Level 1 CFA® Exam:
Real Estate
Real estate investments include investing in:
- residential real estate, and
- commercial real estate.
Residential properties include single-family homes and multi-family properties. They are mainly used as dwellings for families and singles.
Commercial real estate can be divided into office properties, industrial and warehouse properties, retail properties, and hotel properties. Also, parking lots and restaurants are properties to be invested in. Moreover, single-family homes and multi-family properties held by investors to collect rent or lease should be classified as commercial real estate.
Key motivation for investing in real estate is long-term return arising from the increasing value of the real estate and the income from rent. Additionally, investment in real estate can be linked with the benefits of diversification. The returns on real estate are not perfectly correlated with returns on other assets such as stocks or bonds. Last but not least, a real estate investment protects you from the effects of inflation thanks to adjusting the rent to changes in prices.
The basic classification of real estate investments divides them into:
- public (indirect), and
- private (direct) investments.
Direct real estate investments are generally larger in value than indirect ones due to low liquidity and indivisibility, among other factors. On the other hand, indirect investments make it possible to divide the ownership of an investment. As a result, the components of the investment portfolio are more liquid and the portfolio is more diversified.
How can real estate investments be financed? Such financing may have 2 sources:
- equity, or
- debt.
As far as investments based on equity are concerned, their return is usually generated thanks to the increase in the value of the real estate. The situation looks different in the case of investments based on debt where investors usually receive only a specified rate of return on the capital they invested.
| debt | equity | |
|---|---|---|
| public (indirect) | mortgage-backed securities (MBS), collateralized mortgage obligations (CMO), mortgage REITs | real estate corporation shares, real estate investment trust (REIT) shares, real estate operating company, mutual funds, ETFs |
| private (direct) | mortgages, construction loans, mezzanine debt | sole ownership, joint ventures, limited partnerships, real estate funds, private REITs |
Each of the above-described forms of real estate investments has different characteristics, which translates into differences in rates of return, different levels of risk, or differences in legal matters.
For example, mortgage-backed securities are a type of investment based on debt capital, secured by mortgage loans, and associated with both residential and commercial properties.
REIT is a type of real estate investment trust which mainly invests in and manages real estate assets (its revenues come mainly from the rental income that their properties generate). In many countries, REITs are tax-advantaged, which exempts them from income tax. REITs tend to specialize in investing in specific types of property.
Benefits of REITs
The basic benefits of REITs include:
(...)
To grasp the essence of real estate investments, we need to be familiar with their characteristics. We should discuss the characteristics of private real estate investments which distinguish them from other types of assets. These include:
- heterogeneity, which means that there are no two identical assets in terms of location, size, rental terms, etc. Unlike many types of assets, real estate is therefore heterogeneous.
- a high unit value which to some extent results from indivisibility. The unit value of a real property is relatively high compared to other assets such as stocks or bonds.
- real property is management intensive, which is to say that it takes much effort and resources to ensure the ongoing management of a given property. It includes, among other things, negotiating leases, collecting rent, or maintenance.
- high transaction costs that are associated with the need to involve a large number of people in the purchase and sale of real estate. These people include appraisers, lawyers, tax consultants, and engineers.
- depreciation, which translates into a decline in the property’s attractiveness for investors. Buildings are subject to depreciation over time.
- high costs of buying a property, which often requires obtaining external funding (debt capital). The value of real estate is usually negatively correlated with the level of interest rates. This means that when the cost of debt capital increases, both demand and the price of property decrease.
- lack of liquidity, which is associated with the characteristics we’ve already discussed. The real estate belongs to non-liquid assets and selling it is a long and demanding process.
- difficulty in determining the price for a property, which is a consequence of heterogeneity and the lack of liquidity. As a result, the real estate market is less efficient. Property valuations should be performed by experienced appraisers.
You should be aware that investments in real estate also involve a particular level of risk.
Investors using equity capital generally expect a higher return on investment than investors using debt capital. This is because of a greater level of risk. Note, however, that the level of risk depends primarily on the type and purpose of a given property.
The major categories of risk involved in investments in commercial real estate include:
(...)
- Real estate investments include investing in residential real estate and commercial real estate.
- Residential properties include single-family homes and multi-family properties.
- Commercial real estate can be divided into office properties, industrial and warehouse properties, retail properties, hotel properties, parking lots, and restaurants.
- Key motivation for investing in real estate is long-term return arising from the increasing value of the real estate and the income from rent.
- The basic classification of real estate investments divides them into public (indirect) and private (direct) investments.
- Direct real estate investments are generally larger in value than indirect ones due to low liquidity and indivisibility, among other factors.
- REIT is a type of real estate investment trust which mainly invests in and manages real estate assets.