The Basics of Real Estate Investment

Real estate consists of land and buildings. Real estate companies buy, manage, develop, and sell properties, usually for commercial purposes. These companies are classified by location and property type, such as residential, offices, shopping malls, or warehouses.

They create value in two ways:

• Internal Measures: Improving occupancy, maintaining properties, increasing rents, upgrading tenants, and handling expenses more efficiently.

• External Measures: Trading properties wisely and undertaking development projects, either redeveloping existing properties or constructing new ones.

Real Estate Investment Trusts (REITs)

A REIT is an association with tax benefits similar to investment companies. They don't pay corporate income tax; only dividends are taxed, avoiding double taxation. To qualify, a REIT must:

• Distribute at least 90% of taxable net income as dividends or buybacks.

• Have at least 75% of its assets in real estate.

• Generate at least 75% of gross income from real estate.

• Ensure no more than 50% of shares are owned by five or fewer individuals.

Developed in the 1960s, REITs provide investors with a liquid way to own property. About 80% of REITs are Equity REITs, and 20% are Mortgage REITs.

Real Estate as an Asset Class

The three key attributes of real estate as an asset class are:

• Attractive and Stable Cash Flows: Real estate provides a combination of income return and capital appreciation. Historically, it has shown capital growth slightly higher than inflation. For example, from 1948 to 2004, the annual capital appreciation in the US was about 5.8%, with an average inflation rate of 3.9%, resulting in a real appreciation of around 1.9% per year.

• Diversification: The real estate market is less efficient, less liquid, and less transparent than the stock market, making portfolio management skills more impactful. Direct real estate investments have low correlations with equity (0.2 to 0.4) and bond returns (-0.1 to -0.2). Adding real estate to a multi-asset portfolio can improve its risk-adjusted returns by increasing returns per unit of volatility.

• Inflation Hedging: Real estate is often seen as a real asset that offers protection from rising inflation because rental agreements are usually linked to the consumer price index or other inflation measures.

Listed REITs have a higher correlation with equities (0.7 to 0.9) and a negative correlation with bonds (-0.3 to -0.4). This means listed real estate behaves similarly to stocks. Therefore, REITs should be treated as one of many equity sectors, not as a substitute for private real estate investments.

(Source: Real Estate Primer)