It is hard to write an article about real estate as an asset class, because it can mean so many different things.
To most people, their real estate holding is limited to the house they live in. This might be both the largest part of their portfolio and the most illiquid. Counting the house you live in as part of your portfolio isn’t advised as it isn’t a quick or painless process (or even practical in some cases).
However, real estate investments can come in so many other forms, and this article will try and provide an overview of what some of those are. As with the case of the fixed income article, this 101 is just a staging point to go and read up more on the individual classes.
Residential Real Estate
This is when you buy up housing in the form of individual houses, condos, apartments and so on and look to rent them out or to improve and flip them. You might take on a loan or you might(in the case of a flip) use the sale of one to fund the purchase of the next. While it looks like an attractive option, it comes with significant risks and overheads.
First, the investment thesis around these purchases come with expectations around rental yields and asset growth rates. Yields are largely steady and people consider them to be so, but they are sensitive to major events like a pandemic or a recession. In those conditions, society itself changes. An example would be to look at New York rents when work started becoming remote. Suddenly, your expectation of being able to pay off mortgages using your rental also disappears.
Growth rates are also difficult to forecast for similar reasons. Two neighborhoods might start off equal and end up with very different valuations in ten years.
Finally, renting, maintaining, improving and trading real estate is a time-intensive activity. While trading a stock can be done on your phone in a spare minute, these activities will require you to plan your life around them. Its hard enough as a local, but building any real diversification around them require you to build a portfolio involving multiple locations.
Commercial Real Estate
Similar to residential real estate in many of its characteristics, but with some significant differences.
Firstly, commercial real estate is usually skewed to offer higher rental yields. This is offset by the fact that it is also more likely to result in churn and vacancies. Shops and business often close down in unison. People typically move due to their individual circumstances.
Also, depending on the space, you’re constrained to certain types of occupants - shopfronts are different from restaurants or office spaces.
The complications of scouting and managing these opportunities make these a tool for the dedicated or the rich.
REITs
Real Estate Investment Trusts are vehicles that pool in investor money to buy real estate assets and then manage the whole process of leasing them out and maintaining them.
They offer both convenience and diversification, at the cost of reduced yield caused by management fees.
They allow investors to start off with smaller amounts of money, are often diversified in both location and tenant profile, and offer steady income streams.
Depending on the taxation treatment in your geography, these can be even more valuable to you - REITs pay no corporation tax, the dividend income they distribute can have clauses that further reduce your tax liability.
An interesting sub-class of REITs are trusts that own and operate infrastructure such as roads, bridges, energy pipelines, etc.
REITs are often listed on exchanges and allow for easy liquidity in creating and closing positions.
Fractional Ownership
Falling somewhere between owning real estate outright and owning it virtually through a REIT is the concept of fractional ownership. Consider a new mall or office space. Rather than owning a floor or a shop, you can own a specific amount of square feet or meters. Rental income is pooled and distributed proportional to the holding.
The difference between doing this versus a REIT is that you are often tied into a specific floor or a type of unit and often have a contract that states this as well as other terms and conditions.
In investment terms, this is a contractual instrument while a buying into a REIT would likely be via a fungible instrument. Fungibles are more liquid and have simpler and cleaner contracts.
When is this a better option? When you have an opinion on a specific named asset versus the broader pool that a REIT might invest in.
These are the most common direct options you have in investing in real estate. Over time, we’ll dig deeper into some of them.