity Real Estate. Nareit frequently call equity REITs as REITs. National association of Real Estate Trusts (Nareit) is a non-profit trade association, headquartered in Washington, D.C., that represents the interests of businesses involved in the real estate investment trust (REIT) industry. (REITs consist of businesses that invest in commercial real estate or housing or provide related services.) The association lobbies Congress on behalf of the industry, conducts research on the industry, and monitors trends.

Categories of REITs•Mortgage REITs - This kind of REIT provide finance for income-generating real estate by buying or originating mortgages and mortgage-backed securities and realizing income from the interest on these investments.

•Most REITs distribute their taxable income (almost entirely) as dividends to shareholders and the shareholders in turn pay dividend taxes on it.






REITs

REOCs


Due diligence



REOCs•A real estate operating company (REOC) is much like a real estate investment trust (REIT).

•REOC do not distribute their earning to shareholders. They generally reinvest their earnings and hence they do not get the same benefits of lower corporate taxation that are a common attribute of REITs.

•Also, REOCs are less rigid than REITs in terms of what types of real estate investments they can make.

•REOC investors look for capital gains rather than passive cash flows. An investor, when analyzing REOC investment could want high returns on investment capital, equity returns and asset return.






REITs

REOCs


Due diligence



Mortgage Backed Security•Mortgage-backed securities are a type of asset-backed security. Investments in mortgage backed securities are secured by mortgages.

•Generally, buyers who opt for these security investments are individual investors, corporate investors and institutional investors. Investors of mortgage backed securities can gain benefit without actually purchasing or selling home loans.

•An MBS is considered a derivative instrument as it extracts its value from an underlying asset. Investing in an MBS is purchasing the right to receive the benefits from a package of mortgages.

•These securities are divisible and hence you can purchase a fraction of the asset. Payments are received on a proportionate basis.






REITs

REOCs


Due diligence



Due diligence in Real Estate Valuation Real estate investors, both debt and equity, usually perform due diligence to confirm the facts and conditions that might affect the value of the transaction. Due diligence may include the following:

• Lease review and rental history.

• Confirm the operating expenses by examining bills.

• Review cash flow statements.

• Obtain an environmental report to identify the possibility of contamination.

• Perform a physical/engineering inspection to identify structural issues and check the condition of the building systems.

Due diligence in Real Estate Valuation • Inspect the title and other legal documents for deficiencies.

• Have the property surveyed to confirm the boundaries and identify easements.

• Verify compliance with zoning laws, building codes, and environmental regulations.

• Verify payment of taxes, insurance, special assessments, and other expenditures.

Due diligence can be costly, but it lowers risk of unexpected legal and physical problems.






REITs

REOCs


Due diligence



Real Estate Appraisal Methods•Real estate appraisal, property valuation or land valuation is a method of developing an assessment of value for real property (usually market value). Real estate dealings frequently need appraisals because they occur seldom and every property is distinctive in contrary to corporate stocks which trade daily on the stock exchange and are indistinguishable.

•The concept of highest and best use is important in determining value. The highest and best use of a vacant site is not necessarily the use that results in the highest total value once a project is completed. Rather, the highest and best use of a vacant site is the use that produces the highest implied land value.

Real Estate Appraisal Methods•In most of the cases the market value of the property will not match the price of the property. Market value refers to what the property is really worth and the price of the property means what it costs to buy the particular property. Amount paid might not denote the market value of the property.

•There may be special instances of such cases like a unique relationship between the purchaser and seller where one party exercises a lot of control over the other party which may lead to different price being paid in comparison to the market price.

•Alternatively, a purchaser may voluntarily pay a price above the generally accepted market value (premium price), if his individual valuation of the property or his investment value is superior to the market value.

Real Estate Appraisal Methods•Frequently the inconsistency between the value and price is that either the purchaser or the seller is unaware of the property's market value but still accepts a contract at a particular price which may be too costly or too inexpensive. This is an adverse situation for one party.

•It is the real property appraiser’s responsibility to evaluate the correct market value of a property.

Real Estate Appraisal Methods• There are three conventional independent methods of evaluating the

value of the property which are:

◦ The sales comparison approach

◦ The cost approach

◦ The income approach

Real Estate Appraisal Methods•However, nowadays the scientific methodology of appraisal is popular among businesses which are based on the foundation of risk, quantitative-data and geographical based approaches.

•In almost all of the valuing cases, one of the three methods will be applicable and most appropriate and it is upon the appraiser discretion to choose either of the approaches to determine value.

•The appraiser thinks about the type of value, scope of work, quantity of data available, the quality of data and the property itself for each approach. No one can definitely and confidently put a statement saying which method is most appropriate in any instance.






REITs

REOCs


Due diligence



Role of Real Estate in a portfolio•Real estate investment has both bond-like and stock-like characteristics.

•Leases are contractual agreements that usually call for periodic rental payments, similar to the coupon payments of a bond. When a lease expires, there is uncertainty regarding renewal and future rental rates.

•This uncertainty is affected by the availability of competing space, tenant profitability, and the state of the overall economy, just as stock prices are affected by the same factors.

•As a result, the risk/return profile of real estate as an asset class, is usually between the risk/return profiles of stocks and bonds.

“Look at market fluctuations

as your friend rather than

your enemy; profit from folly

rather than participate in it.”

– Warren Buffett

THANK YOU

Real Estate Investment Trusts - AIWMI · REITS •REITs, or real estate investment trusts, are...

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